On September 28th 2018, almost one year ago, in a post titled A SHARP GLOBAL CORRECTION MAY BE IMMINENT, we warned investors about an upcoming correction with the same flashing red light…
We were proved right and the MSCI WORLD INDEX lost 18.5 % between that date and the 24th December 2018 before rebounding with a year-to date performance of +13.5 % in 2019.
In fact, if one uses the MSCI World Equity Index as a benchmark of passive investment in global equity markets, Investors have NOT PERFORMED AT ALL since February 2018 – i.e. for the past 20 months – while they have gone through massive volatility.
2018 happened to be the worst calendar year since 2008 with a -10.44 % performance for the index and, for now, the 2019 rebound has just brought equities back to their previous highs and particularly the high of September 2018 before the vicious correction of Q4 took place.
The 2019 rebound has been happening in an environment of extreme uncertainty, politically, economically, from a monetary policy stand point and from an international politics standpoint.
Managing money under Donald Trump reign has been greatly different from previous years where economic data, corporate earnings, and interest rates were ruling the world of investment management and volatility remained contained.
In 2019, the world economy slowed from 4.5 % in the last quarter of 2017 to 3 % in the second quarter of 2019, with export-driven economies such as Germany, Switzerland or Korea contracting for one or two quarters.
Donald Trump’s trade war brought in a level of uncertainty that froze investments almost everywhere and questioned the stability of integrated global supply chains. Ultimately, it had a major dampening effect on investments and manufacturing while increasing the final cost of goods for US consumers and reducing margins for US corporations.
Although inflation remained surprisingly strong across the board , with the US Core CPI at its highest level since 2008, way above the FED’s target, we experienced an amazing melt-up in bonds with an inversion of the US yield curve and almost US$ 16 trillion of debt offering negative yields, a unique occurrence in the world economic history.
Another unusual development in credit markets has been German 30-year government bonds trading at negative yields and 100 year bonds trading at less than 1 % and if inflation was dead or ever.
Bonds were not the only space of unusual behaviour and disruptions.
Chaos erupted last week after the FED lower interest rates as cash became scarce in the US money markets. The repo rate jumped to 8 % as the Government had to fund it deficit at a time where corporations are hoarding cash for their tax bill and banks keep their liquidities instead of placing them on the market.
Finally, Gold and Precious metals rose sharply in 2019, breaking out of the lengthy consolidation pattern in pace since 2012 and starting a new secular bull market. As is always the case with Gold, the rally was fuelled by investors starting to worry about credit markets and by Central Banks diversifying their reserves out of US dollar and into Gold.
Today, we are putting a strong warning again as global equity markets are trading at a critical juncture.
Indeed, they either break out to new highs OR
they experience a very sharp correction
If one looks at the US Dow Jones Industrial Index, since the January 2018 peak we have had the development of a very traditional “LoudSpeaker” Pattern which, by essence is a succession of higher highs and of lower lows.
The major breakdown and 20 % correction of the 4th quarter of 2018 was the first indication that something major was happening to the longest bull market in the US history, the 2009 – 2019 bull market.
Investors had a first warning in February 2018 with a 10 % correction, then a second one in Q4 2018 with a 20 % correction. As for now, we just completed a third top on July 27th 2019 and failed to make new highs. confirming a lower high last week.
This means that we should be going lower very soon, and, contrary to what most commentators expect, the correction this time round could be sharp and significant with a 30 % downside potential.
The “Loudspeaker” pattern is clearly recognisable with a the lower high in the Dow jones Industrial Index.
Again with the SP500, even if we do not have lower high, we have a clear double top below the upper band of the loudspeaker
And finally, and that is maybe the most glaring warning signal, the clear loss of momentum and divergence of the NASDAQ Index, the backbone of the entire secular 2009 – 2019 bull market, with a clear head-and-shoulder pattern.
And investors are not ready for that …
Indeed, there are a lot of commentators that are worried about equity markets and their extremes of valuation, but most consider that the unusually low level of interest rates provides a cushion that will prevent a sharp fall.
It is interesting to note that at the end of August, two American houses turned bullish on equity markets while UBS turned negative.
Let’s analyse what could take the markets to new highs and what could take them to fall …
The one major factor, if not the only factor is the exceptionally accommodative monetary policies implemented across the three major economies of the world. Considering the fact that inflation remains in positive territory and even at a decade high in the US, REAL INTEREST RATES ARE NEGATIVE in Europe, Japan and the US and that should create a supportive background for global equities.
The FED has lowered rates again in September, but the message form the minutes is that the change of tack of the FED is to be considered as an insurance policy and not as fundamentally driven. The internal dissent has now reached a point where it is almost impossible to get more rate cuts ahead, unless equity markets really fall out of bed.
In Europe, Mario Draghi is prepared to “do everything it takes” but his policy of negative rates has already reached its limits and the debate is now switching to Fiscal stimulus rather than monetary stimulus.
Another factor that should be supportive of equities is that for the first time in a decade, US equity dividend yields are higher than US 10 year treasury yields.
Fair enough !
All these arguments are fine and indeed liquidity is a major driver of equity prices in normal time.
However, this situation one exceptionally low interest rates is what has ALREDY been used to justify the extremes of valuation reached by equity markets in the past two or three years.
Assuming that it will keep pushing valuations to even higher extremes may be overly optimistic.
Moreover as we have seen in Europe, extremely low and even negative interest rate since 2016 have NOT pushed European equities higher.
Finally, we just had a major melt-up in bonds – or melt down in bond yields with US treasury yields falling by 41 % WITHOUT pushing equities higher. This means that equities may have become insensitive to lower yields or more liquidity .
Judging from the massive flow of bond issuance from every corner of the planet including extremely cash-rich companies such as Berkshire Hathaway, Apple Inc or even the extremely cash rich United Arab Emirates, it is highly likely that bonds have peaked and that from. now on interest rates will, climb higher rather than fall further.
In short, it may very well be that the outperformance of US equities since January 2018 when the rest of equity markets peaked, and the extremely complex top that this secular bull market is recording with a highly volatile horizontal trading pattern MAY WELL BE DUE TO THIS EXCEPTIONAL MONETARY ENVIRONMENT.
But there is not much NEW in this environment and therefore its potential to propel equities much higher is probably extremely limited.
When equity markets trade at PE ratios between 20 and 30 times, they normally reflect an economy where earnings are growing at a fast clip.
Unfortunately, America has entered a period of sharp deceleration of corporate earnings since February 2018 and corporate earnings have collapse more than fallen form 30 % growth in March 2018 to barely 2.2 % in the latest reading, after a -12 % contraction in June 2019
Unfortunately, there is not much on the horizon to expect US corporate earnings to start growing again in the foreseeable future. The Trade War is still very much present, and if anything, the latest tariffs that are implemented on September 1st will take their toll on earnings in the coming quarters.
One sharp reminder of the cost of the trade war were Micron Technology Inc. giving a truly disappointing quarterly profit forecast only yesterday and warning that global trade tensions
may prolong the memory-chip industry slump.
The chipmaker expect sales to decline by more than 20% year-on-year for a fourth consecutive
In this kind of environment, it is difficult to see how corporate earnings could start rising sharply again, and the most likely outcome is in fact a corporate profits recession ahead.
Justifying elevated P/E ratios when earnings growth is almost zero is difficult. But it is even more difficult when the market already trades at massive levels of overvaluations, reaching extremes only seen twice in the past, prior to the 1927 crash and prior to the 2000 Dotcom bubble crash.
All the studies show that the best long term indicators of valuation and of the future course of equity markets are the Tobin Q ratio and the Schiller CAPR ratio, two distinguished economies who received Nobel prizes for their economic studies.
The chart below depicts the two ratios going back to 1900 and what they seem to vie saying is that we have ALREDY made the peak. Considering the economic environment we are in, this ratio cannot adjust through an explosion in Corporate earnings but more likely through a sharp fall in stock prices.
Another extremely worrying indicator is the one developed by HSBC for the corporate bond markets which shows that we have now reached an 85 % probability of a bear market in corporate bonds in the following 12 months.
The only time the indicator was that high was in 2000 just before the burst of the dot com bubble took place.
If corporate bonds start falling, it means that the financial costs of corporations will explode upwards and impact earnings negatively in a significant way.
The problem is that we are living in a world that has once again accumulated massive levels of debt as Government, households and Corporations have become addicted to debt and extremely low interest rates.
Having a lot of debt is one thing ! But having a slit of debt in a world where interest rates are at 1 % is another as a rise in interest rates to only 3 %, a low nominal rate by any standards, representer a trebbling of the financial cost of corporations, households and states.
It is proven that US corporations have borrowed massive amounts of money to buy back their own shares instead of reducing their balance sheets, an unhealthy use of money at very low cost, but the latest data show that the ratio of Gross as well as Net debt to Net Worth is back to the unhealthy extremes reached juts before the 2000 collapse.
Investors are betting that the world economy is going to improve soon as extremely accommodative monetary policy starts impacting.
This is true and we are seeing an improvement in economic news overall. We have always considered that the bond market was too sanguine in its view of the global economy and China in particular.
However, things are going to get worse before they get better and the Trade war impact will be more lasting than investors expect.
Regardless of what Donald Trump does in the short term, CEO’s do not trust him anymore and will not start re-investing for the long term inn their global supply chain before he has left office and a new, more reliable, leadership will have taken over.
This may happen in 2020, but it may also happen in 2024 if he is re-elected for a second term.
The world can therefore not expect any major boost from investments and manufacturing in the coming months and monetary policy has reached its limits.
Moreover, the US already had its tax cuts contrary to India which juts had one and Germany where the debate is raging. If anything,m the US administration will start fighting with the corporate world for liquidity as its budget deficit explodes under the cumulative effects of less tax revenues and more expenses.
What Russia did not succeed at, Ukraine scored last week by providing the opportunity to Impeach the US President.
Nancy Pelosi officially launched Donald Trump’s impeachment process this week following the whistleblowing of the intelligence staff regarding Donald Trump’s dealings with the newly elected Ukrainian President.
The case this time round will be relatively straight forward, as was the one of Richard Nixon back then who ended up resigning before being impeached. It is a matter of legality and improper factual elements.
Some US commentators took theimpeachement news as positive news with regards to the Trade War, in the thinking that Donald Trump will give way in the Trade War to soothe the political consequences of the impeachment procedure.
But this is a very simplistic view as the Chinese are even less inclined to make concessions to a President that may be on the ejectable seat and they have the time on their hand.
Impeachment is a period of instability where the President’s attention is focused on defending himself and less on the matters of the economy. Moreover, a President like Donald Trump may be inclined to take drastic and dangerous decisions if put under pressure by the impeachment process.
It is hard to see how the potential destitution of a President could be good news for the stock markets
As our readers know, we have been writing for many many months now that a military conflict in the Middle East was highly likely and the chain of events of the last few months are confirming our view that the conflict may erupt quickly.
Whoever launched a 30-missiles and drones attack on Saudi strategic oil facilities wants a war there. These are not incidental events. They are significant military events that require a will, sophistication and expertise.
Neither Iran nor the US are willing to sit a table and back off in the conflict.
The probability of an escalation is extremely high and may even be made more probable by the impeachment process that has juts started
As our reader knows we do follow the main economic cycles and even some political ones that are identified and ascertained.
We reproduce here a chart of a well-known American financial analysts called Harty Dent who has had a good track record in the 1990s and 2000s at predicting turning point and who has spent considerable time analysing cycles that very few other analysts focus on.
Harry Dent comes to the conclusion that are nearing what he calls ZERO HOUR where long, median and short term cycles all come to a trough together leading to a major disruption in the world financial and political organisation.
Whether Harry Dent is right or wrong, only the future will tell, but we have to admit that he made an extremely bullish call on US equities in the 1990s that looked extremely improbable then but became a reality a few years later.
When all is said and done, the fact of the matter today is that we have equities trading at extremely elevated levels in an environment full of risks, with a limited upside at best, and a considerable downside in case of a break down.
When looking at the SP 500 as a benchmark, some important technical levels must be watched carefully, 2822 and 2730.
Any break below these levels will take global equities much lower with a target at or below 2200 by mid-November 2019.
Another indicator to watch carefully is the behavior of the FAANGs, the leader of the entire Bull market.
They are losing steam and are confronted to massive anti-trust and tax scrutiny.