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.
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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