Last Call

The markets always provide an education. The month of October has been a challenging one personally speaking. We went in with a long bias but gave up those early gains as we started to fade the rally and are now tilted towards a short bias as the market goes higher. We are sticking with our position until further data confirms that we are on the wrong side of the trade.

It appears that the market hasn’t fully weaned off the elixir of the past several years that is Fed driven. The Fed has in essence held off on raising interest rates fully admitting that the U.S. economy isn’t strong enough to withstand a twenty five basis point increase off of zero interest rate policy conditions.  To have the market rally off of such news is indeed curious market action.

A recent article by Jon Hilsenrath of the Wall Street Journal (via Business Insider) indicates that chances of Fed action this year are quickly deteriorating. “Hilsenrath says after jobs, consumer spending and inflation data this month, the chances of a rate hike this month have been “virtually eliminated”. That accords with market price approximating around a 5% chance of a hike.

As a consequence, the focus has turned to the final FOMC meeting of the year with market pricing around a 30% chance of a rate hike. But Hilsenrath suggests even that might be too much, given that vice-chair Stanley Fischer’s much-heralded recovery in growth after the first quarter’s weakness does not appear to be materialising.

“Fed officials have given up on expectations that growth would accelerate in 2015, as they hoped would happen at the beginning of the year,” Hilsenrath wrote. “Their hope now is that a healthy domestic economy can withstand slowing overseas economies and turbulent financial markets and keep growing at a fast enough pace to modestly reduce unemployment further.””

Then we had Federal Reserve Governor Lael Brainard come out specifically questioning Fed policy and future inflation expectations. To have a Fed Governor come out in this way is unique. In her policy speech to the National Association of Business Economists she openly questioned the merits of the Fed’s inflation expectations and its assumptions on the labor recovery. She also questioned the ability for the Fed to react too quickly to stem off inflationary pressures. On his blog Tim Duy's Fed Watch, he wrote an excellent piece comparing the views of Yellen v. Brainard.

And just a day later Fed Governor Daniel Tarullo told CNBC that it wouldn’t be appropriate for the Fed to raise rates this year. This past week saw several market experts come out and reveal their insight on the Treasury market. Gary Shilling warned that he believed 30 year Treasury bonds would fall to 2%.  Komal Sri-Kumar has called for the 10 year yield to drop to 1.5%.

The stock market continued its ascent throughout the week of Fed-speak but I for one am questioning the logic of the rise. With the Fed basically admitting the global – U.S. economic picture is softening confirmed by meek employment, soft wage growth and disappointing retail sales data one would think the market would interpret this as bad news. Certainly other areas of the capital markets are providing warnings, just not stocks.

Warnings

The U.S. Treasury market is increasingly telling us that risk appetite appears lacking. The 10-year treasury yield briefly dipped below 2% in October but more shocking was the sale of three month Treasuries with a zero yield. From Business Insider, “The US Treasury was able to sell $21 billion of six-month bills at a minuscule yield of 0.065%.

It also auctioned off $21 billion in three-month bills. Each dollar of the bills offered got chased by $4.14 in bids – the highest bid-to-cover ratio since June 22 when China was in full-crash mode. With buyers jostling for position to grab whatever they could, these bills sold at a yield of zero for the first time in history.

Even more liquid one-month bills have sold at zero yield in five of the six most recent auctions. And in the secondary market, some bills have traded at slightly negative yields for a while; investors who hold these bills to maturity end up with a guaranteed loss, the price they’re willing to pay to keep their money save and liquid.

But this was the first time for the Treasury to sell three-month bills at zero yield.”  

Not exactly a high sign of economic confidence. High yield spreads are also concerning.

Business Insider, “Surging borrowing costs for companies with speculative-grade credit ratings have some market watchers warning that the US economy is heading into a recession.

The debt issued by these companies — also know [sic] as high-yield bonds or junk bonds — have experienced a surge in spreads. In other words, the interest rates these companies are paying to finance their operations are spiking, making it more challenging to refinance while pushing more companies toward default.

While much of the pain is occurring in the high-yield energy bond market, it nevertheless signals tighter financial conditions are coming.

"This is not just an energy story, but a broader conversation about the credit cycle and our place in it," UBS's Steven Caprio said.

Caprio thinks the US economy is heading for a period of tighter, more expensive money. He observed that what happens in nonbank lending markets, like the bond markets, leads what happens in bank lending.

He homed in on a segment of the junk-bond market.

"Our analysis suggests it is actually the lowest of low quality issuers (B-rated and below) that provides the first leading signal that credit stress may lie ahead, as Figure 3 illustrates," Caprio wrote. "Worryingly, this chart is flashing red. While BB net issuance has held in quite well, B-rated and lower net issuance has plunged in a replay of late 2007, as investors cut back in the face of growing default risk and rising illiquidity."”

“"In sum, we believe that non-bank lending standards illustrate an overall tightness in US financial conditions that signal a downside growth risk to the US economy," Caprio said. "While bank lending standards are healthy, we ultimately believe this misdiagnoses the pulse of the corporate credit cycle. Nearly all of the additional financing provided to nonfinancial corporates has come from non-bank sources, post-crisis. And expecting the banking system to meaningfully pick up the baton from a non- bank slowdown is unrealistic in today's highly regulated environment. In short, non-bank liquidity has been the main driver of the corporate credit cycle post-crisis, and there are now early signs that it is evaporating."”

Low Quality Rally

I was watching CNBC one morning and a guest made a point that the worst performing stocks of the past year were leading the October rally. Indeed Materials, Energy and Industrials – the market laggards of months past had led the surge higher in October.

From MarketWatch, “The recent bounce back in the S&P 500’s weakest sectors is looking like a “bear trap,” according to James Paulsen, chief investment strategist and economist at Wells Fargo Capital Management, in a recent interview.

“Think about how the bull rally was led by growth in health care, tech and consumer discretionary,” Paulsen said. “Now piece by piece it is all been peeled away. It looks more like a bear rally, led by the weakest sectors.””

Manufacturing is a Mess

Data from Business Insider conclude, “On Thursday, regional manufacturing reports for October showed very slight improvement but made clear that the sector is in contraction. In September, all seven regional manufacturing purchasing manager's indexes fell into contractionary territory.

 

The Empire State manufacturing index from the New York Federal Reserve for October was -11.36, improved from -14.67 in September, but still indicating contraction in the New York region. The Philly Fed's index came in at -4.5 for the month, also an improvement from September's reading but still pointing to a deceleration in manufacturing activity.

And the details of the latest regional indexes paint an even bleaker picture than the headlines, according to Pantheon Macroeconomics' Ian Shepherdson.

For instance, new orders in the Philly Fed's index fell to -10.6 from +9.4, the lowest since June 2012. Employment plunged to -1.7 from 10.2. And, shipments tumbled to -6.1 from 14.8.

Shepherdson wrote, "In short, a grim [Philly Fed] report, but it can be argued that the weakness in the sub-indexes represents something of a catch-up after overshooting relative to national ISM manufacturing index."”

“In a note to clients last week, Renaissance Macro's Neil Dutta highlighted that in recent months, manufacturing inventories have run ahead of sales. And in the most recent national manufacturing PMI report, the share of survey respondents who said inventories were "too high" exceeded those who said they were "too low."”

While the manufacturing sector of the economy is smaller relative to consumer spending, it does carry heavy implications for the stock market. As Seeking Alpha points out, “As you can see in the chart[s below], a meltdown of this size or greater in manufacturing has led both a recession in the economy and a decline in the S&P 500 by 30-50% over the next two years. In other words, we need to be very cautious in the coming months. If manufacturing is able to stage a recovery, then I believe that we will be "out of the woods". However, as the economy continues to slow, we need to be vigilant to ensure that we are either out of the market, hedged, or outright short to profit from the slowdown.”

 

 

Oddities

There are a few other tidbits of information that I stumbled upon during my weekly readings. These are items that I don’t typically track but I thought they were interesting enough to mention.

Black swan risk rises to highest level ever – CNBC: “Investors fear a "black swan" catastrophic event in the financial markets right now more than ever before. At least according to the CBOE Skew Index, which measures the prices of far out-of-the-money options on the S&P 500. Its goal is to determine the benchmark's tail risk or the "risk of outlier returns two or more standard deviations below the mean," according to the CBOE website. Put simply, traders are buying options that pay off only if the stock market drops a whole lot.”

 

Dividends: U.S. Economy Back in Contraction in September 2015 – Political Calculations

U.S. Consumer Driven Growth

While it is way too early to start drawing solid conclusions from 3Q15 earnings season I would like to point out one early trend that I will be watching as the quarter progresses – Consumer Discretionary earnings results. According to research at Factset 9 out of 10 earnings pre-announcements – that is guidance on coming quarters has been negative. That appears to be running higher than normal but what strikes me are the early negative preannouncements in the Consumer Discretionary sector. Given that our economy seems to be resting on the strength of the consumer these early signs are not good. Four of the nine negative preannouncements were from that sector.

I probably wouldn’t have even noticed it if not for the complete earnings debacle that Walmart announced last week. The bomb from Walmart (via Business Insider), “Walmart shares had their biggest intra-day drop since 1988, falling by as much as 10%, after the company cut its forecast for profits over the next two years. As it held its investor day, the world's largest retailer forecast an earnings decline of 6% to 12% in 2017. The reason? Higher wages. "Operating income is expected to be impacted by approximately $1.5 billion from the second phase of our previously announced investments in wages and training as well as our commitment to further developing a seamless customer experience," CFO Charles Holley said in a statement. And Walmart CEO Doug McMillon gave some color on the economy, in a CNBC interview. He shrugged when asked how the US economy was doing. "It's steady. It's OK," he said. He added, however, that back-to-school sales were "pretty good". On why consumers aren't splurging savings from lower gas prices, he said they had debt and other issues to deal with.” 

Technically Challenged

The S&P 500 appears to be short term over-bought and is nearing a key resistance level. We will be continuing to sell into the rally unless proven otherwise from the market data we collect.

Bottom Line:

The Global economy is in deceleration – negative.

The U.S. economy is slowing – negative.

Both of the above points have been confirmed by the Fed – negative.

Treasury yields point to risk aversion – negative.

The latest stock market rally is led by the weakest of sectors – negative.

U.S. manufacturing has entered a recession – negative.

Corporate earnings and revenues are contracting – negative.

Consumer Discretionary sector earnings appears to be slowing – negative.

The stock market is still technically challenged – negative.

Given these assumptions we find it hard to get excited about the latest stock market rally. We will continue to assume a downward bias until the data dictates a change in our investment thesis. This rally reminds me of the last call at a cocktail party and the few remaining guests are ordering one last round before its time to leave.

 

 

 

Joseph S. Kalinowski, CFA

 

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