By Doug Kass, reposted from Real Money Review
Things are not always as they seem -- at least that's the lesson we might be learning in the markets right now.
Until recently, markets have willfully ignored the above in addition to rejecting the possible adverse investment consequences of expanding geopolitical risks in favor of, as my pal Mike Lewitt describes, "cold-blooded focus on central bank policy."
As I wrote several months ago, a mini Minksy moment might be at hand -- thanks to an exaggerated exploitation of portions of the equity and fixed-income markets and a growing attitude of complacency that has followed the exploitation of these asset classes.
The road to investment hell is paved with good intentions
After the largest weekly decline in nearly two years, the markets are now near-term oversold and a (weak) rally is possible in the next few days.
Similar to Pavlov's dog, market participants will be inculcated with the notion of buying the dips. You will hear this mantra from the business media, from investment strategists and even from your planners.
It is my view, however, that a more meaningful correction seems likely in the weeks and months ahead.
While it might be tempting to consider last week's drop as another opportunity to buy the dip (similar to earlier in the year), I suspect rallies should now be sold.
With breadth deteriorating and new highs falling, the market's character has changed, and numerous negative market tells abound (and have been heretofore dismissed until the past week).
- Throughout the 2013-2014 rally shallow market declines responded positively to favorable news, but the Thursday waterfall drop followed better-than-expected economic news -- namely, a 4% second-quarter 2014 real GDP reading.
- I have often opined that some of the worst market declines occur when investors can't identify a catalyst for the drop or when good news is ignored -- such as it might be at the current time.
- Just as rising markets tend to result in investors and traders focusing on good news (e.g., the specter of low interest rates and central bankers' more cowbell), the focus in a more significant drop might move toward the bad news -- and there is a lot to worry about (including a subpar global economic recovery, geopolitical risk, Washington dysfunction, the schism between the haves and have-nots, etc.).
- The notion of buying the dip has remained ingrained -- equity inflows into domestic equity funds and ETFs continue strong. This is unhealthy and when in the extreme, historically points to more substantial declines.
- Importantly, the quality of the recent advance and the internals has deteriorated with numerous classical technical divergences. The August-to-October period, as previously mentioned, is among the most seasonally weak periods in history.
- Large-cap, multi-industry stocks with above-average dividend yields have led the market advance, but these stocks are now starting to lose strength. If the drop gathers momentum, these are vulnerable and heavily weighted in the indices, making them likely liquid candidates used to raise cash.
- Generally speaking, the global equity rally is also beginning to get more selective -- another signpost of late bull market behavior.
I have contended in numerous postings that stock valuations are higher than meets the eye, as profit margins lie 70% above the six-decade average. Hence, earnings power is less than the 2014 consensus for the S&P 500 of $119 a share. Normalizing of profits (and profit margins) produces current P/E multiple readings that are well above generally thought of valuations and higher than historical averages.
But what make the recent correction likely to morph into something more than a few percentage points decline are considerations of a credit-kind.
Credit, even more than equity, is the lifeblood of economic growth.
When taken to the extreme (as we witnessed in the mid-2000s), our economic and investment world turns upside down when credit conditions tighten and/or deteriorate.
There is, to this observer, a bubble in elements of the credit market.
Most investors have been lulled into a sense of complacency in recent months. Self-confident bullishness has had little or no appreciation of the potentially adverse consequences of the bubble-like conditions and speculative orgy (especially in the issuance of corporate bonds) nor in the remarkable performance of high-yield/junk bonds.
Surprisingly, most observers fail to recognize one important fact -- namely, that the generational low in interest rates has masked the astonishing notion (and disguised the negative impact) that net corporate debt today lies a full 40% over the levels of 2008 (source: Societe Generale's Andrew Laphthorne).
That's right: Record corporate cash balances have been eclipsed by all-time debt issuance -- little of which has been used for spending, most of which has been used in corporate share buybacks and larger dividend payouts.
In other words, we (in the U.S.) are more addicted to debt than at any other point in modern financial history. Debt loads (as illustrated in Argentina's recent default) are even much higher outside of the U.S.
"On a policy level, it is virtually impossible to direct capital to productive uses with tax policies that favor debt over equity, speculation over production, and non-U.S. over U.S. economic activity."
-- Mike Lewitt, The Credit Strategist
Interest expenses (particularly in a rising rate environment) will take away from productive growth and will increasingly weigh on global growth -- just as the U.S. stock market is virtually at a new high and more than double that level of the generational bottom in 2009.
As a result, some strange things might occur in the years ahead as interest rates normalize.
Low interest rates are entrenched in our economy, psyche and society.
The last federal funds rate hike was all the way back in June 2006 -- that's eight years ago! Low interest rates have the capability of distorting and stretching out investing time. But higher interest rates, in a still levered world, may compress investing time.
Gluskin Sheff's David Rosenberg reports that since 1977 there have been six cycles of rising rates, producing, on average, a 10% drop in the stock market indices, and they have had a median and mean duration of 75 days and 140 days, respectfully. During that time frame, the three-month U.S. Treasury bills and 10-year U.S. notes rose by, on average, 75 basis points.
Last week we saw the tip of that iceberg in a fall in equities and in disruption in the credit markets.
Up until last week, warnings have been ignored.
[A]symmetrical policies over successive business and financial cycles can impart a serious bias over time and run the risk of entrenching instability in the economy. Policy does not lean against the booms but eases aggressively and persistently during busts. This induces a downward bias in interest rates and an upward bias in debt levels, which in turn makes it hard to raise rates without damaging the economy -- a debt trap. Systemic financial crises do not become less frequent or intense, private and public debts continue to grow, the economy fails to climb onto a stronger sustainable path, and monetary and fiscal policies run out of ammunition. Over time, policies lose their effectiveness and may end up fostering the very conditions they seek to prevent.
-- Bank for International Settlements' 84th Annual Report
Take a look at what a modest rise in mortgage rates (from generational low levels) have already done to the residential real estate market over the past 12 to 18 months. Those who suggest that mortgage rates are low by historic standards miss the fact that younger home buyers have no experience in a world of higher rates -- they are conditioned to the low mortgage rates of the last 10 or 15 years. Most first-time home buyers were not adults 30 years ago when rates last rose dramatically in the early 1980s -- they know of only mid-single-digit mortgage rates.
And in the past, a domestic economic recovery has yielded higher real personal incomes. By contrast, in this cycle the necessities of life have risen in cost while salaries and wages have flattened (what I describe as "the screwflation of the middle class"). When you combine this with the proliferation of new-era home buyers (i.e., institutional, hedge funds, private equity, new vehicles such as Altisource Residential (RESI) and its ilk), that have buoyed home prices, home affordability has significantly deteriorated.
With net corporate debt so much higher since 2008-2009, a consequential rate rise will further choke off corporate profits, capital spending and buyback plans. The latter is particularly true regarding a vulnerable high-yield market. Moody's Investors Service reports that junk-rated borrowers have nearly $750 billion of debt coming due in the next five years. Junk bonds are an important source of stock market demand through corporations' share buybacks.
Summarily, since early July there has been a confluence of indicators suggesting that our capital markets are vulnerable to something more than a shallow correction.
The pressures are now intensifying.
Tops are a process, and signs lead to the possible view that the worst might lie ahead for the U.S. stock market.
Err on the side of conservatism.