Monday, December 14, 2015

Four Red Flags to Watch for in 2016


I’m going to take this opportunity to highlight what I believe are four red flags heading in to 2016 as it pertains to the stock market.

Red Flag #1 – High Yield Market

Last week there was quite a bit of news regarding yield spreads, in particular high yield spreads and market implications. On CNBC Carl Icahn said, “The high-yield market is just a keg of dynamite that sooner or later will blow up” They reported, “High-yield funds look perilous because "there's no liquidity" behind them, Icahn contended. He voiced similar criticism of BlackRock this summer, saying some of its bond funds create an "extremely dangerous situation."”

These statements come on the heels of an announcement by Third Avenue Management that they will block redemptions from their credit mutual fund due to liquidity concerns. According to a BloombergBusiness article, “As signs of stress mount in credit markets, a $788 million mutual fund is blocking clients from pulling their money so its holdings can be liquidated in an orderly fashion.

Martin Whitman’s Third Avenue Management put some of the assets in the Third Avenue Focused Credit Fund in a liquidating trust that will seek to sell them over time, the New York-based firm said in a statement on its website dated Dec. 9.

Investors will receive interests in the trust on or about Dec. 16. Any cash that isn’t required for the fund’s expenses and its liquidation will be returned that day.

The step is unusual for a mutual fund, which typically offers daily liquidity to investors, and comes after regulators raised concerns that some mutual funds are investing in assets that could be hard to sell in a market rout. David Barse, Third Avenue’s chief executive officer, said blocking redemptions was necessary to avoid fire sales. The fund, which had $3.5 billion in assets as recently as July of last year, suffered almost $1 billion in redemptions this year through November.”

Swift Energy missed an $8.9 million interest payment last week and that has marked the 102nd global high yield default this year. The last time we saw defaults of this magnitude was back in 2009, according to Standard & Poor’s. Watershed Asset Management recently announced it was returning investor capital due to the lack of buying opportunities in the distressed debt market. According to Edward Altman, the finance professor who invented a widely-used formula that predicts defaults (via The Telegraph), “Defaults, which were running at 2.1pc last year, have inched up to 2.6pc so far in 2015. Worse, they could jump to 4.6pc next year…that doesn’t sound like a huge leap but the 30-year average is 3.8pc and hasn’t been breached since 2009, in the immediate aftermath of the credit crunch.”

S&P issued 224 high yield upgrades YTD and 450 high yield downgrades.  This up/down ratio of 0.50 for 2015 is the lowest seen since 2008-2009. What’s worse is we expect this number to further deteriorate as the up/down historical ratings action by S&P is only 0.29 for 4Q15. This is an extremely low “crisis-like” figure only exceeded in the darkest days of the great recession.


Looking at Moody’s data, there are 247 high yield upgrades versus 412 high yield downgrades YTD. Similar to S&P data, this up/down ratio of 0.60 is the worst since 2008-2009 and the figure has dropped precipitously in 4Q15 to 0.24.



According to BofA Merrill Lynch (via Business Insider), “The US economy is changing gears, and some parts of the bond market are feeling the pressure. Bank of America Merrill Lynch's latest update on global financial flows shows US junk bonds, or bonds rated CCC or lower, are now yielding 17% on average, the highest since 2009. That makes it above where it was during the very worst days of the eurozone crisis.”



High yield returns has suffered this year.




I would imagine it will only get worse from here. According to S&P Capital IQ (via Wolf Street), “$3.5 billion in retail cash fled US junk-bond funds during the week ended December 9, S&P Capital IQ LDC reported on Thursday: $2.8 billion of mutual-fund outflows and $637 million of ETF outflows. It was the second largest one-week redemption ever, behind the record $7.1 billion outflow during the week ended August 6, 2014.”

Volatility in the high yield space will continue to exacerbate the wave of redemptions in my opinion. The following chart from Citigroup (via Business Insider) shows that in the pre-Lehman Brothers bankruptcy era, high yield drawdowns as defined by an increase in yields by 100bps or greater over a 90 day period were relatively rare with only four dating back to 2001. There were massive drawdowns during the great recession, but since recovering from that period, these types of drawdowns have been more frequent as seen in the following graphic.  



So why is tracking the high yield market so pertinent to equity performance. The author of The junk bond market's early warning signs are all flashing red for the global economy sums it up in this way. “In the equity markets, for example – where the upside, and therefore returns, are theoretically limitless – avarice often overpowers anxiety. In the bond markets, where investors mostly just want to get back the money they lend to countries or companies (plus interest), it’s the other way round.

This naturally pessimistic streak can be broken down further. Those who lend money to countries are relatively phlegmatic because governments only rarely default on their debts; those who lend to big, credit-worthy companies are a touch more jumpy; those who invest in high-yield (or, depending on how polite you feel, junk) bonds are as skittish as new-born colts.

This high level of risk aversion makes the antennae of junk bond investors particularly sensitive to the danger signals swirling around the financial ether. And that’s particularly pertinent right now because multiple warning signs are flashing in the US high-yield market, which, true to form, is acting as an early warning mechanism for the global economy.”

The figure below shows that when the high yield market and the US stock market are at odds, the likely outcome is high yield investors coming out on top.



But this time it’s different!

Most of the high yield problems are contained within the energy sector and those smaller exploration companies that fueled the fracking revolution in this country through the use of high yield borrowing. That’s what many are saying about the current state of the high yield dilemma.

Horrible supply/demand dynamics means trouble for high yield.

Many are pointing to a major market bottom for the price of crude through the use of long term pricing support levels.  On Dana Lyons' Tumblr he points to the following chart.



The following chart taken from The Short Side of Long also shows oil prices near major support.



While the charts on oil do look to provide near-term support for crude, consider the following:

Last week a divided OPEC decided to maintain production at 31.5 million barrels per day and US production has slowed but remains robust.




The International Energy Agency said that the world’s stockpile of oil sits at a record 3 billion barrels and it has been growing. In the U.S., the EIA reported on Wednesday that crude inventories fell 3.6 million barrels for the week ended Dec. 4. That was more than expected, but at a total of 485.9 million barrels, inventories remain near levels not seen at this time of year in at least the last 80 years, the EIA said.
It appears the Fed will start its tightening cycle later this week. Given our tighter monetary policy along with the worlds easing policy, it will most likely continue to boost the US dollar which will remain a headwind for the price of crude.



So saying the high yield crisis is contained within the energy space may be true, but given the current state of the energy sector and the deteriorating supply/demand dynamic that the sector faces, I don’t believe it is out of the question that this situation will worsen from here and start to infect other areas of the market. As seen in the next graphic from Real Investment Advice, sector distress ratios within the high yield market have been increasing from this time last year.



Red Flag #2 – Interest Rates and the Yield Curve
The futures market now places a 74% chance that the Fed will raise interest rates by 25bp on December 16.



The yield curve, or the spread between the two year and ten year treasury yield has been an excellent predictor of troubled times ahead. When that curve became inverted in the past it usually was an ominous sign for equity investors. Granted that we have witnessed a high degree of interest rate influence by global central bankers and the question has been brought up as to the validity of this model when free market forces are temporarily nudged in different directions. That said it is still a metric that I constantly track and believe its usefulness in investing remains.
With the implication of higher fed funds, the short end of the curve has been heading higher. The following graphic taken from Pension Partners shows the dramatic comparison between one year US treasury yields to that of one year German bunds.



Contrary to the moves on the short end of the curve, investors recently have been rotating into the safe haven long term US treasury which has driven prices higher and pushed longer term yield lower.

This next graphic from stockcharts.com shows that long term US treasuries are breaking significant resistance levels as money is flowing into the iShares Barclay 20 year treasury ETF (TLT).



They write, “The long bond market (TLT) continues to climb higher in price, but today marks a move outside the trend. The long bond is breaking out to the upside and recently crossed above the 200 DMA. We are seeing the other bond ETF's like IEF moving above the 200 DMA. This move to safety is on the back of significant weakness in the commodity market that seems to be extending.”

The result of these two movements in the treasury markets has narrowed the yield curve significantly.




As seen in the next figure, the yield spread differential is not near crisis levels currently. Perhaps in the absence of aggressively accommodative monetary policy this model will see a sudden drop similar to what we have seen this past week.



The argument stands that the US economy is in strong shape and a recession is not seen in the various economic measures compiled and analyzed by the world’s finest economists. Therefore a 25bp increase in the fed funds rate should easily be absorbed. That may be true and certainly I am not here to call a coming recession in the very near term, I don’t see that in the current economic data as well. But the truth is that the world economy is slowing and one can argue that it is contracting. Given the threat of slowing global economic growth, can we be assured that the US economy in its “strong-enough” state can withstand the pressures that surround it?  Lance Roberts from Real Investment Advice summed it up brilliantly, “According to the IMF’s most recent report, world gross domestic product contracted by 4.9% in 2015. The only other time that world GDP has contracted to such a degree was in 1980, starting year of the IMF database, when it fell by 5.9%. The U.S. experienced a recession at that time as well as in 2001 and 2009 which also coincided with global economic declines. Despite many beliefs to the contrary, the U.S. is not an island that can withstand the drag of a global recession.”



“As I stated above, there is currently a belief that the U.S. can remain isolated from the rest of the world. Given the global interconnectedness of the world today, there is little ability for the U.S. to permanently diverge from the rest of the world. As shown below, historically when international and emerging markets have declined, the U.S. has been soon to follow.”



Red Flag #3 – Corporate Earnings Trends

We are entering 4Q15 preannouncement season. I believe we will continue to see earnings contract year-over-year as the strong dollar and weakening global economy provide a strong headwind for earnings. I’ve written in the past that I believe corporate margins are a key thing to watch as we head into 2016. As seen in the graphic below, when corporate margins peak and start to roll the market is already in a downtrend.



Taken from Real Investment Advice, Lance Roberts points out that Peaks in “real” profit margins have always preceded the onset of an economic recession.



We are also aware that much of the growth in profits over the past several quarters and years was the result of financial engineering. I like to look at an earnings quality measure that attempts to differentiate between the cash and accrual part of earnings. By tracking the relationship between net income and cash flow from operations and investing activity, we can view two companies with identical earnings but determine which of the two has higher earnings quality based on how much of the reported earnings are comprised of actual cash into the business.





We then aggregate that up for the entire S&P 500 and track total earnings quality. As can be seen in the graphic below, SPX earnings quality has been deteriorating (although it has improved over the last few quarters). As the earnings picture for 2016 starts to develop, we will certainly be looking for major moves in this metric and seek potential pitfalls in coming quarters. This metric tends to move quite fast.





We also speak extensively on valuation. While it is important to track and decipher appropriate values to be placed on certain parts of the market or the market as a whole it is very difficult to trade based solely on fundamentals. It doesn’t make much of a difference to me if the S&P 500 is trading 10x, 15x, or even 30x expected twelve month forwards earnings…if its trending higher then I’m going to attempt to capture as much of that upside as possible using whatever instruments seem appropriate. It’s a fool’s game to short an upward trending market simply because it appears overvalued based on fundamental metrics. What is very important to me is the confirmation of an upward trending market with upward trending forward earnings estimates.

Based on the figure below, we can see the S&P 500 bouncing strongly from the early 2009 lows and continue decidedly higher with a few hiccups in 2010 and 2011. The corporate earnings trend followed suit. To me that is a healthy fundamental picture and I wouldn’t be so concerned with what multiple the S&P 500 sported on the way up.

Now it’s a different story. Notice how the earnings trend stalled at the start of 2015 and is slowly moving in a downward direction. Based on the current corporate earnings and global economic growth picture it’s hard to imagine that we will start a significant renewed uptrend. Once the trend in forward earnings starts to stall is when I start to look at valuations and we currently believe the market to be almost 20% above fair value. For our full analysis on market value please read Positioning for a Year-End Rally.




Red Flag #4 – SPX Long Term Technical Picture

The long term technical picture for the S&P 500 looks worrisome. We have dropped below the important 20 month moving average; RSI (14) is trending lower as is the MACD (20, 35, and 10). We need to regain the 20 month moving average quickly. If we fail to do so and that moving average starts sloping negative, I think it may be game over for a while.





These are just a few items that I am watching that could lead to unfavorable market results. I don’t know where the S&P 500 will end up next year and much of this analysis may be incorrect. I’m not looking to be right or wrong on the call. I just want to be aware and prepared. Know the potential dangers that arise, recognize the trend and trade accordingly. Better to be overly cautious and preserve profits than be caught off guard and lose a significant portion of wealth.

Bottom Line: We believe there are several indicators that are pointing to a tough and volatile year in 2016. High Yield spreads, interest rates, corporate earnings trends and technical deterioration are on our radar as hints that the market could be heading lower. Will this lead us into a bear market next year? We don’t think that is likely unless the US suffers a recession. While it doesn’t appear that we are heading for one, I also recall at the start of 2000 and 2008 market experts didn’t expect a recession or a bear market then either. I’m not looking to be right or wrong in the call…just aware and prepared.

Joseph S. Kalinowski, CFA

 

Additional Reading

On High Yield

Why the junk bond selloff is getting very scary – MarketWatch

Bad omen: Junk bonds are getting trashed – USA Today

What Are Negative Junk Bond Returns Telling Us? – Barron’s

On Oil Prices

IEA Warning Drives Crude Oil into 2009 Lows - FXEmpire

4 reasons crude-oil prices are in a nasty death spiral—again - MarketWatch

On the Fed

The Fed’s Painted Itself Into The Most Dangerous Corner In History - Why There Will Soon Be A Riot In The Casino – Daily Reckoning

 

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