There have probably never been as many characteristics of a top as we are experiencing today…
It is clear that it would have been a very hard sell a year ago that every single risk-on asset class from equities, to corporate bonds, to commodities would end up rallying as much as they did in 2019.
And so perhaps the message for 2020 is to fade all the optimism since fading the pessimism a year ago paid off very well. The sharp slide in Treasury yields this past year does not exactly comport with the risk-on view that has morphed into the consensus forecast.
Fed policy, the trajectory of GDP growth and global economic fundamentals in general all tell a cautionary tale. Both bonds and stocks can’t be right at this moment in time.
We have to choose which asset class has the story right, and history sides with the Treasury market. So, that indeed is how we are tilted for 2020. Defensively positioned — again. In addition, from a total return perspective, a near-20 per cent gain in the long bond not only didn’t hurt you, but meaningfully outperformed the S&P 500 on a risk-adjusted basis and by not having to take on any inherent equity (capital) risk.
Right now, it is critically important to get as close to the truth of clients’ risk tolerance. There have probably never been as many characteristics of a top as we are experiencing today. At some point, as unpopular as contrarianism can be, we all need to ponder deeply about Bob Farrell’s Rule #4:
“Exponentially rapidly rising or falling markets usually go further than you think but they do not correct by going sideways.”
No one really knows how far up the top is, but what happens after the top does not fit into very many people’s risk tolerance. In the meantime, another year of double-digit returns on the highest quality, long duration bonds is our expectation and the interest rate risk associated with them is entirely manageable from my perspective as a market economist.
While I cannot pick the date, I can tell you that this turbocharged debt cycle will end miserably, not unlike 2008 and 2001. Don’t try to time the inevitable mean-reversion trade. Just heed this first Bob Farrell rule of investing on ‘mean reversion’ and know that it’s out there. In nearly 11 years the S&P 500 has soared nearly fivefold to multiples (on earnings, sales and book value — take your pick) we have only seen twice in recent history.
Corporate bond spreads off Treasuries are squeezed to levels that fall well short of compensating for imminent default risks, and there really is no reason to wait for the herd to head for the exits. That time will come sooner rather than later because Mother Nature will not tolerate leverage and multiple-expansion supplanting corporate earnings and productivity growth indefinitely.
We recall all too well the euphoria that followed the early 2001 and late 2007 Fed rate cuts and curve-steepening shifts, that then switched to malaise as the recession nobody saw coming took hold in the next few months. The lags between monetary policy and the real economy are both long and variable. We are still feeling the effects of the tightening in Fed policy from 2015-2018, as we were feeling the 2004-06 effects by the time the 2008 recession kicked in.
Remember, it cannot be denied that during the summer months the ‘normalized’ New York Fed recession probability model did breach the 80 per cent threshold, and it cannot be taken back, even if it has receded in response to the Fed’s recent liquidity infusions. The Fed has employed both actual rate cuts, and an aggressive QE4, which in the past two months has more than fully funded the U.S. fiscal deficit. But, with a typical year-long lag, a recession has ensued after the 80 per cent mark has been crossed in the ‘normalized’ New York Fed model every single time in the past five decades.
And, of course, there are ongoing uncertainties around the global trade picture (not to mention the U.S. fiscal outlook) as it pertains to the November 2020 election. I see little reason for a capex cycle to emerge in 2020 given the wide divide that has opened up on tax policy between the Democrats and Republicans — to the point where even a centrist like Joe Biden is now campaigning on rolling back the Trump tax cuts of 2018. What business is going to embark on a major multi-year spending project not knowing what the after-tax rate of return on the capital invested is going to look like?
Lately, the equity market no longer seems to trade off the economic fundamentals. Never before has there been such a loose relationship to economic growth. While the GDP recession never did materialize, the median economic sector stopped expanding mid-year and the portion of the economy that is not the consumer has posted no growth at all in the past three quarters. That may well be a bit of data mining, but it is to show how narrowly concentrated the economy has become.
Not just that, but corporate profits are set to be in a four-quarter recession and investors have barely blinked. More like shrugged. At the start of 2019, the consensus was for a V-shaped earnings recovery to take hold by year-end, but instead of double-digit growth that the consensus had once penned in, Q4 2019 is now seen as coming in at -0.3 per cent on a YoY basis.
If corporate earnings had gone up four quarters in a row and the stock market plunged 30 per cent, such a mismatch would make the temptation to turn bullish irresistible. Please stand by. But what happened in 2019 was the exact opposite. That was not in the consensus forecast at the turn of the year, and the stock market soared by more than 30 per cent.
So, the market has rallied completely on the back of multiple expansion — to the point where the price-to-earnings, price-to-cash flow and price-to-book ratios are all near-one standard-deviations above their historical norms. The price-to-sales multiple for the S&P 500 actually is back to where it was at the 2000 dotcom bubble peak.
The ratio of corporate debt-to-GDP is at all-time highs. In addition to the unprecedented fiscal stimulus at this late stage of the economic cycle, and accompanying trillion-dollar deficits, we also have corporate leverage ratios at record levels. An enormous volume of corporate debt has been issued exclusively for the purpose of buying and retiring shares. This includes both buybacks and acquisitions of other companies. And in classic mature-cycle fashion, we are seeing some cracks emerge in the junkiest parts of the U.S. credit market. This is an area to be focused on as leveraged credits are in an eerily similar situation to what was surfacing out of the subprime mortgage market back in 2007.
In any event, we are light years away from a stable equilibrium. Leverage, financial engineering and the restructuring of the capital structure that followed the recent M&A wave, have become the defining features of this bull market in risk assets — namely equities and corporate credit. The proverbial canary in the coal mine usually resides somewhere in the credit market (think of LBOs in 1989 and subprime mortgages in 2007).
The bottom line is that this is a stock market that is being driven by flows rather than by economic fundamentals. The ongoing wave of stock buybacks has taken the S&P 500 share count to two-decade lows, so to some extent the equity market now behaves more like a commodity. This was achieved primarily by the issuance of low-rated corporate debt. In addition, the Baby Boomer generation has done its best in a decade-long effort to build retirement savings, primarily in index fund purchases in their retirement plans.
This is the Chinese Year of the Rat. Last year was the Year of the Pig, and there was a whole cosmetics bag of lipstick that was applied, primarily by central bankers. There is just too much air underneath equity valuations and there is no room for credit spreads to tighten any further. The world’s economic and financial problems have been papered over by even more debt and we now have hit leverage ratios that look to be highly unstable and unsustainable.
In 2020, I smell a rat. The central bank liquidity taps are likely to be turned on even more, but the impact at current valuation levels across the various risk asset classes will be far more muted now than was the case a year ago. And there is always the prospect that the monetary authorities will stay on the sidelines and await a budgetary tax cut or government spending response, which itself is futile given that fiscal policy in most countries is just as tapped out as monetary policy.
There are no easy solutions and it is doubtful that we will have another year where central banks can transform the weakest period for global economic growth in a decade and pull another rabbit out of the hat in terms of massive excess returns for equity and corporate bond investors.
Article written by David Rosenberg for The Financial Post