Second Quarter Review
After a volatile first quarter, the S&P 500 traded in a narrow range (SPX: 2,025 to 2,110) and ended the second quarter with a 2.0% increase. Additionally, after a strong first quarter, the safe haven assets (intermediate-term U.S. Treasury bonds and gold) also performed well, appreciating 2.77% and 6.77%, respectively.
While all major asset classes performed well during the second quarter, the economic fundamentals continued to deteriorate despite significant central bank intervention. In the first quarter, to assuage fears of a global slowdown, the European Central Bank ((ECB)) cut short-term interest rates to minus 0.40%, increased their QE bond buying program to $80 billion per month, and expanded their bond purchase program to include corporate bonds. Additionally, the Bank of Japan ((BOJ)) reduced short-term interest rates to below zero, while the Federal Reserve shifted from a tightening to a neutral bias. While this unprecedented level of central bank intervention did little to improve the global economy, it "kicked the can down the road" and successfully drove stocks higher and bond yields lower. As a result of these market interventions, more than $13 trillion of bonds yield less than 0%. Incredibly, an investor must pay a debtor to lend them money on nearly 30% of the debt outstanding.
Through the first six months of 2016, stocks are slightly higher (S&P 500 up 3.4%), while intermediate-term U.S. Treasuries and gold have outperformed equities (up 7.6% and 24.6%, respectively). It is unusual that the S&P 500 is at an all-time high, yet has underperformed the safe haven assets over the past six and twelve months. Historically, when safe assets outperform, the markets are discounting a potential economic problem (e.g., recession, inflation, financial crisis). We believe that the strong performance of Treasury bonds and gold confirm our longstanding view that: stocks offer a very poor risk-reward, the economic cycle has peaked, and growth rates are slowing.
We are confident that our Value-driven Liquid Alternative investment strategy, which is diversified and economically balanced (stocks, bonds, currencies and commodities) is poised to continue to perform well in today's volatile and uncertain investment environment. Since we are late in this economic cycle and stocks offer a poor risk-reward, we are primarily focused on protecting capital and providing positive absolute returns, with reduced volatility and a low correlation to the risky stock market.
Investment Outlook Summary
Equities continue to offer a very poor long-term risk-reward . Nearly eight years of unprecedented and reckless global monetary policy - negative interest rates, Quantitative Easing (creating money to buy bonds) and competitive currency devaluations - drove stocks to a very unattractive level, while providing little stimulus to the real economy. We estimate that the S&P 500 is poised to provide investors with a prospective real return of only 1% per annum over the next ten years, versus the historic real return of a 6.5%. Also, we continue to believe that we are in a global bear market, which began in May 2015. Despite the recent flood of liquidity from the central banks, corporate profits are in recession and most global stocks remain significantly off their highs. While the typical bear market decline is 32.4% over 13 months, we estimate that fair value on the S&P 500 is 1,265, down more than 40% from this week's all-time high.
While both the S&P 500 and the 10-year U.S. Treasury bond reached an all-time high this week, we believe this is a monetary illusion, created by the central banks . In our view, the global risks are extremely elevated because of the slowing global economy and the uncertainties due to Brexit (e.g., European recession, Italian banking crisis, Chinese yuan devaluation). Since the last recession, the global economies were driven by very loose monetary policies and tight fiscal policies. These policy errors by the central banks and politicians, coupled with structural imbalances (too much debt, technological changes, large current account imbalances, declining labor forces and aging populations) has led to a period of "secular stagnation" - i.e., stagnant wages, increased unemployment and declining living standards. We believe that this secular stagnation partially explains the surge in global nationalism, populism, and the Brexit. Also, instead of addressing the economic structural imbalances, these monetary policy errors only "kicked the can down the road".
The economic cycle peaked nearly eighteen months ago, and the recent slowing growth rates will continue to lead to disappointing fundamentals and weak corporate profits . Historically, once the economic growth rate peaks and then decelerates to a below average growth level, stocks typically underperform bonds. We believe that the recent twelve-month underperformance by equities, relative to Treasury bonds and gold, supports our view that we are late in this economic cycle and that the fundamentals will continue to disappoint investors.
Market based indicators also confirm our view that the economic cycle has peaked and that growth is decelerating . The yield curve and inflation expectations are both reaching cyclical lows and continue to indicate that the economy is headed for a significant slowdown or recession. While corporate bond spreads have improved from February's low, they are still elevated on a year-over-year basis and it is difficult to discern the impact from the ECB's new policy of buying corporate bonds.
In the short term, the equity market is rallying because "bad news is good news" . This week the S&P 500 reached an all-time high despite the recent increased economic and financial uncertainty (e.g., slowing growth, Brexit, European/Italian banking crisis, and the gradual Chinese yuan devaluation). We believe the markets recent post-Brexit strength is driven by the ECB's call for a coordinate global response to low inflation and the belief that Japan will utilize Ben Bernanke's "helicopter money" stimulus scheme (the central bank buys zero-coupon perpetual bonds from the government to monetize government spending) this fall. While this liquidity-driven rally could drive the S&P 500 higher by another 5% (S&P 500: 2,250) over the next four to six weeks, we believe it is more likely that this is a false breakout, and stocks will be driven lower as the faltering global fundamentals manifest.
Asset Allocation: As value investors, the market's long-term risk-reward drives our strategic asset allocation. Currently, we remain defensive and positioned to perform well during periods of slowing economic growth and rising market volatility. Our tactical risk management overlay, which is based on volatility, trend and rate-of-change, continues to partially hedge our equity exposure.
Current Asset Allocation:
Large Cap Equity
Long-term U.S. Gov. Bonds
Small Cap Equity
Int-term U.S. Gov. Bonds
Equity Hedge (small-cap and volatility)
Equity Market Outlook : We remain underweight equities. In our view, equities are significantly overvalued, earnings are in recession and profit margins are regressing to mean from an extreme level. We believe that despite the expectation of continued central bank intervention, stocks offer a very poor risk-reward.
By creating money to buy bonds, central banks drove financial assets far from their intrinsic value. We believe the central banks have reached the limits of monetary policy and because the economic cycle is decelerating, they will not be able to provide enough excess liquidity to artificially prop up risk assets. Risk assets will be vulnerable as valuations and profit margins regress to normal levels.
For nearly eight years, central banks have set short-term interest rates at 0% and created money to buy bonds, hoping low interest rates and higher stock prices would stimulate the economy. The Fed - based on portfolio balance theory and the wealth effect - believed that lower interest rates would lead to higher stock prices, and since consumers would feel wealthier, they would spend more. They believed that this additional consumption would increase aggregate demand and drive economic growth.
Unfortunately, this elaborate theory didn't work, we had the weakest economic recovery on record and even worse, few of the structural imbalances from the last recession were addressed. While the economy received little benefit, it is clear that the QE programs (i.e., creating money to buy financial assets) drove stocks and bonds far from their fundamentals and intrinsic values. Now, because the economic cycle has peaked and growth is decelerating, it will take more and more liquidity from central bankers to support these artificial price levels.
While our market outlook and asset allocation has not changed much in nearly eighteen months, neither has the S&P 500. On January 1st, 2015, the S&P 500 was 2,059 and it closed the second quarter at 2,099. Incredibly, while the S&P 500 appreciated only $40, (a 1.9% increase), over last eighteen months, General Accepted Accounting Principles ((GAAP)) earnings fell 18% (from $105.96 to $86.53). So, while stocks were essentially flat over the past eighteen months, they became more expensive because the GAAP P/E increased from 19.4 to 24.2. Additionally, over the past eighteen months, U.S. Treasury bonds and gold outperformed the S&P 500 and appreciated by 9.3% and 11.9%, respectively.
It is evident that risk assets are no longer driven by the fundamentals (e.g., declining earnings, flattening yield curve), but the expectation of further liquidity provided by the central banks. Speculators believe that bad news for the economy (Brexit) becomes good news for stocks because the central bankers are forced to print more money. While this dangerous game may work in the short term, fundamentals matter and eventually buying bad news will lead to significant loss.
Chart 1: Market Capitalization to GDP
In a 2001 Fortune Magazine article, Warren Buffett stated that market capitalization relative to GDP "is probably the best single measure of where valuations stand at any given moment." Currently, stock market capitalization is 122% of GDP; this is significantly above the 50-year average of 65%. Based on this valuation measure, stocks would need to decline by 47% to be considered fairly valued.
Chart 2: S&P 500 and GAAP Earnings
Over the past eighteen months, the S&P 500 is essentially flat, while GAAP earnings have declined 18% (S&P 500 earnings declined to $86.53 from $105.96) from the September 2014 cyclical peak. In our view, stocks remain detached from their fundamentals due to central bank activism and complacent investors.
Chart 3: Corporate Profits to GDP
It appears that profitability has peaked for this cycle. Currently, corporate profits are 9.3% of GDP, which remains significantly above the historic average of 6.5%. We expect earnings growth will continue to disappoint investors as economic growth slows and profitability returns to a normal level.
While many speculative investors buy bad economic news on the expectation of more central bank accommodation, we believe that the ability of the central bankers to drive financial asset prices is reaching its end game. In our view, central bankers have pushed monetary policy to the limit because they are running out of bonds to buy in their QE programs and their Negative Interest Rate Policy ((NIRP)) is a policy error that actually tightens financial conditions, especially in the vulnerable banking system. In general, the central bank's policy of financial repression - negative real interest rates due to ZIRP, NIRP and QE - which punished savers, has led to secular stagnation and increasing social unrest.
It is estimated that $13 trillion of bonds currently yield less than 0%. So, nearly 30% of bonds outstanding yield less than zero and investors are actually paying the debtors to lend them money. Unfortunately, the central banks are not allowed to buy negative yielding bonds, so they are running out of eligible bonds to buy. Also, it appears that negative interest rates are stoking the very deflationary pressures that the central banks are trying to fight in the first place.
In our view, central bankers have been "pushing on a string" and the recent advent of Negative Interest Rate Policy ((NIRP)) in Europe and Japan indicates a level of desperation, which will ultimately undermine the financial system that they are attempting to prop up. Because negative interest rates hurt banks by reducing their profitability, future interest rate reductions will only lead to lower bank profits, less lending and tighter monetary conditions. We believe that the ECB and the BOJ made a significant policy error by implementing a negative interest rate policy. Since this policy was enacted in the first quarter, European financial stocks have performed poorly, with many stocks declining by more than 30% this year, while the Italian banking system is in crisis.
The NIRP, coupled with the implementation of the Bank Resolution and Recovery Directive ((BRRD)) by the European Union ((EU)), which mandates bail-ins to capitalize struggling banks, has accelerated a banking crisis in Italy that could potentially spread to the rest of Europe. Italy, now the third largest economy in the EU, has a public debt to GDP ratio of 135% and has $400 billion of bad loans, which is equal to 20% of GDP. If the EU enforces the BRRD and demands that the bank's equity and bonds holders fund a recapitalization through losses, instead of a EU bailout, Italy may follow Britain and leave the Euro, which will surely create a financial crisis and a global recession.
Since no one, especially central bankers, knows how long the salutary effect of QE will overwhelm the weakening global fundamentals, we continue to believe it is prudent to underweight equities and overweight the safe assets (U.S. Treasury bonds, TIPs, U.S. dollar and gold) until the equity market offers a favorable risk-reward.
Economic Outlook: While most Wall Street economists and strategists expect a strong second half, we believe the economic cycle has peaked and growth is decelerating. Market-based indicators (the yield curve, credit spreads, inflation expectations, and gold's twelve-month rate-of-change) do not confirm the stock market's recent strength or the expectations that the U.S. is poised for a strong second half.
Chart 4: Yield Curve (2-year to 10-year)
A flattening yield curve does not bode well for economic growth. The yield curve has flattened dramatically since its January 2014 high, and has narrowed by 91 bps over the past year to its lowest level since the 2008 recession.
Chart 5: Inflation Expectations (10-year TIPs Breakeven)
Inflation expectations have declined to 1.40% from 1.85% a year ago. Declining inflation expectations are not consistent with stronger economic growth.
It is our belief that economic growth peaked in late 2014 and now the economy is in the early stages of its down cycle. The previous expansionary cycle was muted because of the excessive debt burden, aging demographics, technological change, increases in the tax and regulatory burden. Additionally, the Fed's QE program, which punished savers and reduced productivity by incentivizing corporate America to grow earnings through financial engineering rather than capital investment.
As discussed previously, we believe the economic cycle turned down just as the central bankers ran out of tools. If so, equities and the speculators who buy risky assets on bad news will be vulnerable as valuations are driven by the fundamentals and not the excess liquidity provided by the central bankers.
Chart 6: Consumer Spending is Decelerating
Chart 7: Industrial Production is Declining
Chart 8: Capital Investment is Poised to Contract
Chart 9: Employment Growth is Decelerating
We believe that many of today's economic problems and the recent global nationalist and populist movements are due to the economic policy errors over the past fifteen to twenty years. In general, the global economies were driven by very loose monetary policy (negative real rates and weak currencies) and tight fiscal policy (higher taxes and increased regulation), which led to the current secular stagnation (i.e., increased unemployment, stagnant incomes and declining living standards) in the developed economies. Instead of addressing the structural issues - too much debt, technological change, aging demographics, and the excessive tax and regulatory burden - the central bankers adopted a policy of financial repression (negative real rates, ZIRP, NIRP, QE and currencies devaluations) that punished savers, inflated risk assets, and provided little stimulus to the real economy.
After more than fifteen years of secular stagnation, individuals in the developed world are upset with the lack of economic opportunity and are rallying against globalism and the status quo. Individuals now recognize that trickle-down monetary policies create wealth inequality, while doing little to create jobs or improve median living standards.
In our view, the Brexit and the increased popularity of populist and anti-globalization candidates are the result of the secular stagnation induced by failed monetary policies. We expect these trends to accelerate, especially as the global economy continues to slow. Additionally, as the follow-on effects of Brexit manifest (e.g., European recession, Italian banking crisis, Chinese devaluation, and additional reformations to leave the EU), the U.S. economy and financial markets will be vulnerable.
As we have argued for a long time, solid fiscal policy, not unprecedented monetary policy, is the solution to repair our economic problems. In our view, it is essential that central bankers "get out of the way" and let the markets work. Once the free markets adjust and clear, they will give investors and corporations valid economic signals and the confidence to make long-term investment decisions that will spur economic growth. Additionally, if simple fiscal measures are enacted, such as, simplifying and reducing the tax and regulatory burden, while adopting a rules-based monetary policy, we are confident that the significant pent-up demand from at least eight years of underinvestment would lead to very robust growth.
Short-Term View (three months): In our last letter, we expected that "a weekly close below 2,000 on the S&P 500 would increase our confidence that the next leg of the bear market has arrived". While the market traded in a tight range, during the second quarter, it never closed below 2,000 on a weekly basis.
This week, the S&P 500 broke out of its eighteen-month trading range fueled by a dovish ECB statement, and the expectation of helicopter money (central bank buys zero-coupon perpetual bonds from the government to monetize government spending) in Japan. The Japanese yen, the world's carry trade currency, plunged 6% in four days - igniting a speculative, liquidity-driven, risk-on frenzy - after Ben Bernanke met with Japanese officials and discussed how to implement "helicopter money" stimulus. This discussion with Bernanke about "helicopter money", in our view, is another tacit acknowledgement that Abenomics (aggressive Keynesian stimulus) has failed and the Japanese economy is in a depression.
While we believe that this is a false breakout (i.e., liquidity driven, not fundamental), the market could rally 5.0% (S&P 500: 2,250) over the next four-to-six weeks. While we expect to participate in this potential liquidity rally, we believe that the broader market will not confirm the new high and equities will be vulnerable to a significant decline into the fall due to weak fundamentals. We continue to believe that a weekly close below 2,000 on the S&P 500 will mark the beginning of the next leg down in the global bear market.
Chart 10: S&P 500 and Potential Negative Divergences
While the S&P 500 broke out of its eighteen-month trading range to an all-time high, the Russell 2000 remains 7% off its all-time high and its twelve-month rate-of-change is negative. We do not expect the broader market to confirm the recent all-time high in the S&P 500 and believe the next leg of the global bear market will begin within the next four to six weeks.
Equities remain overvalued and offer a poor long-term risk-reward. We estimate that stocks will provide a real return of less than 1.0% per annum for the next 10 years (versus a 6.5% historic real growth rate), and fair value for the S&P 500 is 1,265, 41% below this week's all-time high.
The economic cycle has peaked, global growth is decelerating and the fundamentals are poised to disappoint. The Brexit adds additional economic uncertainty (e.g., European recession, Italian/European banking crisis, Chinese devaluation due to recent dollar strength).
Central bankers have reached the limits of monetary policy. The ECB and BOJ are running out of eligible bonds to buy in their QE programs and their NIRP tightens the financial conditions that they are trying to ease. In our view, the central bankers are out of tools, just as economic growth is decelerating.
The populist and nationalist sentiment across the globe, which led to the Brexit, are a result of the "secular stagnation" that was created by the failed monetary policies of the global central bankers. Instead of addressing secular imbalances, central bankers implemented financial repression, which punished savers and led to anemic growth. Free markets, fiscal reforms and stable currencies will lead to strong global growth and improving living standards.
In this uncertain period, we believe that investors should remain focused on preserving capital until the equity market offers a favorable risk-reward. Risk management and an economically balanced portfolio (stocks, U.S. Treasury bonds, gold and currencies) are critical, in our view, to achieving this goal.
See also Should Investors Be Concerned About A Dearth Of Insider Buying? on seekingalpha.com
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.