Summertime and the livin’ is easy ! The markets are at record highs, President Donald Trump delivered good news on the trade front, the labor market is thriving and the Federal Reserve is considering cutting rates.
June was a fabulous month, recovering almost all the losses of May 2019 and the first half of 2019 is the best in decades after the longest bull market on record and the longest US expansion phase in history.
In truth, European, Japanese and Chinese equity markets are not partying as much and the global economic recovery has been severely dented by Donald Trump’s protectionism, phenomenon that is now gathering speed if one is to judge from the recent spat between Japan and South Korea.
Nevertheless, the US equity market is the tail that is wagging the global dog and when the US equity market turns, then the party will be over for all equity markets, at least for a while.
Unconstrained Asset Management
We have been actively participating in the philosophical debate between Constrained / Unconstrained Asset Allocationand Passive / Active management and we are clearly in the camp of Unconstrained Asset Allocation and Active Management.
Over the past few years, with a lasting and stable bull market, passive or indexed management has become extremely fashionable, overtaking substantially active management.
And rightly so; the performances of the Equity indexes ( SP500 up 17 % year to date ) dwarfed the very disappointing performances of hedge funds in the first half of 2019 and over the past decade.
Although, Hedge funds reported their best first half in the last 10 years, they rose only 5.7% from January through June, according to Hedge Fund Research Inc.’s asset-weighted index of managers. Equity funds were the best-performing broad strategy, gaining almost 9% in the period.
Why on earth would anyone give money too manage to Hedge Fund Managers or Active Managers – we are not Hedge fund managers, we are active managers- and pay their hefty management and performance fees when investing in tracker funds at 0.5 or 0.2 % management fees beats the h… out if them.
The shift to passive investing has been a global phenomenon over the past ten years.
In the U.S., the shift has been especially evident among mutual funds (MFs) and in the growth of exchange- traded funds (ETFs), which are largely passive investment vehicles.
As of December 2017, passive funds accounted for 37 percent of combined U.S. MF and ETF assets under management (AUM), up from 3 percent in 1995, and 14 percent in 2005.
This shift for MFs and ETFs has occurred across asset classes: Passive funds made up 45 percent of the AUM in equity funds and 26 percent for bond funds at the end of 2017, whereas both shares were less than 5 percent in1995,
Since the end of 2006, investors have withdrawn nearly $1.2 trillion from actively managed U.S. equity mutual funds, and have allocated roughly $1.4 trillion to U.S. equity index funds and exchange-traded funds (ETFs).
These figures are much higher today. Passive funds will top 50 percent in 2019 if the current trend holds. That would mark a tipping point for the investing industry, which for decades built its stature on the prowess of stock-and-bond pickers seeking to beat the markets.
One of the benefits of the growing trend towards passive investing is lower fees to the investor. Not only do passive ETFs generally charge lower fees, but the competition is driving fees lower among active managers.
But the shift in market structure towards rules-based, passive investing over the past decade means a lot of the trading is no longer based on fundamentals.
And this shift in market structure could well be a trigger for the next global downturn.
The US Federal Reserve is concerned enough that “Changing Market Structure and Implications for Monetary Policy” is the topic for this year’s economic symposium in Jackson Hole.
JPMorgan notes that only about 10 per cent of US equity investment is now done by traditional, discretionary traders. Besides ETFs and Passive Mutual funds, Artificial Intelligence quant funds use powerful supercomputers to crunch huge amounts of data, unearth patterns and survey trading strategies across different markets in real time. They do not care why markets move, only that they do.
They do not listen to economists, earnings growth, valuation, dividends or take-overs any more.
When the markets turn and equities are no longer in a bull market, investors will just sell their ETF’s indiscriminately and Artificial Intelligence quants will short the markets just because they are going down…
Constrained Asset Management
The debate about Constrained and Unconstrained Asset Allocation is of the same vein and has been going on for decades in the more cosy worlds of pension fund management and Private Banking.
In the traditional wisdom of Pension fund management and Private Banking, “risk profiles” are determined by the asset allocation to various asset classes that, themselves are considered to be more or less risky, based on a risk measure called volatility.
Traditionally, Pension funds have been constrained in allocations of 60 to 70 % in Bonds and debt instruments and 30 to 40 % in Equities. Equities are considered to be more volatile than bonds.
In Private Banking, moderate risk profiles entail the same type of ratios, sometimes going as high as 80 % in equities and as low as 20 % in equities.
By opposition, Unconstrained Asset allocation enables to move up or down the allocation to any asset class depending on the risk level of the said asset class, not measured by volatility anymore, but measured by fundamental risks.
And this is exactly where we stand today in bonds and equities where risk levels have reached extremes that warrant almost zero exposure to both.
The current occurrence is extremely rare !
It is extremely rare to have BOTH bonds and equities at extremes of overvaluation and it is entirely due to the extraordinary monetary policies implemented by Central Banks around the world, save for China and Asia, injecting liquidity into the economy at a pace unheard of in history.
The recent pressure by the markets and by Donald Trump on the President of the FED to lower rates again and again at the first sign of a slowdown is similar to a drug addict begging for his drug injection.
Today’s breach of the 3’000 level on the SP500, despite its extreme overvaluation and corporate earnings that have started to recede is the testimony that investors want more liquidity at any cost.
Donald Trump fixation on Jérôme Powell and the need to lower interest rates shows that his re-election in 2020 depends on a rising stock market…
The king market has become the one that decides on the politics…
The reason why we advocate active management and unconstrained asset allocation is rooted in history.
Every ten years or so, a major bear market unfolds in global equities and shaves between 40 and 80 % of equity values.
Staying invested at that time and going through a bear market because of passive investment or constrained asset allocation is suicidal.It usually takes between 6 and 9 years to recover from a bear market and surpass the previous peak.
Active management is all about timing those entry and exit points in any equity market or asset class.
Over the past ten years, Fixed rate bond yields have been below inflation, effectively yielding NEGATIVE REAL RETURNS for investors keeping 60 % of their portfolios in bonds.
Achieving decent returns when 60 % of your assets are invested in bond yielding 1 % or even negative yields because of constrained asset allocation is almost impossible.
Today, more than 15 % of the world GDP is in negative nominal yielding bonds. Investors are PAYING the borrower to borrow money if you hold these bonds !! But Pension funds have no choice because of their statutory asset allocations.
As our readers know we have been advocating to avoid most Government bonds for almost three years…
We are now recommending investors to bail out completely of equities as well.
Our call is one we have been making for a while now ( see THE LAST RALLY) and July 2019 should mark the end of the secular bull market that has started in 2009.
The main culprit and the main victim will be the US equity market but all equity markets will be taken down in sync in the coming six months before a major buying opportunities appears in China and Asia.
Let’s examine why equities should come down in the coming months.
Professional prognosticators often dance to the same tune but what’s unusual now is how glum the music has become of late. With $5 trillion added to equities already, pessimism pervades second-half forecasts.
It will be hard to sustain the advance, they say — the market can’t defy gravity forever. And freakish June, when just about everything rallied, won’t be repeated.
Clearly, anyone who has been in te markets for long knows that the 17 % performance of the first half will not be repeated, even less with corporate earnings and the economy falling
Concern about the economy and trade won’t go away. Negotiations between the U.S. and China may be set to pick up, but little else has been agreed to following the Group of 20 summit.
Nobody is rushing to revise year-end S&P 500 targets higher. The majority of those surveyed by Bloomberg expect the S&P to end at a lower level than it’s at now.
Forecasters at RBC, for instance, reiterated a year-end S&P 500 target of 2,950, about 1.3% below current levels. Citigroup maintained its 2,850 target, and both shops warned rallies won’t be sustainable. Jonathan Golub at Credit Suisse recommended “cautious positioning” given the decelerating environment.
JP MORGAN just warned investors that the peak was being made and that the second half would be difficult. With stocks hovering near spots where past rallies failed, many say it’s time to take profits or re-position. JPMorgan Chase & Co., for one, is advising clients do just that.
Sentiment should usually be a contrarian indicator and it is ! When we are talking about pessimism here we are talking about professionals. Individual investors are back into buying mode again and the put/call ratio is decisively bearish form a contrarian standpoint
Second, The Economy
A focus on economic data doesn’t do much to instill confidence, despite the strong jobs report last week.
Equity bull markets cannot happen without economic growth. Equities are a call on the health of any economy as corporate profits are a leveraged call on economic growth rates. When the economy is good, companies sell their goods and services, make profits, invest and expand. When the economy is in recession, revenues fall, profits turn into losses and companies lay off staff.
What we are contemplating now is the first recession since 2009, if the forecasting abilities of the bond market are right
Since the launch of Donald Trump’s Trade War, much of the US economy has been weakening. Virtually everyone is still pinning their hopes on a so-called insurance cut from the Fed that may boost growth while the trade mess is unscrambled.
But even that may be too little, too late.
A gauge of U.S. factory activity is at its lowest level since October 2016, for instance, and many other data points are already headed lower. An accommodative Fed might cushion the blow but likely won’t prevent it.
The damage to investments and production has already been made and is slowly but surely filtering through the consumer and the job market.
The employment market is a very slow mover and as our readers know, all over 2015 and 2016 we were advocating that employment would improve at a time where everybody else was tearing their hair because employment was not picking up and wages not increasing.
Today, the economy has tarted to slowdown but the labor market is still strong, leading the consumer to feel good as long as the stock market hovers near record highs.
But this will ultimately change… In fact Deutche Bank’s models are already showing that wage growth is peaking and will Strat rolling over.
On the monetary front, If and when the Fed starts cutting rates , it will be first and foremost an acknowledgement that they already went too far to begin with, and two a sign that the economy is starting to weaken and they’re trying to offset the impact of a weaker economy,.
Neither one of those are positive for stocks informal environment
Ignoring the weakening economic data comes with great perils.
Investors may be fooled by the “bad news is good news” mantra but they will soon hit the hard wall of declining earnings
Third, Corporate Earnings
Investors are so focused on monetary policy and this mythical China deal that they just don’t seem to be paying attention to earnings, which are really what should be driving stock prices.
Earnings forecasts for S&P companies have been getting worse by the week.
More than 80% of those that have issued new forecasts have slashed their profit estimates. At Citigroup, a client survey showed a majority believes profit forecasts for next year are too high.
And the one thing that is certain is that no one today factors in the possibility of sharply negative surprises on this front. And this is even more worrisome considering the highly negative economic environment of the second quarter of 2019.
Markets are setting records a decade after the financial crisis. The current U.S. economic expansion is now the longest on record, running parallel with the bull market in stocks.
Confident and continual assertions that the rally in the stock market was unsustainable have been proved wrong.
Indeed, US corporate earnings have been rising steadily and exponentially, save for the massive downturn of 2008 – 2009.
But for the first time in 10 years, earnings are bound to decline this quarter when compared to last year’s second quarter and there is strictly no reason why this decline should be just a bump in the road.
Valuation becomes a real problem then as stocks are trading at extremes, especially o. long term measures and keeping them up there when earnings are declining will take more magic than the FED can deliver.
There are several ways of looking at valuation and the two most accepted gauges are Price to Book and Cyclically adjusted Price Earnings Ratios. ( CAPE Ratio )
At 3.51 Book value, the SP 500 trades at the highest level seen since the 2000 dot.com bubble
The Nasdaq is in the same position and the FAANGS trade at a Price to book ratio of more than 10x.
The message from the CAPE, or cyclically adjusted price-to-earnings multiple, is as clear and as negative as ever.
For those uninitiated in the arguments over long-term gauges of market valuations, the CAPE is a measure first promulgated by Benjamin Graham in the 1930s and popularized by Nobel laureate economist Robert Shiller 30 years ago.
The idea is that earnings tend to follow a cycle, and that investors adjust for this when deciding what multiple to pay for a stock’s recent earnings. If at the bottom of the cycle, investors will tend to pay a higher multiple because they expect earnings to rise, and vice versa.
The CAPE therefore compares prices to an average of earnings, adjusted for inflation, for the previous 10 years.
This number provides a much better gauge of how optimistic investors are at a point in time — and over the preceding century, all the major market secular highs and lows overlapped with extreme readings for the CAPE.
This is how the CAPE has moved since 1880, as presented on Shiller’s website:
Shiller found fame for using the CAPE to help predict the dot-com crash of 2000 in his book “Irrational Exuberance.”
Subsequently, the CAPE stayed very high in the years leading up to the financial crisis, sending a valuable signal that the rally from 2003 to 2007 was not to be trusted. But the CAPE has risen steadily since then, suggesting for years now that share prices are highly overvalued, and yet the rally has continued.
This distortion has a lot to do with the extraordinary monetary stimulus injected in the economies over the past ten years.
Before the sharp sell-off in early 2018, the CAPE showed the market to be as expensive as it had been on the eve of the Great Crash of 1929, and more expensive than at any other time apart from the dot-com bubble.
It is still at levels only seen before the crashes of 1929 and 2000.
The extent of the earnings collapse during the 2007 crisis was extraordinary and totally unpredicted apart form very few economists including Robert Schiller and oursleves..
In 2006, we called the top of the US real estate cycle and in 2007 we predicted the collapse of Lehman and Bear Sterns. But was was striking then was the fat that almost no one would have forecasted the earnings collapsed that ensued.
Commentators later called it a Black Swan event, but there was nothing such as a Black Swan on the horizon as all the Swans on the horizon were clearly black then, with the excesses of the subprime and the high leverage in the economy.
Today, we have the same black Swans flying low with the Trade War, the Uncertainty, the disruption to the global supply chains, the technological war that will unfold and the real war that is clearly on our doorsteps with Iran.
The following chart shows the 10-year rolling average for Shiller’s earnings numbers.
Again, it is necessary to use a log scale. They suggest a remarkably steady trend:
The extraordinary earnings recession of 2008 shows up as the worst blip in the steady upward trend since the war. But it is no more than a blip. Nevertheless, that blip sent equity prices down between 60 and 80 % over a period of two years.
Whichever way you look at it, the CAPE ratio continues to suggest that stocks are historically expensive. That message should not be ignored because there are many black swans on the horizon and each one of them could send stock prices tanking, especially with 50 % of all assets invested in equities in passive types of management.
Strategically, it has been a key call of our 2019 strategy to expect the December rebound ( Wave B ) moving into a summer top as the starting point of a new significant decline (wave C) into later Q3 and ultimately into late Q1 2020, where according to our model, we expect the next major buying opportunity for global equities.
As our Readers know, we called the top of the global equity rally in 2018 and the September 2018 December 2018 correction was Wave A of the cyclical Bear market.
Over the last 2 weeks the market internals in the US have started again deteriorating.
The mega cap outperformance, particularly the defensive leadership that holds the flag high – is the reason why the SPX is trading at a new all-time high.
On the other hand, we have a declining number of new 52-week highs. In the number of SP500 stocks trading above their 20-day moving average, we have a classic momentum divergence forming and the gap between mega caps (SPX-100) and the Russell-2000 is further widening.
It is not just the major non-confirmation between the new SP500 high versus the July 2018 high in the Russell, we now have also a classic tactical divergence forming, where the Russell is posting a lower high versus its April high, whereas the SPX hit a marginal new high.
A major divergence between the Russell and the SPX-100 was usually a leading indicator for a major top!!
In other words, the recent melt-up in bonds and new highs in equity markets mark the end of the bull phase and we are entering a very negative second half of the year.
It is always difficult to pinpoint the catalyst for the turn, be it disappointment with the FED, negative earnings surprises, a war situation in the Middle East of the blow-off of Deutsche Bank with its 48 trillion US $ of derivatives exposure….
But what is sure is that considering the environment, we are happy, for the first time in a decade to be out of BOTH BONDS and EQUITIES.
It may take until the end of July for the markets to turn and new marginal highs are possible, but the reward is not worth the risk