Is The Selling Over?

The market, now driven primarily by “headline watching” algorithms, ran up and down this past week on the back of a “tweet.”

Stocks plunged on a tweet that more tariffs would hit China. Then surged on a tweet of a September “trade deal,.” The market then plunged again on a tweet that restrictions would return on Huawei, just to surge again on news the ban would only apply to Federal agencies.

I’m exhausted just typing that.

As I said above, it is difficult to trade kind of volatility.

The good news is the market did rally this past week, as hopes the Fed will continue to cut rates to support asset prices. (I am writing an article for next week on the “Pavlovian effect.”) 

The bad news, is the current set up, technically speaking, is much like we saw last September/October as markets. The chart below is the S&P 500 as compared to the “Volatility” index which is inverted for clarity.

As we saw last year, the market plunged from very overbought conditions, rallied sharply back, and failed again before crashing to lows. The strong contra-rallies pulled investors into the markets before crushing them into the end of the year. 

Currently, while it may not be the Fed causing problems for the market, it is the White House that is raising red flags. If the White House follows through on its threats to increase tariffs on China, and assuming that China doesn’t retaliate in return, there is not an inconsequential risk to asset prices as markets begin to reprice earnings. (More on this in a moment)

Importantly, the market has triggered a “sell signal” much like was seen in both May of this year, and in February and October of 2018.

Given that we took profits in May and July from portfolios, raised cash, and are carrying hedges, we will “sit on our hands” for the moment and wait for the market to “tell us” what it wants to do next. 

However, our signals suggest the risk, at the moment, is to the downside.

Risk Happens Slowly Too

While “risk happens fast” in the financial markets, it builds up slowly as well. As Doug Kass noted this past week:

“The odds of a U.S. recession according to JP Morgan is 40% – a cycle high. The rate of growth is slowing measurably. The manufacturing recession is now seeping into the consumer sector.”

“Like in 2007, (though the circumstances are far different) many investors, and even Administration officials, are ignoring the tea leaves of substantially slowing global economic growth.

With the world more interconnected at any time in history, non-domestic economic activity is importantly influencing the S&P Index’s constituent companies’ top- and bottom- lines.”

He is absolutely correct. 

Most importantly, while investors are betting on more Fed rate cuts, they are missing what is happening with earnings which continue to erode. The first chart is our earnings estimates (which we projected in June, 2018, unrevised for accountability) versus S&P’s estimates (which are constantly revised.) Note that estimates not only caught up with our original projections (wiping out the entire benefit of tax cuts) but has now exceed those levels. 

Despite the collapse in earnings, stocks are currently trading higher than they were in then. Valuations have expanded by 3x, while earnings have deteriorated. More importantly, and even less optimistic for the bulls, is the continued deterioration of 2020 estimates.  (The orange dashed line is our estimate for earnings based on assumptions of trade war impacts.) 

This is not a problem the Fed cutting rates, or doing QE, will fix. 

The other problem for the bullish view is the global glut. 

Following the financial crisis, it was China’s consumption binge which bailed out the majority of the world. While many believe it was Central Banks that rescued the globe, it really wasn’t. 

However, now, China is at its limits, and the global glut and output gap has now come home to roost.

Doug drives this point home:

“An output gap is the difference between actual global GDP and the level that would be consistent with operating at full capacity. The difference today is a consequential 0.5% – an unusually large figure considering the late stage cycle of economic growth.

In other words, a subpar economic recovery since The Great Recession has yielded excess global supply. This idle capacity has been accompanied with a continuous deflationary influence that has contributed to generational lows in worldwide interest rates and a central bank community that is quickly out of monetary bullets.

This means that since 2007, the $128 trillion of new global debt has been supported by only $27 trillion of new income. (Debt has grown by a factor of 5x against the amount of money that can support it!)

World debt is now about 295% of world GDP – a new record.

To understand the severity of this problem we should look back into the 2001-07 cycle. During that period global debt rose by only $30 trillion (from $86 trillion to $116 trillion). In the interim interval, global GDP rose by $25 trillion to $58 trillion. So, in the bubble cycle of 2001-07, debt growth (+$30 trillion) outstripped economic growth (+$25 trillion) by only 20% compared to the 2007-19 time frame in which debt growth (+$128 trillion) outstripped economic growth (+$37 trillion) by nearly 400%!!!

Ignore the massive buildup of global debt (against the backdrop of slow global nominal GDP) at your own risk.”

While investors are hoping that Fed rate cuts and QE will extend the current cycle, I can’t stress enough that when the recession hits, and it will, it will be a far more destructive process than the current consensus believes. 

It will be the “Perfect Storm” when debt, demographics, and unfunded pension obligations collide. There is simply not enough money to bail it all out at once.