August 2017 Newsletter
Did the Market and Earnings and the Economic Expansion Peak in July or Not…and If Not Why Not?
“Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.”
– Sir John Templeton
As we wind down the summer vacation time and trading volumes are super light, I want to step back from the day-to-day warfare in the stock market and make sure you are prepared for the next 4-6 months.
BTW—we are going to roll-out our new Transformity Research site and NBTI Pro newsletter will become Transformity Investing. We have been working on this rebrand and new paid subscription service for eh…for a LONG time. Check out the new site www.transformityresearch.com.
We will get you all the details on this important move shortly and how to get registered for the new site ASAP. But in the meantime, me thinks it’s a good time for us to look rationally at the good, the bad and the ugly of the stock market in general and sectors in particular.
Key Point:Economic expansions in the modern era do NOT die of old age; they die because something kills them. Usually that something is
A) An oil/energy price spike
B) Fed raising short term interest rates too quickly
C) A financial bubble bursting or
4) An explosion in inflation all of which bring end the expansion phase of the business cycle and a GDP contraction aka recession.
The hardest cause to nail though is a change in sentiment. You saw how investors and business owner/corporate sentiment exploded with the surprise Trump victory and visions of tax cutting/regulatory cutting/infrastructure building visions of sugar plums danced in their heads.
What remains to be seen is what will happen to sentiment if NONE of those legislative victories come to pass (or do happen but are extremely watered down).
Key Point: Investor and consumer sentiment IS the recession wildcard.
In the Here and Now: Bull markets of course die 4-6 months ahead of a recession. Our macro forecast (which has been spot on for the last 48 quarters) is 3.4% GDP growth Q3 and 3% Q4. Q2 U.S. GDP has been marked up to 3% from 2.6% in early estimates.
Transformity MacroMarket Index: 18.1 ALL CLEAR for stocks . . .less than 2% chance of recession in next 4-6 months.
The Atlanta Fed agrees with us. Latest Q3 GDP forecast: 3.4 percent — August 25, 2017
The GDPNow model forecast for real GDP growth (seasonally adjusted annual rate) in the third quarter of 2017 is 3.4 percent on August 25, down from 3.8 percent on August 16. The forecast of third-quarter real GDP growth fell 0.3 percentage points to 3.5 percent after the Federal Reserve Board's industrial production report on August 17 and the forecast of third-quarter real residential investment growth fell from 3.4 percent to –0.4 percent following the housing market data releases on August 23 and 24. The forecast of third-quarter real nonresidential equipment investment growth increased from 6.4 percent to 8.1 percent after this morning's durable manufacturing report from the U.S. Census Bureau.
Action to Take:We are STILL buying the dips. Investors will continue to buy the dips as long as synchronized global growth and thus global earnings continue to move forward.
#1 Reason: Because investors know the market is going to continue to follow those rising earnings—let's call this “stock market gravity.”
#2 Reason: Because there is SO MANY good analysts calling for the very near END of the bull market. Bull markets end with euphoria, not caution (see below!)
But When Does The 100-Month Expansion & Bull Market End?
I think it's high time to make the “Bull Case” and the “Bear Case” so you and I are on the same page economically and market timing wise. This requires some reading and pondering on your part, but I think its worth it if for NO other reason than YOU sleeping better the next time North Korea launches a missile at Japan.
Rule #1 of Transformity Investing: We are long stocks during economic expansion and short stocks 4-6 ahead of recession (as called by our TI MacroMarket index rolling over and under its 60-day moving average for 20 trading days.)
The Bull Case in Short: It ain’t over till it’s over.
I have known and respected Krishna Memani, Chief Investment Officer of Oppenheimer Funds, since the late 90’s. He sees what I see: a stock market still in the sweet spot of a very rare synchronous global growth trend with dovish central banks, below trend inflation/productivity and unattractive/non-compelling alternatives to stocks aka bond yields.
In a recent note he sent me he captures this reality very well I think with his list of 15 specific events he thinks would be necessary to make him abandon his bullish position. (Comments in parentheses and italics are mine and I added #16)
1. Global growth would have had to decelerate. It is not.
(In fact we are in a global synchronous growth cycle with 42 countries all growing at the same time and 33 accelerating y-o-y growth. This has not happened since late 80’s and a few years before the early 70’s oil crisis. European Union growth is actually picking up. Germany blinked on financing Italian bank debt, and that means the capital markets now have more confidence that Draghi can do whatever it takes to keep the European Union growing faster than the U.S.)
2. Wages and inflation would have had to rise. They are not.
(As I have beaten this dead horse to a pulp over the last 24 months, let me just say for the record that we have below trend inflation, productivity growth and rampant sector disinflation in America because)
1) Productivity growth is on life-support at just 0.6% annual rate for the last FIVE YEARS because
2) its either cheaper for many manufacturers to hire low-skill labor at hourly wage than invest in new advanced manufacturing equipment OR the new advanced manufacturing technology that IS being purchased and installed bangs out a $million of product with 80-90% less assembly labor than a decade ago.
3) The lower cost digital disruption (read Amazon + Walmart + AirBnb +Uber +Netflix+Apps for Everything +Generic Everything++) of almost every analog consumer service and product ex-rent and home ownership is accelerating and taking consumer prices for everything down every quarter—even food!
4) Health benefit premiums have eaten up hourly wage pay hikes since 1990
5) The hydrocarbon fracking revolution has turned America into an energy exporter with excess supply and the swing producer for global energy pricing
6) Now many 4-year colleges are lowering tuition to compete for dwindling students who can afford 4-year college tuition.
7) We are a 72% service based economy and it’s very difficult to significantly enhance the productivity of service labor and knowledge work.
8) The robot age is coming rapidly but it’s coming primarily to advanced manufacturing systems that have already cut 85% of manufacturing jobs. )
3. The Fed would have planned to tighten monetary policy significantly. It is not.
(They should have been raising rates four years ago but whimped out. It is too late in the cycle now…we are 80% ish through the expansion. It’s now just a 32% chance they raise rates once more (based on Dec Fed Futures contract) but the paltry amount of “quantitative tightening” they are likely to do is not going to amount to much. The slow and steady reduction of the $4.5 trillion bond portfolio will be VERY carefully handled and basically they will have buyers in place before they “sell” their paper. They understand they could screw the pooch so to speak by tanking the AAA bond market which then tanks the stock market.)
4. The ECB would have to tighten policy substantially. With Brexit coming it will not.
(Like I said, Draghi will go through the motions, though he knows he is limited in what he can actually do because they are running out of bonds to buy – unless for some unexpected reason Europe takes off to the upside. And while Eastern Europe is actually doing that, “Old Europe” is still significantly slower with over-capacity in everything and Brexit is coming.)
5. Credit growth would have had to be surging. It is not.
(Credit growth is generally picking up but not surging. And most of the credit growth is in government debt. Business credit is flat or slightly down to the SMB customers according to the Fed. The FDIC reports third straight quarter of loan origination deceleration and down from the 6.7% growth pace from a year ago.)
6. Corporate animal spirits would have been taking off. They started 2017 with Trumpian dreams; they now have Trumpian remorse (see White House “business councils writ large)
(That is basically true for most public corporations. NO ONE expects a Trump tax reform beyond 23-25% corporate rate (pubcos pay 23% effectively now) and a 10% repatriation tax of $3 trillion sitting in cash around the world which is actually a joke--they have access to the money--it's just an accounting entry. But the PRO BUSINESS GOP knows they HAVE to pass “tax reform” aka tax cuts or get crushed in 2018 mid-terms AND they have to pass a budget and debt extension by Sept 30 OR GET CRUSHED in 2018 mid-terms. Now with the $60 billion Harvey Disaster they have to get THAT passed or …. you get the point.
7. Equities would have had to be expensive relative to bonds. They are not.
(Other than Netflix, Tesla and Amazon. We are still in a “what other choice do I have” world with bonds expensive and with little yield. Everyday money managers wake up and have $billions of new money they have to put to work. But as I point out in a wee bit…we have a bifurcated market with the top 10% of stocks big winners on top and almost 60% of the rest of stocks under their 200-day moving averages. This rate of market dispersion must resolve itself in the next 60-90 days with another round of 8% y-over-y earnings growth or a correction of the top 10% (that represents 70% of market cap value) has to correct.)
9. Investors would have had to be euphoric about equities. They are not.
(In fact for the last 10 weeks investors have PULLED $30 billion from the market—mostly from actively managed U.S. equity funds). As you will read later, many of the best and brightest on the Street are very worried.)
10. The current cyclical rally within the secular bull would have had to be old and stretched. It is not. (Eh…I’ll give ya the benefit of the doubt on this one.)
11. High-yield spreads would have had to be widening. They are not.
(I pay attention to high-yield spreads, a classic warning sign of a turn in market behavior. Are they at dangerous levels? NO...they are the reverse at record LOWS.)
12. The classic signs of excess would have had to be evident. They are not.
(The bubble in cryptocurrency is a CLONE of the Internet Bubble. The difference is cryptocurrencies could go to ZERO and only the tiny part of our economy that is denominated with crypto would care.)
13. China’s credit binge would have had to threaten the global financial system. It does not.
(Xi has somehow managed to push off the credit crisis, at least for the rest of this year, until after the five-year Congress. Rather amazing.)
14. Global trade would have had to be weakening. It is not.
15. The US dollar would have had to be strengthening. It is not(it’s at its lowest value since 2015 down 8% vs. basket of currencies since Jan but down 15% against the Euro. The weak dollar is juicing durable good output 1.5% and June exports are up 7% versus declines in 2015 and 2016. The International community thinks very little good of Trumpism…and that ironically has the dollar 15% weaker since the reality of Trumpism has become clear. The strong dollar is Germany's problem.
16. I’ll add WW III with North Korea would have to look imminent. It is not. North Korea has “gone the brink of war” at least 80 times since 1993—it’s performance art for the Dear Fathers. 36 missile tests have brought an average one-day decline of 0.4% to stocks. NO ONE with any institutional memory thinks that test number 37 will be the real deal. Christ the Dow only dropped 3% after Japan’s attack on Pearl Harbor!
Key Point: The 100% chance of asymmetric thermonuclear destruction of North Korea will keep them yapping but not launching.
So What About Bond Values vs. Stocks?
To pick just one for closer scrutiny, let’s consider #7. Are equities expensive relative to bonds? That’s a good question because it really matters to big, long-term investors like pension funds. Pension fund managers need to meet certain return targets, and they want to put the odds on their side. Treasury bonds offer certainty – presuming the US government doesn’t default (it won’t—GOP would get the blame and get killed). Stocks offer higher returns but obviously more variation of return.
Memani explains this relationship by looking at earnings yield. That’s the inverse of the P/E ratio. Essentially, it’s the percentage of each dollar invested in a stock that comes back as profits. Some gets distributed via dividends, buybacks, etc., and some is retained. Compare earnings yield to the 10-year Treasury yield over time and you get this:
If you think there’s a stock mania today akin to the euphoria of the late 1990s, you’ll find no support in this graph. Back then, bonds were dirt cheap compared to stock market earnings yield.
Key Point: Now we have the reverse: stocks are cheap compared to bonds thanks to $10 trillion of global central bank bond purchases.
Credit Default Swaps on High Yield Are Low Too
The Markit CDX North American High Yield Index, a credit-default swaps benchmark used to hedge against corporate credit losses remains at just over half the level it reached early last year. Back then, oil falling below $30 a barrel and a slowdown in emerging markets added to investors’ concerns about the state of global economy. IF the bond market is not scared of recession, I'm not.
However: Let’s Revisit the Digital Gazelles vs. the Slow roll death of the Analog Dinosaurs in the REAL Economy
In the U.S. stock market and the real economy what we do have is a case of the “digital haves and legacy analog havenots.” This is why stocks that have a solid case for non-cyclical self-generated growth (which we of course call secular transformational sectors and stocks) attract growth money and cyclical “value stocks” get pounded.
Key Point: Companies that can increase growth and EPS independent of economic conditions go up in value a lot faster than business cycle dependent growth—particularly over 100 months into an economic expansion. The 90’s expansion lasted 120 months…and again unless we have WWIII we fully expect to pass that record.
REALLY Key Point: This is why we invest in NON-CYCLICAL "growth at a reasonable price" aka GARP stocks in sectors whose growth comes from 3-5 year secular transformations. This is also why we avoid "value cyclical stocks" like the plague at this part of the cycle.
Look at the out-performance of Russell Growth stocks vs. Russell Value—The Russell 1000 Growth index for the year is beating the Russell Value Index by a whopping 13.7 percentage points.
Why We AVOID (and will short from time to time) Legacy Analog Dinosaurs
The reality in 2017 is that buried within the US economy there are MANY sectors of the analog/physical/legacy economy that ARE getting crushed by the Digital Gazelles:
- Legacy brick-and-mortar retail stores
- Car rental agencies
- Legacy fast food/ fast casual restaurants
- Thermal Coal mining
- Non-premium retail (only ultra-discounters are growing)
- Non-premium retail malls and strip centers (only malls in high income zip codes are healthy)
- Legacy food/packaged goods consumer brands aka crap food
- The ad agencies that advertise for legacy foods & stores
- Grocery chains other than low cost Aldi and Trader Joe’s
- Legacy Newspapers and Magazines
- Local Radio and Radio Networks (except talk radio) getting killed by streaming music and podcasts
- All legacy media ALL getting destroyed by the masters of the Digital and Attention economy (Amazon, Google, Facebook, Snapchat, Apple, Netflix, AirBnB, Uber, Spotify, You Tube)
- Legacy overseas US based airlines getting killed by new no frills discount long distance carriers
- Industries subject to new regulations (generic pharma, cigarette/tobacco companies, check cashing etc.).
Action to Take: AVOID the Victims of Transformational Digital and Regulatory Change.
Our 40%+ performance in 2017 vs. 8.8% S&P 500 means you just can’t own the S&P 500 index and go to sleep. Because of the confluence of
- A) 2 billion+ super computers aka smart phones in the hand/pocket/purse of nearly 3 billion humans
- B) Low cost digital transformation of work flows and labor processes
- C) Cheap and ubiquitous/ambient 4G and soon 10X faster 5G wireless broadband in 2019
REALLY Key Point: The very nature of the creation and consumption of intermediate and final product and services consumption has and continues to rapidly be changing…forever.
We have entered a mostly new economic age that I first wrote about in my first book ChangeWave Investing. Today, in addition to the physical products we will always require (i.e., the “stuff economy” aka a bed, a roof over our heads, furniture, clothes, shoes and digital devices) we have
- The Stuff aka Analog Economy—the physical goods, shelter and transportation we (or businesses/organizations) own and need to live and operate
- The Infrastructure Economy—the physical underlying infrastructure that powers our economy (which desperately needs $5 trillion in Netherlands like flood control systems for ALL our major coastal cites obviously)
- The Attention Economy: where we spend our non-working attention. Subtract work, eating, personal hygiene and family/social time and there is a $trillion industry of gaining our attention in return for ad sales or subscriptions or streaming egaming.
- The Appified/API Digital Economy: how we produce and find and buy and sell stuff and services for our work and home lives
- The Experience Economy: The places, people, technology and experiences that we prioritize over the “Stuff Economy”
- The On-Demand/Sharing Economy: Rooms, cars, boats, art, jackets, handbags and other stuff we no longer buy but we use on-demand.
- The Subscription SaaS/IaaS/PaaS etc. Economy: Services and technology we don’t buy, we subscribe to and plug in via API
- The Mobility Economy: today dominated by owning vehicles and people driving/flying trucks and planes. Soon…driverless trucks, cars and planes.
- The Artificial Intelligence/Machine Learning/Robotics Economy: Which is driving the wave of Analog and low-skill AND algorithmicly replaceable knowledge work disruption.
- The Biotechnology & Immunotherapy Economy: The next wave of turning deadly disease into treatable chronic illness.
- The Geriatric Economy: The fastest growing age group in America and modern world is people turning 70...and the fastest growing service position is geriatric care person.
- The Smart City Economy: Phasing out the hydrocarbon economy and replacing it with renewable energy and sustainable resources
The economic impact of all this is informational change is gigantic. For example, in the 20th century we produced cars and trucks for “transportation”: by 2025 many urban and suburban 2-car households with be down to one car or none—they will cut their cost of car payments/insurance/service by $2-$5k a year by using “mobility on demand” services. Those with self-driving cars could be paid for others to use the vehicle when its not in use...and auto insurance premiums will drop substantially.
Where will they spend those savings?
NOT by buying “more stuff”—but by having more highly sought after experiences (or maybe invest more for retirement?)
OK: Now the "Imminent" 10%+ Correction and Bear Market Case
We ARE going to have a 10%+ correction in stocks sometime…its been 20 months and that eventuality is coming. The question is what will set off the meltdown?
With blind index funds replacing active funds and robot AI hedge funds and so-called risk-balanced portfolio strategies I can (and have) given you multiple scenarios where the underlying mechanics of the stock market could simply melt down to the 200-day moving averages.
But as we all know (or should know) corrections are required in healthy bull markets...they scare out the weak hands and build cash to be reinvested for fear of missing out on the next leg up. I’ve assembled the best correction and bear case research NOT to scare you but inform you as to current set of market risks OUTSIDE of the growing international distrust of U.S. institutions such as Congress and the White House/POTUS (which again is the main reason my trip to Italian Rivera in September is going to cost 15% MORE than this time last year.)
ACTION TO TAKE: WHEN either A) the next rally stalls or B) the S&P 500/Nasdaq 100 break their 50-day and then 100-day moving averages, we will hedge our gains. UNTIL THEN we are buying the dips but being healthy skeptics and not underestimating the current White House and Congress to engage in a circular firing squad of dysfunction.
PS--all this negativity is the biggest reason we WONT have a correction soon! Here goes.
1) Sector vs. Market Correlations
The pairwise correlations between the S&P 500 and its industry sectors have fallen near levels that preceded the last two bear markets, according to the Citigroup strategists. The previous downturns in stocks started when correlations re-established themselves.
2) Transport Stocks Under-performance
The Dow Theory: Under-performing transport stocks are another concern. The Dow Jones Transportation Average, the gauge of airline, railroad and trucking companies, has fallen about 5 percent from its July 14 high. The index’s decline from its 2014 peak led a similar move in the S&P 500 by about seven months.
3) Bearish Put-to-Call Option Bets
The ratio of outstanding puts to calls on the S&P 500 has risen to levels last seen in the late-2015 market sell-off, according to Richard Turnill, BlackRock Inc.’s chief investment strategist. The put/call ratio for German stocks has also risen. The move to boost downside protection shows investors are getting nervous, he said.
4) Risk Off Flow of Funds
Bond investors are also shunning risk. While high-yield funds suffer ‘considerable’ redemption's, cash has flowed into those that invest in government debt, according to Commerzbank strategists including Alexander Kramer and Ulrich Urbahn.
5) Option Skews Rise for Downside Protection
Equity investors are now willing to pay more for protection against losses than gains. So-called equity implied volatility skews are above the 10-year average, according to the Commerzbank strategists. This implies they are willing to pay more for downside protection than upside potential compared to the last decade.
6) Growing Markets Volatility Across the equity, bond and currency markets, price fluctuations are climbing. The JPMorgan Global FX Volatility index, the Chicago Board Options Exchange’s VIX Index and the Merrill Lynch Option Volatility Estimate are all trending higher, having hit low points in June, July and August respectively.
7) Option Bears Trading of bearish options on the S&P 500 Index jumped to a three-month peak last week, and the ratio of outstanding puts to calls climbed to its highest level since January 2016. Back then, equity losses were accelerating toward a two-year low.
8) Small-Cap Distress
The Russell 2000 had fallen for four weeks in a row on the weakening dollar and declined about 7 percent since touching a high in July. Societe Generale SA recommended investors watch this barometer closely for signs of a wider pullback (but it bounced HARD off its break of 200-day)
Is This the Last Gasp High?
HSBC Holdings Plc, Citigroup Inc. and Morgan Stanley see mounting evidence that global markets are in the last stage of their rallies before a downturn in the business cycle. Analysts at the Wall Street behemoths cite signals including the breakdown of long-standing relationships between stocks, bonds and commodities as well as investors ignoring valuation fundamentals and data.
It all means stock and credit markets are at risk of a painful drop. “Equities have become less correlated with FX, FX has become less correlated with rates, and everything has become less sensitive to oil,” Andrew Sheets, Morgan Stanley’s chief cross-asset strategist, wrote in a note published Tuesday. His bank’s model shows assets across the world are the least correlated in almost a decade, even after U.S. stocks joined high-yield credit in a selloff triggered this month by President Donald Trump’s political standoff with North Korea and racial violence in Virginia.
Morgan Stanley: Global Correlations and Late Cycle Blues
Just like they did in the run-up to the 2007 crisis, investors are pricing assets based on the risks specific to an individual security and industry, and shrugging off broader drivers, such as the latest release of manufacturing data, the model shows.
As traders look for excuses to stay bullish, traditional relationships within and between asset classes tend to break down. “These low macro and micro correlations confirm the idea that we’re in a late-cycle environment, and it’s no accident that the last time we saw readings this low was 2005-07,” Sheets wrote. He recommends boosting allocations to U.S. stocks while reducing holdings of corporate debt that’s linked to consumer consumption and energy. That dynamic is also helping to keep volatility in stocks, bonds and currencies at bay, feeding risk appetite globally, according to Morgan Stanley.
Merrill Lynch--Zero Alpha Beats
For Savita Subramanian, Bank of America Merrill Lynch’s head of U.S. equity and quantitative strategy, signals that investors aren’t paying much attention to earnings is another sign that the global rally may soon run out of steam. For the first time since the mid-2000s, companies that outperformed analysts’ profit and sales estimates across 11 sectors saw no reward from investors, according to her research. “This lack of a reaction could be another late-cycle signal, suggesting expectations and positioning already more than reflect good results/guidance,” Subramanian wrote in a note earlier this month.
Citigroup analysts also say markets are on the cusp of entering a late-cycle peak before a recession that pushes stocks and bonds into a bear market.
And finally...STOCK BUYBACKS ARE PLUNGING - Bloomberg's Luke Kawa: "U.S. stocks have been able to hit fresh highs this year despite a dearth of demand from a key source of buying. Share repurchases by American companies this year are down 20 percent from this time a year ago,according to Societe Generale global head of quantitative strategy Andrew Lapthorne. "Ultra-low borrowing costs had encouraged large firms to issue debt to buy back their own stock, thereby providing a tailwind to earnings-per-share growth. 'Perhaps over-leveraged U.S. companies have finally reached a limit on being able to borrow simply to support their own shares,' writes Lapthorne."
So There YOU Have It!
My point of putting you through this ordeal is simple: IF you had ignored our Transformity MacroMarket Index and followed any of this bear market advice you would have been out of stocks a long time ago or losing many nights sleep...and lost a ton of profits.
OUR 45-part economic index DOES measure these economic issues...that is the BEAUTY of its recession/expansion and market timing forecasting. I am good with 75-80% completion of this expansion cycle...BUT UNTIL something happens to KILL the expansion (as we talked about in the beginning of this slog)...we are buying the dips because investors will NOT be able to sit on their hands as the global synchronous expansion continues to raise PROFITS in the secular growth sectors of the 21st century economy.
Key Point: With all the central bank liquidity in the world economy the U.S. expansion through 2019-2020 looks VERY realistic from where I sit. IF the POTUS and GOP Congress can actually get ANY friggin legislation through by year end (or early 2018) we will add the stocks with high tax rates & secular growth to our winning portfolio.
We will update the portfolio and buy under/target prices after close of market tomorrow.Thursday August 31.
Have a GREAT Labor Day!
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