January was a challenging month but we stuck to our trading
thesis and produced a +5% return in the portfolio for the month. As we have
written, we were short the market in the early part of January and then went to
cash waiting for a rally day and a follow through before deploying money on the
long side. We considered Wednesday January 20 a nice capitulation day as the
SPX fell hard to near its 200 day moving average and recovered quickly from
that level. The next day the market was up and on January 22 there was
additional strength that we bought into.
On Friday we took profits into the strength and while we are
still net long in the portfolio we brought the beta of the portfolio to 1.0 vs.
SPX. We are most likely going to fade
the rally if the stock market continues higher as we are unconvinced that the
lows have been put in place this year. Our plan is to start building cash
should momentum carry us higher and wait for a larger high volume sell-off and
start building shorts again.
A few items that we noticed while trading confirms our
thesis that more downside is likely. First the velocity of gains in the SPX
when compared to several technical indicators doesn’t seem right. We have
written in the past that this latest sell-off didn’t come with a level of panic
seen in other such moves (read Trading
Thesis for 2016 - Initial Thoughts). We are seeing a lack of excitement
during this brief rally we have seen. Many oscillating metrics such as RSI and
Stochastics are already approaching “over-bought” levels and truthfully the SPX
hasn’t really moved all that much. We suspect the pattern of lower highs and
lower lows will remain intact.
On Thursday the S&P 500 moved higher but that was
largely due to the influence of the rally in Facebook (FB) shares after a
blow-out quarter. Looking at the S&P 500 on an equal weight basis, we would
have been down that day. Granted the huge earnings miss by Amazon (AMZN) didn’t
crush the market on Friday and we have been reading the rally on Friday could
have been caused by a bout of portfolio rebalancing that day as constant mix
portfolios probably hit thresholds to justify equity purchases. Through
Thursday the SPX was down over 7% for January while long-term Treasuries as
measured by TLT was up 3.5% and investment grade bonds as measured by AGG were
up almost 1% for January. We suppose that could be the case except both TLT and
AGG rallied higher that day so perhaps the rebalancing came from another asset
class.
Lance Roberts from Real Investment Advice elaborated on the
January weakness. He writes, “It would
seem logical that a weak performance in January would lead to some recovery in
February. Markets are oversold, sentiment is bearish and February is still
within the seasonally strong 6-months of the year. Makes sense.
Unfortunately, the historical data suggests that this will likely not
be the case. The chart below is
the historical point gain/loss for January and February back to 1957. Since 1957, there have been 20 January
months that have posted negative returns or 33% of the time.”
“February has followed those 20 losing January months by posting gains
5-times and declining 14-times. In other words, with January likely to
close out the month in negative territory,
there is a 70% chance that February will decline also.
The high degree of
risk of further declines in February would likely result in a confirmation of
the bear market. This is not a market to be trifled with. Caution is advised.”
Market Volatility
We came across this interesting piece in Dana
Lyons' Tumblr, “Through today, there
have been 17 trading days in January. Based on the Dow Jones Industrial Average
(DJIA), 12 of them have seen moves of at least 1%, up or down. At 71%, this
marks the highest percentage of January days seeing moves of at least 1% in
history…we took a look at all January’s over the past 100 years that exhibited
a high level of volatility, as measured by an elevated number of 1% days. Since
71% is unprecedented, we had to relax the parameters a bit to find other years
in the sample. So we arbitrarily picked January’s with over one third, or 33%,
of their days moving at least 1%. This netted us 22 years prior to 2016 in the
past 100 years.
Some of these years,
not surprisingly, occurred after sustained bear markets had already driven
stocks down some 20%, 30% or even as much as 60% off of their highs before
January even got started. Again, such volatility is commonplace within the
depths of bear markets, such as in the January’s of 2009, 2003, 1974-75 and the
early 1930′s. As comparisons to our present situation, however, those years
don’t seem to fit the bill.
So, of the original
22, we looked at just those years when January began with the DJIA within 10%
of its 52-week high (this year began with the DJIA just less than 5% from its
52-week high). Such high volatility within arm’s length of a 52-week high is
less conventional and probably serves to be a bit more instructive to our
present situation. That stipulation weeded out half of the results and left us
with the following 11 years:
1916
1929
1934
1939
1976
1983
1987
1999
2000
2008
2015
First of all, 9 of the
11 occurred within the confines of a secular bear market (FYI, our view is that
the market is still likely in the post-2000 secular bear so we are including
2015 in that category). Only 1983 and 1987 took place in a secular bull. And while
the market fared just fine in the years following those two, 1987 did bring a
little surprise later in the year. All in all, however, these volatile
January’s that occurred relatively close to the DJIA’s highs did not lead to
very attractive returns over the long-term.”
“Including the 2
occurrences in the 1980′s, a majority of these precedents showed negative
returns as far out as 4 years. Yes, this study has involved a fair bit of
data-mining, however, it is still difficult to run tests that produce results
showing median 4-year returns in the red.
Is it a coincidence
that so many of these volatile January’s coming just off of 52-week highs
occurred during secular bear markets? We don’t know but we generally don’t
believe in coincidences in the markets. Regardless, a large percentage of these
previous occurrences very closely marked cyclical tops within those secular
bear markets. If we are indeed still within the confines of the post-2000
secular bear market, the volatile January to begin 2016 would seem to bear the
threat of another cyclical market top – and perhaps market tremors for some
time to come.”
The US Economy
John Hussman from Hussman Funds has had a fairly pugnacious
view towards the bull-run that started in 2009, especially since 2011. That
said his work is brilliant and he has been quite accurate in a historical
sense. In his latest piece entitled An Imminent Likelihood of Recession he writes about his miscalculation a few years back but goes on to
make the case for a coming recession. The article is worth reading in its
entirety but I’ve pulled a few key points.
“While I’m among the
only observers that anticipated oncoming recessions and market collapses in
2000 and 2007 (shifting to a constructive outlook in-between), I also
admittedly anticipated a recession in 2011-2012 that did not emerge. Understand
my error, so you don’t incorrectly dismiss the current evidence. Though not all
of the components of our Recession Warning Composite were active in 2011-2012,
I relied on an alternate criterion based on employment deterioration, which was
later revised away, and I relied too little on confirmation from market action,
which is the hinge between bubbles and crashes, between benign and recessionary
deterioration in leading economic data, and between Fed easing that supports
speculation and Fed easing that merely accompanies a collapse.
Much of the disruption
in the financial markets last week can be traced to data that continue to
amplify the likelihood of recession. Remember the sequence. The earliest
indications of an oncoming economic shift are observable in the financial
markets, particularly in changes in the uniformity or divergence of broad
market internals, and widening or narrowing of credit spreads between debt
securities of varying creditworthiness. The next indication comes from measures
of what I’ve called “order surplus”: new orders, plus backlogs, minus
inventories. When orders and backlogs are falling while inventories are rising,
a slowdown in production typically follows. If an economic downturn is broad,
“coincident” measures of supply and demand, such as industrial production and
real retail sales, then slow at about the same time. Real income slows shortly
thereafter. The last to move are employment indicators - starting with initial
claims for unemployment, next payroll job growth, and finally, the duration of
unemployment.
Last week, following a
long period of poor internals and weakening order surplus, we observed fresh
declines in industrial production and retail sales. Industrial production has
now also declined on a year-over-year basis. The weakness we presently observe
is strongly associated with recession. The chart below (h/t Jeff Wilson) plots
the cumulative number of month-over-month declines in Industrial Production
during the preceding 12-month period, in data since 1919. Recessions are
shaded. The current total of 10 (of a possible 12) month-over-month declines in
Industrial Production has never been observed except in the context of a U.S.
recession. Historically, as Dick Van Patten would say, eight is enough.”
“A broad range of
other leading measures, joined by deterioration in market action, point to the
same conclusion that recession is now the dominant likelihood. Among confirming
indicators that generally emerge fairly early once a recession has taken hold,
we would be particularly attentive to the following: a sudden drop in consumer
confidence about 20 points below its 12-month average (which would currently
equate to a drop to the 75 level on the Conference Board measure), a decline in
aggregate hours worked below its level 3-months prior, a year-over-year
increase of about 20% in new claims for unemployment (which would currently
equate to a level of about 340,000 weekly new claims), and slowing growth in
real personal income.”
The latest Chemical
Activity Barometer release from the American Chemical Counsel indicate a
slowing in the chemicals sector. They report, “The Chemical Activity Barometer (CAB), a leading economic indicator
created by the American Chemistry Council (ACC), ticked up slightly in January,
rising 0.1 percent following a downward adjustment of 0.1 percent in December.
All data is measured on a three-month moving average (3MMA). Accounting for
adjustments, the CAB remains up 1.6 percent over this time last year, a marked
deceleration of activity from one year ago when the barometer logged a 3.2
percent year-over-year gain from 2014. On an unadjusted basis the CAB fell 0.1
percent and 0.2 percent in December and January, respectively, raising concerns
about the pace of future business activity through the second quarter of 2016.”
For those unfamiliar with this economic gauge, “The Chemical Activity Barometer is a
leading economic indicator derived from a composite index of chemical industry
activity. The chemical industry has been found to consistently lead the U.S.
economy’s business cycle given its early position in the supply chain, and this
barometer can be used to determine turning points and likely trends in the
wider economy. Month-to-month movements can be volatile so a three-month moving
average of the barometer is provided. This provides a more consistent and
illustrative picture of national economic trends.
Applying the CAB back
to 1919, it has been shown to provide a lead of two to 14 months, with an
average lead of eight months at cycle peaks as determined by the National
Bureau of Economic Research. The median lead was also eight months. At business
cycle troughs, the CAB leads by one to seven months, with an average lead of
four months. The median lead was three months.”
Monetary Policy
It appears that the Fed is backing off its hawkish stance
from late last year given the recent market turmoil. The market is pricing in a
14% probability that the Fed will raise rates at their March meeting. It should
be noted that the expectations for a rate cut anytime this year is at 0%
probability according to the latest implied probabilities from Bloomberg. That
said there are plenty folks coming out to counter that argument.
According to Peter Schiff, CEO and chief global strategist
for Euro Pacific Capital (via Business
Insider), “…serious economic
destruction is just a few months away. “I think the Fed is going to have
negative interest rates before the election because we're going to be in a
serious recession," Schiff told Business Insider on Friday.
In fact, Schiff said
that we may already be in recession and this one is going to be a doozy.
"We're in worse
shape now than we were in 2007," he said.
Chief among his
concerns is a growing bubble of debt that has accumulated in the US, which he
said "is even bigger than the real-estate bubble" that burst in 2008.
He said that there
isn't as much debt in the real-estate sector, but the total sum of debt from
student loans, auto loans, government debt, and the Fed's balance sheet is
massive. According to Schiff, this total is by far bigger than what we saw
before either the housing or tech bubbles.
Once this bubble pops,
and Schiff fears that it may already have, the following recession will force
the Federal Reserve's hand. This will make them pull interest rates into
negative territory, much like the Bank of Japan's move on Friday.”
They go on to state, “The
common counterargument to Schiff's pessimism is that while manufacturing in the
US has slowed, American consumer spending really drives the economy. And as we
learned on Friday, consumption rose 3.1% in 2015, the most in a decade. Schiff,
however, thinks that this isn't as strong as it seems.
"Most of the
growth has been in things like healthcare," he told us. "It's not
that [consumers] are spending more on things they want, they just have
healthcare and they're being forced to pay more for it."
Schiff added that the
only thing helping consumers is low gas prices, which he says aren't going to
stay low forever.
"So what's going
to happen when the one things keeping consumers afloat — low gas prices —
disappears?" Schiff said. "Simple: They're going to sink."”
Indeed Zero
Hedge pointed out this very item from last week’s GDP release. “By now, not even CNBC's cheerleading
permabulls can deny that the US is in a manufacturing recession: in fact, it is
so bad that even the staunchest defenders of Keynesian dogma admit what we said
in late 2014, namely that crashing oil is bad for the economy.
And yet, the
"services" part of the US economy continues to hum right along,
leading to such surprising outcomes as a stronger than expected print in
Personal Consumption Expenditures. How can this be?
Simple: one look at
the chart below should explain not only how the "services" half of
the US economy continues to grow, but just which tax, because that is how the
Supreme Court defined Obamacare, is responsible for healthcare
"spending" amounting to a quarter of the growth in US personal
consumption expenditures, almost 100% higher than the second highest spending
category which was... Recreational goods and vehicles?”
“And that, ladies and gentlemen, is how you convert a tax into a source
of economic progress.” {Emphasis added}
Law of Diminishing
Returns
Our view on the market, as sanguine as it seems is not
without risks. Although the US Federal Reserve has taken a hawkish stance,
albeit a very weak one we are seeing other central banks going in the
completely opposite direction. The ECB has gone all in on its QE experiment and
is showing no signs of letting up. PBOC will most likely continue to throw stimulative
policies into the mix to further attempt to cushion their economic transitions.
BOJ has now graduated to a new level of monetary stimulus by moving to negative
official interest rates.
From Business
Insider, “The basic idea behind
taking interest rates into negative territory is to encourage lending from
banks who are now charged a small amount to keep cash at the Bank of Japan,
which in theory will increase economic activity.
The BoJ also stated
that it will be willing to cut interest rates further if necessary.
Akin to the same
policy implemented by the Swiss National Bank, the BOJ announced that it will
adopt a tiered system for interest rates, stating that outstanding balances of
each financial institution at the Bank will be divided into three tiers, to each
of which a positive interest rate, a zero interest rate, or a negative interest
rate will be applied.
The BoJ has used the
chart below to demonstrate how the tiered system will work.”
““Although a negative
interest rate is not applied to the total outstanding balances of current
accounts, costs incurred with an increase in the current account balance
brought by a new transaction will be -0.1% if it is applied to a marginal
increase in the current account balance,” the BOJ wrote.”
“The BoJ cited recent
volatility in financial markets, particularly toward the outlook for the
Chinese economy, as one of the catalysts behind its decision.
“There is an
increasing risk that an improvement in the business confidence of Japanese
firms and conversion of the deflationary mindset might be delayed and that the
underlying trend in inflation might be negatively affected, said the bank.
“To preempt the
manifestation of this risk and to maintain momentum towards achieving the price
stability target of 2%, the bank decided to introduce QQE with a negative
interest rate.””
The USD/YEN rallied sharply on the news most likely
providing additional headwinds for the US economy.
So with global economic growth unable to gain significant
traction and the US economy displaying lackluster growth after years of massive
fiscal and monetary policy measures, one needs to ask as to the effectiveness
of the repertoire of unorthodox measures undertaken by the world’s central
banks.
Traditional monetary policy measures are not an option. The
following graphic shows the current trend of the fed funds rate and it’s
obvious there isn’t much room to maneuver but negative. We wonder if the Fed
and their global counterparts are at this point pushing on a string and perhaps
causing more economic strife than relief.
We came across an essay that addresses this very question
written by Van R. Hoisington and Lacy H. Hunt, Ph.D. (via Mauldin
Economics). The full piece is worth the read. They go on to site work by Michael
Spence and Kevin M. Warsh explaining how aggressive QE and guidance policy
measures are actually a net negative for the US economy.
They go on to elaborate, “Their
line of reasoning is that the adverse impact of monetary policy on economic
growth resulted from the impact on business investment in plant and equipment.
Here is their causal argument: “...QE is unlike the normal conduct of monetary
policy. It appears to be qualitatively and quantitatively different. In our
judgment, QE may well redirect flows from the real economy to financial assets
differently than the normal conduct of monetary policy.” In particular, they
state: “We believe the novel, long-term use of extraordinary monetary policy
systematically biases decision-makers toward financial assets and away from
real assets.”
Quantitative easing
and zero interest rates shifted capital from the real domestic economy to
financial assets at home and abroad due to four considerations:
First, financial
assets can be short-lived, in the sense that share buybacks and other financial
transactions can be curtailed easily and at any time. CEOs cannot be certain
about the consequences of unwinding QE on the real economy. The resulting risk
aversion translates to a preference for shorter-term commitments, such as
financial assets.
Second, financial
assets are more liquid. In a financial crisis, capital equipment and other real
assets are extremely illiquid. Financial assets can be sold if survivability is
at stake, and as is often said, “illiquidity can be fatal.”
Third, QE “in effect
if not by design” reduces volatility of financial markets but not the
volatility of real asset prices. Like 2007, actual macro risk may be the
highest when market measures of volatility are the lowest. “Thus financial
assets tend to outperform real assets because market volatility is lower than
real economic volatility.”
Fourth, QE works by a
“signaling effect” rather than by any actual policy operations. Event studies
show QE is viewed positively, while the removal of QE is viewed negatively.
Thus, market participants believe QE puts a floor under financial asset prices.
Central bankers might not intend to be providing downside insurance to the
securities markets, but that is the widely held judgment of market
participants. But, “No such protection is offered for real assets, never mind
the real economy.” Thus, the central bank operations boost financial asset
returns relative to real asset returns and induce the shift away from real
investment.”
They point to several economic trends that justify this
thesis. “The trend in economic growth in
this expansion has been undeniably weak and perhaps unprecedentedly so. Real
per capita GDP grew only 1.3% in the current expansion that began in mid-2009;
this is less than one half the growth rate in the expansions since 1790.”
“Central banks in
Japan, the U.S. and Europe tried multiple rounds of QE. That none of these
programs were any more successful than their predecessors also points to
empirical evidenced failure. The pattern is shown in year-over-year growth in
U.S. nominal GDP. Three weak transitory mini growth spurts all reversed, and
the best rate of growth in the current expansion was weaker than the peak
levels in all of the post 1948 expansions.”
Additionally, “Growth
in nonresidential fixed investment fell substantially below the last six
post-recession expansions. Spence and Warsh calculate that S&P 500
companies spent considerably more of their operating cash flow on financially
engineered buybacks than on real capital expenditures in 2014; this has not
happened since 2007. According to them, during the past five years, earnings of
the S&P 500 have grown about 6.9% annually, versus 12.9% and 11.0%,
respectively, from 2003-2007 and 1995-1999. Inadequate real investment means
demand for labor is weak. Productivity is poor, which in turn, diminishes
returns to labor. According to a Spence and Warsh op-ed article in the Wall
Street Journal (Oct. 26, 2015), “... only about half of the profit improvement
in the current period is from bu siness operation; the balance of
earnings-per-share gains arose from record levels of share buybacks. So the
quality of earnings is as deficient as its quantity.””
The way we see it, as the Fed attempts to reload its chamber
with monetary ammo in preparation of the next recession, they may actually be
fanning the flames of recession in doing so. Their actions may well be a
catalyst for the next economic downturn. During years of aggressively loose
policy, we believe the convexity of policy has skewed to an extreme. Additional
dovish policy going forward will have less and less of a desired outcome…laws
of diminishing returns, while even a slightly hawkish policy stance will have
exponential ripple effects throughout the economy.
As the authors in the previous article point out, “The increase in short-term interest rates
that the Fed has thus far achieved is small, but public and private debt stands
at 375% of GDP, far above the historical average of 189.4% from 1870 to 2014.
Thus, the higher cost reverberates much more significantly through the U.S.
economy...
The extremely high
level of debt suggests that the debt is skewed to unproductive and
counterproductive uses. When the composition of debt is adverse, less
flexibility exists for the end users of the debt to absorb the higher costs
engineered by the Fed.”
Crisis of Confidence
We are fully expecting additional monetary stimulus from the
world’s central banks and considering how our fiscal policy measures in this
country have been a drag on economic growth in my opinion, last December may
have been the last rate increase that the Fed is capable of. Indeed some of the
extreme cases for negative rates and additional QE by the Fed may come to
fruition.
That may continue to drive assets into more risky investment
choices and the sugar rush of the stock market high could continue, but we
believe a move back to that stance will decrease further the credibility of the
Fed that they have a handle of what is actually happening in the economy. That
crisis of confidence may end up spooking investors as prospect theory takes
hold and fear outweighs greed. Perhaps another leg down in the stock market may
be the final nail in that coffin.
Bottom Line: The
global economy continues to struggle and appears to be slowing further. The
same can be said for the US economy and there are few who are calling for an
outright recession. While we are not saying a recession is inevitable, it is a potential
risk that needs to be taken into account and the outcome is alarming at best
given our current state of fiscal and monetary policy. We shouldn’t be
blindsided by an additional 10% to 20% drop in the stock market from here. Let’s
stay prepared.
As far as trading the market is concerned, we
have a negative longer-term bias in place but a positive shorter-term reading
so we are net long with a portfolio beta of 1.0 against the SPX. If the market
continues higher from here we will fade the rally accordingly taking profits on
the way up. On the next high volume sell-off, we will be getting aggressively
short as we believe the lows for the year haven’t been set.
"Those who have knowledge,
don't predict. Those who predict, don't have knowledge. "
--Lao Tzu, 6th Century
BC Chinese Poet
Joseph S. Kalinowski, CFA
Email: joe@squaredconcept.com
Twitter: @jskalinowski
Blog: http://squaredconcept.blogspot.com/
Additional Reading
About
That Head And Shoulders Top in the S&P500 – All Star Charts
People
are afraid these 'zombie ships' are the first sign of global economic collapse
– Business Insider
The
recession of 2016 – Washington Times
Do
Or Die Time: 3 Reasons The Market Decline Is At Crossroads – See It Market
If
History Rhymes This Indicator Suggests Stocks Still Have A Long Way To Fall
– The Felder Report
The
$29 Trillion Corporate Debt Hangover That Could Spark a Recession –
Bloomberg Business
Gargantuan!
The Next Generational Bust Is Coming – Economy & Markets Daily
Weak
American growth is probably a blip – The Economist
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