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June 30, 2017

Beware the Hard Data

Soft data belies record market

A persistent trend was maintained in the second quarter in that the raw economic data showed continued weakness whereas the soft data such as the indexes that measure confidence maintained its strength. Surely the markets at all time highs contribute to this confidence, but investors may be overlooking just how broad the weakness is throughout the economy. Of course, this trend has been the hallmark of the rally in stocks since 2009 with real economic growth coming in at less that 2% on average despite the markets more than tripling during this period.

Consider the following hard data points: The New York Federal Reserve revised Second quarter GDP downward from over 3% to just 1.86%, Durable Goods was negative in May and is still 5% below its 2007 levels, and the National Economic Surprise Index was also negative in May. Retail sales across the board are weak except for Amazon and credit card defaults are now at the highest levels since the financial crisis. Crude Oil is now in correction phase, down 20% from its high.

Yet the markets by most measures are very overvalued. My favorite is the one that is favored by Warren Buffett— the ratio of GDP to the overall market and the last time it was this high was just before the internet bubble burst in the spring of 2000. Also, the Dow Jones price to sales ratio is the highest since 2000. An article was published in December of 2016 on Zerohedge that made the case for the PE ratio of the Russell 2000 to be a staggering 243 times trailing earnings by virtue of the fact that so many of the biotechs in that index are losing money and may never show revenues. You can access this by searching for Banks in Drag — the Russell 2000 Exposed. Such an article is typical for markets at or near all-time highs. Of course, that ratio would be closer to 270 now with the surge in stocks this year.

One market that doesn’t seem to be overvalued is the US Treasury market. You would think bond prices would lose value in a rising rate environment and the stock market at record levels but that is not the case at all. Here investors are taking a cue from the soft economic data and pricing these securities in line with that. And history shows that bond investors almost always get it right when there is such a discrepancy.

So how did we get here? While the U.S. Federal Reserve has been raising rates, albeit slowly for a year and a half they have still maintained their bloated balance sheet by allowing maturing bonds to be reinvested. So QE is still in place. But perhaps the biggest reason for the outsized rally since 2015 comes from the expanded monetary policy enacted by the ECB, Japan and China. With negative rates and QE in full tilt, much of that cash has found its way into US markets given the perception that the US is still the safest house in a bad neighborhood. Much like the outsized QE by the Fed in the years following the financial crisis their QE has elevated stock markets far more than elevating economic growth.

Of course, the hundreds of billions in stock buybacks in recent years has also been a significant factor in elevating stocks to historically high valuations. I mentioned in a previous post that since the financial crisis the sum of these stock buybacks has actually exceeded US corporate profits.That fact is so staggering and unprecedented it boggles the mind. What we have here, along with QE, is stimulus to stocks that lie outside their fundamentals. Corporations have chosen to borrow to finance most of these buybacks so they now have much higher debt levels. But no one seems to care given that they are making money. But what happens when the next recession or financial crisis occurs? They will the regret buying their shares at such inflated prices and investors will regret owning their shares. I would urge everyone who owns stocks to be very careful about owning stocks that have high debt levels.

I would actually argue that corporations should now do the exact opposite — issue more shares in new massive secondary offerings. The demand would surely be there and they could raise adequate capital to get through the next crisis. They would also be issuing shares at historically high levels and could possibly buy them back years later at much lower prices. In particular Amazon should do this.

Amazon would be among those companies most severely hit by a recession as the margins on their core business are so razor thin. The recent announcement of their plans to buy Whole Foods for $17 billion will also put them much further in debt yet I have heard no plans for a secondary offering. Why? Like other corporations they are just too enticed by the ultra low yields that large debt offerings of blue chip companies have had in recent years. Corps have elected to just keep on piling on the debt because the markets have shown seemingly that off the charts debt levels just don’t matter. But one day they will. Just like central banks, corps will find out probably when its too late.

Speaking of stock buybacks, most all large banks announced just days ago their plans for massive stock buybacks just seconds after the Federal Reserve gave them the new green light. In recent years the Fed has lightened up on many of the variables they used to measure the health of banks and also recently Treasury Secretary Mnuchin suggested he would advocate doing the stress tests every two years instead of each year.

This is in line with the new winds of deregulation blowing in Washington since Trump was elected. But historically just when regulations hit their lows, stemming from being years away from a crisis, the next crisis is just around the corner. In 1999 President Clinton did away with the Glass Steagal Act that prohibited banks from mixing commercial and investment businesses and we had a crisis shortly thereafter. Same happened eight years later after a steady drip of deregulation under President Bush.

And now, nine years later, it is about to happen again.

It seems we are in a classic topping process right now. Momentum is fading, fewer companies are participating in the rally, volume is way down and high yield credit is rolling over. Finally, the Federal Reserve is not so accommodating to the markets anymore. They have already raised rates to 1% and indicate one more is coming this year. Perhaps more importantly, they signaled at the last meeting their intention to drain off $10 billion in bonds each month in an attempt to reduce their bloated balance sheet. So QE will indeed finally end and this policy change bodes very well for the US Dollar index and thus very poor for US stocks given how much corporate profits come overseas from countries with ever cheaper currencies relative to our dollar.

We have also see some dramatic moves downward lately from the FAANG stocks Facebook, Netflix, Apple, Amazon and Google. Goldman Sachs downgraded most of them recently on concern for their rich valuations and this may be the first crack in the armor of a market that has surprised so many, including myself, with its resilience over the years. But the factors cited above indicate this resilience will be soon tested. Let’s remember that despite the markets making new highs there is still ample evidence we remain in the winter phase of the Kondratieff Winter.

Low growth and puny bond yields do not lie.

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