To give you a sense of the insanity, ask yourself the following question: Would you park your money in US Treasury bonds at 1.74%, Italian bonds yielding 1.06%, or Greek bonds yielding 1.21%? We sit in a dysfunctional period in time. My two cents: A sovereign debt crisis awaits. The ECB (European Central Bank) now owns 40% of the Eurozone’s government bonds. Can they avert a crisis? Depends on whether Italy, Portugal, or Spain exits. But, when and to what magnitude, I have no idea. Risk? Elevated.

So, the hope is that interest rate manipulation will depress currencies to boost trade and that the growth it creates will lift the economy. That’s the idea anyway. However, lower-to-negative rates have not helped Germany or Japan lift their economies so far.

Yields around the world look like this:

 

 

Instead of restructuring worsening policies, the ECB is searching for a scapegoat. Christine Lagarde blamed EU member states for not spending more to stimulate the European economy. “Why not use that budget surplus and invest in infrastructure? Why not invest in education, and why not invest in innovation?” Lagarde questioned. Lagarde will be appointed as ECB president this Friday and seems poised to carry out much of the same policies as Mario Draghi.

Which brings us back to the root cause of the global economic illness: debt. For countries, creditable academic research says stress begins when the debt-to-income ratio exceeds 90%.

Today, the global landscape looks like this:

 

If 90% is that stress threshold, what on God’s green earth does 325.8% in the US, 457.7% in the Eurozone, or 595.8% in Japan do to us?

Ray Dalio says the national debt, pension liabilities, and healthcare liabilities will ultimately have to result in higher taxes.

 

Good News For The Markets
  • The October employment report exceeded economists’ expectations.
  • The core PCE (Personal Consumption Expenditures) inflation, the Fed’s preferred measure, was in line with market expectations (1.7%).
  • The Fed’s QE is still on, pumping money into this market advance.

 

Bad News For The Markets
  • The October ISM Manufacturing PMI ticked up, but the increase was softer than the market was expecting. Manufacturing is weak in the world economies, too.
  • Capital goods orders remain soft, which is an indication of weak business investment.
  • US auto sales continue to drift lower.
  • The Fed is sidelined.
  • Hong Kong and German economies are in recession.
  • UBS expects slower corporate earnings growth next year, especially for the Eurozone and emerging markets.
  • The Cass Freight Index is the most comprehensive, high-frequency indicator of this. It tends to lead the economy by a few quarters but has signaled almost every economic turning point. So, the fact its year-over-year change has been negative every single month since December 2018 is more than a little concerning.

 

The One Question About The Current Market

With the market breaking out to all-time highs, the media has started to, once again, reach for their party hats as headlines suggest clear sailing for investors ahead.

After all, why not?

  • The Federal Reserve cut rates for the third time this year.
  • The Fed is also back in the Quantitative Easing (QE) game of buying bonds.
  • President Trump has “surrendered” to China in order to end the “trade war.”
  • Corporate stock buybacks are on track for the second largest year on record.
  • Earnings, due to buybacks, are beating lowered estimates.
  • Consumer sentiment remains near record highs.
  • Economic data is weak, but not terrible.

The Bull Case For S&P 3300

  • Momentum
  • Stock Buybacks
  • Fed Rate Cuts
  • Stoppage of QT
  • China Trade Deal
  • They want to believe the trade talks between the US and China will be real this time.
  • They want to believe there is no “earnings recession” even though S&P profits through the first half of 2019 are slightly negative (year over year), and S&P EPS estimates have been regularly reduced as the year has progressed.
  • They want to believe stocks are cheap relative to bonds even though there is little natural price discovery as central banks are artificially impacting global credit markets, and passive investing is artificially buoying equities.
  • They want to believe technicals and price are truth – even though the market’s materially influenced by risk parity and other products and strategies that exaggerates daily and weekly price moves.
  • They want to believe today’s economic data is an “all clear” – forgetting the weak ISM, the lackluster auto and housing markets, the US manufacturing recession, and the continued overseas economic weakness.
  • They want to believe, given no US corporate profit growth, valuations can continue to expand (after rising by more than three PEs year to date).
  • They want to believe though the EU broadly has negative interest rates, and Germany is approaching recession (while the peripheral countries are in recession) – the Fed will be able to catalyze domestic economic growth through more rate cuts.
  • They want to believe the US can be an oasis of growth, even though the economic world is increasingly flat and interconnected, and the S&P is nearly 50% dependent on non-US economies.

Here is CNN’s Fear & Greed Index:

 

 

With cash levels at the lowest level since 1997 and equity allocations near the highest levels since 1999 and 2007, it suggests investors are now functionally “all in.”

Poor or deteriorating market fundamentals, excessive valuations, and/or rising credit risk is often ignored as prices increase.

Which brings us to the ONE question everyone should be asking:

“If the markets are rising because of expectations of improving economic conditions and earnings, then why are Central Banks pumping liquidity like crazy?”

Despite the best of intentions, Central Bank interventions, while boosting asset prices (stock markets) may seem like a good idea in the short-term, but in the long-term it harms economic growth. As such, it leads to the repetitive cycle of monetary policy.

  1. Using monetary policy to drag forward future consumption leaves a larger void in the future that must be continually refilled.
  2. Monetary policy does not create self-sustaining economic growth; therefore, it requires ever-larger amounts of monetary policy to maintain the same level of activity.
  3. The filling of the “gap” between fundamentals and reality leads to consumer contraction and, ultimately, a recession as economic activity recedes.
  4. Job losses rise, wealth effect diminishes, and real wealth is destroyed.
  5. The middle-class shrinks further.
  6. Central banks act to provide more liquidity to offset recessionary drag and restart economic growth by dragging forward future consumption.
  7. Wash, rinse, and repeat.

If you don’t believe me, here is the evidence:

The stock market has returned more than 100% since the 2007 peak, which is more than 2.5 times the growth in corporate sales and almost 5 times more than GDP. The all-time highs in the stock market have been driven by the $4 trillion increase in the Fed’s balance sheet, hundreds of billions in stock buybacks, PE expansion, and ZIRP (Zero Interest Rate Policy).

 

 

What could possibly go wrong?

However, whenever there is a discussion of valuations, it is invariably stated “low rates justify higher valuations.” 

Maybe.

But, the argument suggests rates are low because the economy is healthy and operating near full capacity.

The reality is quite different.

The main contributors to the illusion of permanent prosperity have been a combination of artificial and cyclical factors. Low interest rates, when growth is low, suggests that no valuation premium is “justified.”

Currently, investors are taking on excessive risk, and thereby virtually guaranteeing future losses, by paying the highest S&P 500 price/revenue ratio in history and the highest median price/revenue ratio in history across S&P 500 component stocks.

 

 

 

There are virtually no measures of valuation, which suggest making investments today, and holding them for the next 20-30 years, will work to any great degree.

That is just the math.

S&P 500 valuations (based on the NTM EPS consensus), while not unreasonable (17.5x), are at the highest level since the vol blowup in early 2018.

The spread between the Conference Board’s and the U. Michigan’s present-conditions sentiment indices signals that we are in the late phase of the economic cycle.

 

 

The markets are indeed bullish by all measures. From a trading perspective, holding risk will likely pay off in the short-term. However, over the long-term, the “house will win” and Buy and Hold strategies will lose. Our strategy should do very well with the coming volatility.

 

Gold

Central banks have been buying gold at a rapid pace. Russia has expanded its gold holdings by nearly 120 tons this year alone, and the pace of gold buying in China has also quickened this year.

 

 

Gold has a reputation for being a safe place to hold wealth when economic confidence begins to slip. The huge purchases we’ve seen this year from some of the world’s biggest monetary authorities likely reflect a growing bearishness on the global economy, and many investors believe that a move into precious metals also shows a weakened outlook on currencies. The US dollar is one of the major assets held in reserve by global central banks. So, a larger holding of gold could be a sign that foreign governments are also bearish on the longer-term outlook for the US dollar.

 

The “ETF Effect” On The Markets

The meaninglessness of quarters must not be lost on you. On Monday, we had a host of companies whose stocks went nuts despite the fact that as recently as a couple of weeks ago — or even a few days ago — they reported widely panned numbers. Take Caterpillar (CAT). When CAT reported, it was plum ugly. The great machinery maker cut its forecast and told a pretty darned negative story about the world. The stock was looking down six to $129 and change at 8:15 a.m. ET, and there was no sign that it could possibly be bottoming.

Freefall.

Now, it’s at $146 and breaking out as if the quarter were a fantastic one. It was anything but. The best thing you got was a commitment to the dividend and the buyback.

Or, take Union Pacific (UNP). Its stock got slugged when it reported weaker carloads and weaker earnings, and I thought gave a pretty downbeat forecast. It stung: This is a fabulous railroad, but it could be considered hostage to China, coal and oil, all softer end markets.

It just went up twelve points in two days on no news at all.

And then there’s Federal Express (FDX), which doesn’t report for a while but with a stock that rallied eight points in one session completely out of nowhere. Based on what? Trade rumors? Oh, please. Nothing’s happening even if the Phase One of talks go well. China’s slowing regardless. Who really knows how FedEx is really doing?

Oh, and it’s not just transports. Chevron (CVX) reported an extremely light quarter Friday, both top and bottom line. You can see why it needed Anadarko Petroleum (APC) as much as Occidental Petroleum (OXY). It needed to buy some growth. It should have sold off on that disappointing quarter, and it ultimately did fall a couple of bucks in pre-market trading. Then, it flatlined back at the previous close. Yesterday, it rallied five dollars and thirty-six cents. Make sense to you? It shouldn’t. It was all some sort of strong economy buy program.

I wish I could tell you how all of this can happen. The un-inverted yield curve? Some good trade talk chatter? A better overall tone to earnings? A weaker dollar?

But, I can’t.

In fact, I will go one step further. This is a rally based on vicious ETF buying where there aren’t enough sellers materializing. These ETFs suck the liquidity out of the market.

 

No Deal With China

Adding to the world’s slow-growth challenges is the burgeoning realization that China may not be a good partner, due to intellectual property theft and global ambitions that clash with a free world’s ideology.

US Secretary of State Mike Pompeo said China’s communist policies are incompatible with US democracy. “We accommodated and encouraged China’s rise for decades—even at the expense of American values, and security, and good sense. We did everything we could to accommodate China’s rise, in the hope that Communist China would become more free, market-driven, and ultimately, hopefully, more democratic,” Pompeo stated. “It is no longer realistic to ignore the fundamental differences between our two systems.”

Bottom line: While optimistic China trade tweets fill the ether, there will be no deal of substance. Global supply chains are shifting—and will continue to do so—as the US and its free-world allies stop ignoring the differences between true democracy and authoritarian-dictatorship rule. It takes time for businesses to move away from a revenue stream, and it takes time to reroute supply chains. Add this to the slowing global growth pressures.

 

Debt

Japan now has an astounding government debt-to-GDP ratio of around 240% – by far the highest level of any developed country in the world. (For perspective, the US has a government debt-to-GDP ratio of 103%.)

Conventional wisdom holds that Japan has long been bankrupt and is “monetizing” its debt. This should have caused the Japanese yen to collapse and rates to skyrocket.

Yet, the yield on 10-year JGBs went negative for much of 2016. It was no anomaly, either. The interest rates on 10-year JGBs have been negative for much of this year, as well.

Basically, a government that issues a fiat currency can borrow as much as it wants as long as some slack exists in the economy. Big budget deficits aren’t an issue until inflation rises, which signals that the government has reached its debt capacity.

 

 

However, as the chart shows, the budget deficit is now equal to 4.6% of U.S. GDP. This is an unprecedented deficit outside of a recession (or post-recession period).

Deficits of 5% or more will become common, and you should prepare yourself for a 10% budget deficit if there should even be a mild recession.

The point is, no matter who’s in office, outsized federal budget deficits are here to stay.

Fiscal austerity is dead, and the U.S. federal debt will continue its upward spiral.

 

S&P Profits

Are equity markets recognizing the decline in profits for corporations?  The chart below shows the SPX rising despite flat national corporate profits since 2013, with a huge divergence emerging in the past four years. The SPX soaring to new heights tells us that stock market complacency is at record levels in appraising stock valuations versus actual corporate profits. The chart below shows how wide the gap has become which is about twice the gap size just before the Dotcom decline into 2002 from a peak in 2000.

 

 

Business Leaders Remain Gloomy Duke University conducts a quarterly business optimism survey of Chief Financial Officers (CFO) at 225 US firms. In the latest survey, 53% of those that responded believed that the US will be in a recession by Q3 2020 and 67% predicted a recession by the end of 2020.

 

 

This chart shows optimism for the US economy from business leaders has steadily slipped for four straight quarters. The index now sits at its lowest level in three years. This is important, as CFOs control the purse strings of a company. If they are not confident in the direction the economy is headed, they may cut back or delay spending on things like investing in their business and hiring new workers. Those actions alone could bring on an economic slowdown; the outlook becomes self-fulfilling. There is ample evidence that links recessions to investor and consumer psychology. When the social mood swings to worry and anxiety about the future, the change in our collective behavior can push the economy into recession. The anxiety level of CFOs is on the rise.

 

Market Data
  • Sentiment has been improving rapidly and is registering some of the most extreme readings in five years. The spread between Smart and Dumb Money Confidence is now at worrying levels.
  • Public pension funds have been adding to their stock allocation, raising it significantly over the past year. They’ve also dropped their allocation to cash, so their exposure to a downturn is among the highest in history.