Archive for June, 2019

Stocks, Bonds and Gold Soar Higher – Which Is Correct?

Thursday, June 20th, 2019

NY Fed

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Investment Strategy Executive Summary

With the stock market at its all-time high, and the various technical indicators we follow telling us that the market is over-valued, caution is warranted.  However, stock markets can continue to move higher for longer than makes sense.

In recent weeks, we have raised cash by booking profits on holdings that our analysis showed were over-valued compared to their discounted cash flow fair value.  We invested that cash in bonds, some longer duration, and in gold miners to hedge against a prolonged downturn in the market, along with cash equivalents.  This allowed us to outperform our benchmarks in May as the market corrected as we anticipated.

The graphic above (courtesy of the Zero Hedge Blog and Real Investment Advice) shows the NY Federal Reserve Bank’s Recession indicator.  The current reading is where we were exactly 12 years ago prior to the 2008 recession and stock market crash induced by the sub-prime bond market disaster.  It graphically illustrates why we need to be cautious at the current time.

In early June, the Federal Reserve announced additional monetary stimulus was back on the table and that they would be ending their policy of Quantitative Tightening in the Fall.  This cause the correction to reverse and stocks to go higher.  Even though we were at Max levels of Equity underinvestment, the bonds and gold both continued to move higher in anticipation of lower Fed Fund rates.

Now that we are back at all-time highs, we need to examine our cash/gold/bond hedges.

  • If the market can close at a new all-time high and sustain it for three trading days, we will invest some of the cash we have on hand in a beta driven strategy of buying the SPY. We will set stop losses for that position and raise them as the SPY moves higher in order to capture what could potentially be a blow-off top prior to a recessionary bear market.
  • We will keep a normalize amount of cash equivalents on hand along with our bond and gold positions.
  • If gold moves above its long-term resistance level as represented by 130 on the GLD and sustains it for three trading days, we will add to our gold miners positions, buying the GDX with a similar trailing stop strategy as the SPY.
  • If we see any corrections in defensive equity companies, we will likely swap some higher beta holdings in tech and biotech – particularly if they are overvalued compared to DCF FV – in anticipation of a potential recession but without increasing overall equity exposure.

With the stock market and the bond market giving us two different forecasts of the future, we are in a difficult investment environment.  Historically, the bond market has won the forecasting contest, but you cannot use it as a timing mechanism.  We will continue to be cautious, but with the strategy outlined above, act opportunistically based upon sound investment management techniques.

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Market Outlook   –   June 20, 2019

Economy

The economic numbers continue to be mixed, with the bond market pricing in two rate cuts in 2019 and a third in 1Q2020.  The most recently released numbers show a major drop in the manufacturing index but stronger than expected retail sales numbers.  I am writing this prior to the Fed meeting on Wednesday where many anticipate the first rate cut, but my best guess is they will not cut but say some soothing words to make people believe they will cut in July.

Bond Market

Over the past several weeks, yields at the middle and longer end of the yield curve have dropped materially.  Investors are looking at the weak economic data and driving down rates; many are also predicting recession odds are rising.

The bond market is pricing in two rate cuts in 2019 and a third in 1Q2020.  I am writing this prior to the Fed meeting on Wednesday where many anticipate the first rate cut, but my best guess is they will not cut but say some soothing words to make people believe they will cut in July.

Post-Fed Meeting, the 10-year treasury yield dropped below 2% for the first time in three years and the Yield Curve inverted even further with the Fed not cutting rates but indicating there will be cuts in July.  The Fed Fund Futures are now pricing in a 100% chance of a cut in July with another 65% chance in September and another 45% chance in December.

Stock Market

After the big sell-off in May, the market fell further in June before rebounding by 180 S&P 500 points, or 6.5% from the June low.

In May, the market peaked at 2,954.13, up 25% from the Christmas Eve low of 2,346.58.  Unfortunately, we closed May at 2,752.06 below the 12-month moving average and down 6.7% from the high and below the previous three months closing lows.  This indicates a potential change in trend that would need to be confirmed by a June close below the May close.

In June so far, we saw the market trade at 2,728.81, below the May low and below the 12-month moving average, but it has since rebounded by 6.5% and is now trading above the May close.

There are three possible outcomes to the month of June:

  • If we can close June above the May low but below the May high, this could just be a consolidation of the December to May rally, with potentially higher prices ahead.
  • If we can close June above the May high, then the rally from the December lows is still in place and May was just part of the ebb and flow of the markets.
  • If we close June below the May close and below the 12-month moving average, then we are looking at a change in trend with lower prices likely ahead.

The first level of resistance at 2,849.65 was broken above and the market has stayed above it, which is quite bullish.  The second level of resistance is at 3,192.44, well above the May high.  If we can break above the second resistance level and close June there, then the rally is certainly back on.

Post-Fed Meeting, the market rallied, and as of this morning we are threatening to close the day at a new all-time high.

Given our defensive stance, I have a plan to deal with this intermediate move higher in the markets – see the summary at the end for details.

Macro Issues

Tariffs: Tariffs are by their nature negatively impact corporate profits, are ultimately inflationary as companies raise prices to maintain profits, and generally disruptive to global growth.   While it is positive that the potential punishment tariffs on Mexico have been sidelined, the tariff war with China continues.

Earnings Estimates:  Corporate earnings before tax (Operating Earnings) have been flat since 2011, with EPS showing growth due to the financial engineering of stock buybacks.  However, 2019 has seen Operating Earnings fall even while valuation multiples have expanded.   Since the December low in the stock market, P/E multiples have expanded by 300 bps.  Investors are now paying very expensive prices for earnings that are at risk of falling further if the current economic weakness expands.

Debt:  Personal, corporate, and government debt is exploding worldwide.  It is a very worrisome situation, particularly if we are headed into a weakening economy.  If unemployment begins to increase materially, a larger than reserved percentage of personal debt becomes uncollectable.  If corporate profits continue to weaken, the corporate bond market and other lenders will experience write-offs greater than anticipated.  If unemployment increases and corporate profits fall, government tax revenues will suffer and additional debt will need to be issued to sustain our government’s unsustainable level of spending.

Government Debt Ceiling:  September 30th marks yet another opportunity for a government shutdown over the corporate debt ceiling.  We will be facing a $4 trillion continuing resolution to fund the coming year’s expenditures along with a $1.5 trillion anticipated deficit.  At some point, the global debt bubble will explode.  The fight over our debt ceiling could be a catalyst for that or it could be a non-event as the politicians try to kick the can down the road for future elected officials to deal with.

Fiscal Policy:  There do not appear to be any fiscal stimuli on the horizon to give the stock market and the economy a boost.  Tax cuts are behind us and the unacceptably huge budget deficit does not really allow for aggressive government spending.  There appear to be no tailwinds that will push us higher, if only temporarily.

Is the Fed Changing the Game:  There is a movement out there to accept that Modern Monetary Theory, negative Fed Fund rates, and pegging of bond market yields will allow the economy to go on into the future with no major economic disasters.  Modern Monetary Theory says that the government can continue to spend without regard to debt levels because the Fed will buy up all the debt, much like has happened in Japan.   In this way, we can spend the $92 trillion required to implement the Green New Deal and other socialist ideas.  In order to keep the debt service on all the new debt reasonable, both negative Fed Fund rates and setting fixed bond yields for government debt will ensure a low and positive yield curve.

Many economists are arguing strenuously against this, but many politicians and liberal economists are promoting it.   With the budget deficit at nearly 5% of GDP, I do not see how bond investors will stand for these actions without crashing the bond market first.

Immigration and Demographics:  As the G20 continues to age demographically with a birth rate below the replacement rate, their economic dominance declines over time.  To combat this, a country needs a sound immigration policy to bring their population growth back to the level where economic growth can be sustained at a reasonable level.

 

Weather:   We are currently in a Solar Minimum cycle of Sunspot activity.  These cycles last several years and impact the weather patterns on Earth in a few key ways:  the climate gets cooler and wetter, winters are longer and summers are shorter.

We can see this playing out right now with its impact on our Agriculture in terms of the reduced growing season from late planting due to the wet weather.

From a historic standpoint, insects, bacteria, and fungus that normally do not live at various climate zones are seen and attack crops, much as China is seeing today.  Here is an excerpt of the news report:  “A crop-eating pest first detected in China about five months ago is spreading rapidly and could hurt production of key crops critical to the populous nation’s food supply, according to the U.S. Department of Agriculture.  Damage from the so-called fall armyworm, which gorges on corn, soybeans, cotton, rice, and dozens of other crops, could force China to import more corn, rice or soy to makeup for the shortfall..as authorities expect it to expand to all provinces in coming months.”

From a historic standpoint, diseases that you thought we under control begin to proliferate.  The black plague came about during a solar minimum, while we have ebola once again proliferating out of control in Africa and measles gaining traction in the states even though a small minority of children have not been vaccinated against it.

From a historic standpoint, earthquakes and volcanic activity also increase.  It was during a Solar Minimum in 1465 that a volcano erupted in the tropics spewing so much ash into the air that the skies in Europe were darkened for years, leading to the mini Ice Age.  The impact of the mini Ice Age was reduced agricultural activity, increased disease, and European exploration of foreign lands and migrations of Europeans leaving Europe in search of land to farm and exploit natural resources.

Recession:  Many of the recession indicators published by the Regional Fed Banks and other entities are showing an increasing likelihood of recession in a range of six months (or sooner?) to two years.

Based upon this, lets look at the components of GDP to see what we believe.  Here is the normal calculation of GDP:   GDP = Personal Consumption + Investment + Government Spending (not including transfer payments) + Exports – Imports.

  • Personal Consumption (69% of calculation): this is typically the last item to turn down (ignore government spending which never turns down); at the moment it is in a debt-fueled growth move higher
  • Investment (18% of calculation): Housing and Business Investment in Capital Equipment are the two big factors here.  Housing has turned down at the national level (although lower rates are helping to stem the drop).  We need to watch Business Investment which usually trails Housing in movement.  If Business Investment drops then we have a problem.
  • Government Spending (17% of calculation): always growing and currently accelerating in a debt-fueled rage.
  • Exports – Imports (-4% of calculation): Tariffs are negatively impacting this at the present, even though the theory is that they will fix the imbalance over time through fairer trade deals, the short term impact is negative.

Personal consumption is by far the biggest component of GDP, and it continue to move higher as consumers continue to buy on credit and increase balances.  As long as employment stays relatively strong, and consumers can service their debt, this component should be solid.  However, if businesses lose money on tariffs and start to downsize, employment could suffer.

Business Investment as measured by Core Capital Goods Orders has been sluggish for a year.  It has neither grown nor shrunk markedly, meaning corporate CEO’s are cautious about the future.

Government Spending always increases, even net of transfer payments.  However, if we begin to see weakness in employment and corporate earnings, that spending will have to be funded by even more debt issuance.

Net Exports have been negatively impacted by the tariffs as China has curtailed its purchases of our goods in response to tariffs.

Based upon these issues, keeping an eye our for a potential recession is a necessary and prudent thing at this time in the battle.