In the era of fake news and artificial liquidity why even bother writing an epitaph on what could be described as one of the oddest years in recent memory? Precisely because dialectic truth appears sorely missing in the public narrative, but such is the nature of bubbles. In fact, it was the lessons of 2007 when Wall Street led investors right off the cliff with overly rosy projections that prompted my personal interest in independent market analysis realizing that not only can Wall Street be wildly off the mark, but that it is their seeming mission to get investors to add money to the pile until the bitter end, consequences be damned.
Before I publish our 2017 outlook in the days ahead I wanted to offer a counterbalance view to what’s happened in 2016 from a structural and technical perspective as it lays the foundation and context through which we approach 2017.
As many regular readers know I consider markets to be in an artificial liquidity driven bubble. What is a bubble? In markets it’s generally a period when the majority of participants adopt an excessively positive and unrealistic outlook about the future and are ignoring underlying fundamentals. They are willing to pay a big premium for assets based on beliefs that ultimately turn out to be false and are ignoring the current state of actual reality and/or any warning signs. The perceived state of a possible positive future trumps (pun intended) everything else. Ultimately the recognition of actual reality deflates the bubble and reverts the premium to a more balanced state. This process can take months even years to pan out.
Another key ingredient of a bubble: Naysayers are ignored and mocked as there is no apparent path but up. The $NDX may serve as a case in point here: 8 years up in a row and only 4 down years in the past 25:
We are back in a period that sends the following message to investors: If you ever sell anything you are an idiot. If you hedge anything you underperform, and you must buy any tiny dip or you won’t get in. Corrections, bear markets and risk are a thing of the past. It’s a dangerous message and perhaps more dangerous than ever as the structural and technical picture continues to point to massive risk expansion to come.
On the surface 2016 was pretty straightforward party hardy from an investment perspective: After the worst start to any year stocks recovered quickly and any further downside experienced during the year had a lifecycle of a few hours at best and stocks finished the year near record highs with big gains for the year on the main indices.
Yet as positive as the index performance appears to be the majority of hedge funds were underperforming and so were individual investors if they have adopted any sort of balanced and/or diversified portfolio approach as the real gains were in the few and not the many while 2016 offered plenty of opportunities for investors to get hurt somewhere.
Indeed a structural review of markets shows plenty of opportunities for active trading of the ranges in both directions over the past several years. Key ingredients: Steep corrections can be bought for technical reconnects and big rallies to new highs can be sold for either technical retraces or outright reversals of size. Specifically periods of low volatility and low volume levitation have laid the groundwork for pullbacks of size and incidentally I’ve outlined why the recent rally was sell worthy (Caution Required) as well:
In 2016, aside from the initial correction in January/February which prompted global central banks to act openly with new QE, lower rates, and a removal of a rate hike path in case of the FOMC, every single corrective move in 2016 ended in the dark following what was pegged to be bad news. Brexit, Italy referendum and the US election come to mind.
Indeed just during the November election night $ES dropped not only negative on the year, but below November 2014 highs. Yet it was all operating in the green by market open. The main culprit: More stimulus was coming with a surprise Republican majority in Congress in essence throwing fire on an already liquidity drenched market.
For point of reference: In 2009 president Obama came into office and immediately authorized a giant stimulus package. It was labeled the American Recovery and Reinvestment Act of 2009 and ended up costing over $800B. Fast forward 8 years later and $10 trillion in additional debt and over $4 trillion in FOMC balance sheet expansion and here is president-elect Donald Trump proposing tax cut and spending measures that would even exceed the 2009 program in form of a promised $1 trillion infrastructure program and board based tax cuts. For good measure of comparison: That 2009 stimulus package was larger than the 50 year running budget of NASA.
In this context so what if EPS expectations for Q4 have fallen by 2.2% since September 30, or by 3.7% over past 26 weeks:
It’s all about future expectations. Real or not.
And markets have reacted consistent which is to embrace free money. For years we have seen trillions of dollars of artificial liquidity slugging through these markets. It needs to be pointed out that no year has ever seen greater central bank intervention than 2016. Over $2.2 trillion in added QE and dozens upon dozens of rate cuts, indeed the acceleration in central banks asset growth has been quite the show:
And we all know many central banks buy stocks directly. The BOJ and the SNB are buying stocks outright with the BOJ not only being the largest buyers of Japanese stocks but also becoming the largest shareholders go Nikkei listed companies in many cases. And the ECB is buying corporate bonds like there is no tomorrow with their program even putting the US Fed to shame:
If you don’t think intervention of such grand scale has no impact on price levels think again. To put all this in perspective: Central banks adding over $2.2 trillion in artificial liquidity a year exceeds the $1.7 trillion it costs to run all the militaries in the world by over $500B per year.
We also know from Mario Draghi that the ECB was prepared to intervene with additional liquidity in case of a Brexit vote. He said so himself. Which brings me to the next point: My assertion is that bad news has morphed into good news because of central bank intervention. In the dark, virtually hidden from public view, unaccountable.
The Bank of Japan’s contribution:
And despite a couple of puny rate hikes the US FOMC remains fully engaged with awesome power:
By constantly intervening in everything central banks continue to distort market conditions. Why? Because they have to to keep the illusion alive. There is zero evidence to support the notion that markets can maintain current price levels without trillions of dollars in ongoing intervention. Don’t believe me? Let them all stop tomorrow. See what happens. They won’t of course because they can’t.
I am firmly convinced all this intervention has impacted the psychology of the entire global marketplace in major and very dangerous ways. Risk has been removed as a factor in markets setting up an illusory complacency. Buy the dip as quickly as possible, don’t even give it more than a few minutes to make its presence felt. This has been the Pavlovian effect cultivated for years and brought to a new accelerated level in 2016. My view is that the perception that risk no longer exists is the greatest illusion, one that investors will pay dearly for at some point.
And frankly these actions explain why price has accelerated despite the fundamental backdrop.
The reason I point all this out again is that price, as it is presented to us now, is not the result of a booming organically growing economy with a broadening earnings picture.
Earnings growth on the S&P was 0.1% in 2016:
If you exclude the worst performing sector, energy, then things look a bit brighter with earnings growth at 3.4%. Before you get too excited recognize that the $SPX gained 9.5% in 2016. The obvious disconnect being valuations as no matter how you look at it stocks are historically expensive with most gains coming from pure multiple expansion:
And this multiple expansion is the result of a fundamental backdrop not keeping up with price as struggling GAAP earnings remain masked by pro forma reporting, a multi year trend now:
Indeed revenue growth, while positive excluding energy, shows precious little signs of an organically expanding economy. And seriously, is this all we get with record central bank intervention?
No, global market performance still remains a function of massive liquidity and promises of stimulus and tax cuts. Even crude’s recovery was driven by hundreds of OPEC related headlines and rumors of production cuts.
A plain fact: We’ve never had such distortions operating freely and unchecked in capital markets.
One of the big question marks was always whether all this artificial liquidity would ultimately result in a blow-off top.
Indeed in April 2016 in The Big Move I mused precisely about this question and it appears we are getting an affirmative in response:
“The bottom line: This is a big battle for control. On the one hand fundamentals and technicals suggest a breakdown of size may well be in the cards, while on the other hand, continued “highly accommodative” central bank policies coupled with perhaps an incremental relative improvement in earnings to come may result in a breakout making stocks even more expensive than they are now, the classic blow-off top scenario if you will.”
The main premise for the year end rally: Tax cuts, deregulation and a coming administration extremely friendly to big banks and corporate business in general. After all Donald Trump’s new administration is filled with Goldman Sachs alumns. Note Trump’s first 17 cabinet-level picks have more money than a third of American households combined.
On this basis is it then a surprise that banks are celebrating? As outlined earlier during the night of the US election $ES futures fell below November 2014 highs. In the weeks since we have not only seen it transverse 2015 and 2016 highs, we have witnessed a vertical upward crash in financials never seen before. And I mean never before:
And it is this vast outperformance that has skewed much of the latter part of the year. Indeed just THREE $DJIA stocks account for 40% of the $DJIA’s gain this year. Call it whatever you want, but don’t call it broad based. Indeed going back to the 2015 highs the outsized performance of the financial sector cannot be overstated impacting the $DJIA and the $RUT as well while other indices lagged:
The great irony of 2016 is that the populist movements, borne out of a deep felt frustration of a middle class feeling left behind in a world ever more skewed toward wealth inequality, have so far accomplished precisely the opposite of their goals: It has made the 1% even richer to the tune of over $237 Billion in gains for the world’s wealthiest.
Brexit? Equities race higher. Trump win? Equities race higher. Italy’s failed referendum and prime minister resigning? Equities race higher. As a result of these populist votes it appears corporations are getting everything they wanted: Less regulation, lower taxes and governments taking on more debt to pay for it all. I don’t think those actions were on the voting agenda, but nevertheless this is what voters are getting as not only the US is heading toward that path but the UK as well.
We heard that the UK has to borrow even more money than expected over the next few years as a result of Brexit. So what is the government’s plan? Cut corporate taxes further:
Which is ironic as effective corporate tax rates are at their lowest levels already, the same being true in the US:
And so nothing, absolutely nothing, suggests any change coming in the long standing trends of wealth expansion toward the few with all data points suggesting that the vast debt expansion and market party has left the middle class and workers in the dust:
So here we are after 8 years of intervention with just 8% of people controlling virtually all wealth on the planet and just 0.7% holding almost half:
Yet it is precisely now that we are at the cusp of this grand central bank experiment nearing the end of its lifecycle. While we still see immediate intervention on any bad news item there is a notable shift taking place in the central bank narrative. They all want governments to step up and provide fiscal stimulus, in other words more debt. Why? Because they are at the end of the line here. The ECB is running out of bonds to buy and will start reducing QE next year, the Fed will continue to raise rates, albeit slowly, and the BOJ will become majority shareholder of many Japanese companies. It’s absurd, but they have done all they can do and this is why it took: Since the financial crisis there have been 690 rate cuts across the globe. That jig is up.
It is then a fair question to ask what this has all has produced in light of business cycle theory demanding that eventually a recession will hit the world again. How well is the world prepared? Shockingly not at all. In fact it may be said it is in worse shape ever to handle a future recession.
Global debt has exploded higher and has been the primary vehicle to finance the 8 year bull run.
“At $152 trillion, global debt was 225% of world GDP in 2015. 2/3 of debt or $100T consists of liabilities of the private sector”.
It is higher now and is getting higher every day. While peoples’ eyes tend to glaze over at mention of data points like this not realizing that the seeds for a massive reset are in the works.
Also consider it’s not only government debt.
Household debt has ballooned to record levels as incomes have not kept pace with expenditures:
Indeed consumers are loading up on debt they can’t repay:
“In the past few weeks, some auto lenders have warned that default rates are creeping up. Used-car prices are also falling faster than many anticipated, leading to lower recovery amounts when borrowers do default.
The latest stress signal comes from auto research firm Edmunds.com, which said in a recent report that record numbers of shoppers are trading in old cars for new ones when they still have substantial amounts due on their existing car loans.That is significant when one considers that the average selling price for a new car is around $33,000, says Edmunds analyst Ivan Drury.
As a result, many borrowers are rolling over their balances into new loans, pushing loan-to-value ratios above 100%.They have to pay that back over time, either through higher monthly payments or a longer payback period. Already, payback periods have risen to an average of 69 months, from 63 months five years ago, according to Edmunds.”.
And just before the cost of carry will increase as a result of rising rates households have loaded back up on debt in full exceeding even the 2007/2008 peak:
On the corporate side we see the same trend as 2016 was a bonanza in new debt issuance: Corporates lead surge to record $6.6tn debt issuance
“Companies accounted for more than half of the $6.62tn of debt issued, underlining the extent to which negative interest-rate policies adopted by the European Central Bank and the Bank of Japan, as well as a cautious Federal Reserve, encouraged the corporate world to increase its leverage.”
The net effect:
“Net debt-to-Ebitda (earnings before taxes, interest, depreciation, and amortization) among S&P 500 companies is pushing a high near 1.6 times, so some of the cash might be quietly steered to pare debt. And companies are using just 75% of their capacity, still below the long-term average of 80%.”
And pay close attention: Deficit spending is already flying higher again exacerbating the increasing amounts of debt that being added to keep the game afloat. And this is before additional spending/tax cuts promised by Donald Trump:
So are $1T+ deficits on the way again? We won’t know until we see an actual budget proposal from the new administration with actual spending line items.
What we do know is that with higher rates the biggest growth line item in the budget is likely to be interest on debt payments:
In this context the current trend on Federal Tax collections is not encouraging:
The summary picture:
The larger message: The system requires ever more debt to sustain itself, and sustainability will become a major obstacle as rates rise.
We are firmly in a make belief phase of the market. People embracing narratives on face value and with it high valuations based on premises of a better future. Indeed excessive optimism, a key ingredient to any bubble, can now be observed everywhere including asset allocations:
Big time pig time and investors have decided to finally throw in cash at the top of the market:
“TrimTabs said that U.S. stock ETFs saw $97.6 billion in inflows between Nov. 8 and Dec. 15—around 150% of the $61.5 billion that flowed into the category over all of 2015.“
In short: Going long at a time when markets are the most expensive in years.
Look, I can’t dissuade anyone from these narratives and neither can I influence people’s willingness to pay high prices for equities. But I can do my dearest to stick to process and analysis and both keep telling me this market has an appointment with pain. How severe this pain will ultimately be remains to be seen, but reality has a way of catching up.
Angela Merkel recently stated:
“In 2016, the world has not become stronger and more stable, but weaker and more unstable”.
In such a world should there not be an increase in risk premium? Yet markets want to tell us that risk no longer exists.
In my humble view risk is not dead. In fact it’s the next big one way ticket.
Why? Because, I for one, still believe in math:
“Stanford University’s pension tracker database pegs the market value of California’s total pension debt at $1 trillion or $93,000 per California household in 2015.
In 2014, California’s total pension debt was calculated at $77,700 per household, but has increased dramatically in response to abysmal investment returns at California’s public pension funds that hover at or below zero percent annual returns.
Pension Tracker recently added the 2015 data, and plans to also add data for 2016 and 2017 when it becomes available. The market value of California pension debt is expected to likely exceed $100,000 per household in 2016, based on recent market calculations.
Nation says Pension Tracker is also slated to include data on unfunded liabilities for “other post employment benefit” obligations, which is mostly retiree health care costs.”
The total picture:
Hey what’s $5.6 trillion in pension debt among friends? I guess in a country $20 trillion in debt and heading toward $30 trillion it matters not. That’s at least what every Wall Street analysts is telling retail.
Here’s the trend:
So either pensions funds are defaulting or they need to be financed somehow and currently the answer is they are being funded with more debt and allocate ever more risk exposure into equities.
A larger point I keep raising concerns about: Investors are bidding up equity prices along with entities that face no personal consequences for overpaying: Central banks and corporate buybacks. And buying they will continue to do:
“Norway’s $860 billion wealth fund recommended it add about $130 billion in stocks and sell off bonds as it presented a bleak view on the returns from its investments across the globe in the decades to come.
The central bank’s board, which oversees the fund, on Thursday recommended an increase in the equity share to 75 percent from 60 percent. That will raise the expected average annual real return to 2.5 percent over 10 years and to 3.5 percent over 30 years, compared with 2.1 percent and 2.6 percent, respectively, under the current setup.”
And one can argue we are already seeing some of this happening now:
Yup, it’s a perfect storm alright. A financial system where everyone owns the same stocks and ever more debt and ever higher valuations are required to sustain it. And while investors are riding the wave higher at the moment I remain highly skeptical that this the wave they want to ride.
Nobody sees any downside, recession risk or any doubt that markets will simply continue on a bull run:
Well everyone except for the US’s largest pension fund that is not all that optimistic it seems as it is considering reducing its expected growth forecast. One of the key issues I keep harping on about:
“Compounding the problem is that CalPERS is 68% funded and cash-flow negative, meaning each year CalPERS is paying out more in benefits than it receives in contributions, Mr. Junkin said. CalPERS statistics show that the retirement system received $14 billion in contributions in the fiscal year ended June 30 but paid out $19 billion in benefits. To fill that $5 billion gap, the system was forced to sell investments.
CalPERS has an unfunded liability of $111 billion and critics have said unrealistic investment assumptions and inadequate contributions from employers and employees have led to the large gap.”
But markets are ignoring it all for the moment despite all warning signs. Examples:
House flipping is also back and in a big way. Here’s a unicorn with a $1 billon valuation, a company’s whose primary business model is house flipping. You can’t make it up:
“Silicon Valley’s club of unicorn startups hasn’t been growing as fast as it once was, and its newest member is unlike most of is venture-backed peers. Opendoor Labs Inc., a San Francisco startup that buys houses and then resells them, received a valuation of at least $1 billion after its latest funding round, said people familiar with the matter.
Opendoor said it raised $210 million, which it will use to fund expansion to 10 cities next year.”
Maybe it’s a trade nuns are interested in. No really, nuns are now running portfolios:
“On a recent morning, Sister Lioba Zahn read the Bible, attended prayer, did the laundry and then prayed again.
In the afternoon, she called her bank and started trading.
Ultralow and negative interest rates have hit savings and investments around the developed world, crushing the income that many mom and pop investors rely on. Mom, pop and Sister Lioba.
For over a century, Mariendonk financed itself by selling milk and candles, and through income on its bank deposits. After the European Central Bank began cutting rates, eventually going all the way below zero to their current -0.4%, Sister Lioba realized her convent needed extra income to survive.”
Yea it’s quite the world we live in and these are mere symptoms, but I am using them to illustrate a larger point: Exuberance and leverage is in the system, yet it is based not on organic growth, but a false complacency that has been created by artificial liquidity while the underlying risk factors have been masked.
For now markets have pretty much decided to view everything through the prism of rose colored glasses. The concept of risk has been neutered and nobody sees any downside for next year.
As you may guess I have a variant view and I’ll discuss the main risk themes in my upcoming 2017 outlook.
In the meantime here are some select charts for you to ponder:
What’s the main technical message? Price continues to operate within the confines of potentially devastating bearish chart patterns showing new highs came on large negative divergences masking underlying weakness.
More to come in the 2017 outlook.
Categories: Market Analysis