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This week, there was another victory for the DIY investor.

Weak Economic Data Led to a Sharp Drop in Interest Rates, but Stocks were Flat Because Bad News is Good News — For Now

The fourth quarter began on a volatile note when disappointing economic data led to a 4.5% drop in the S&P 500. Stocks declined on Tuesday because the ISM Manufacturing survey was significantly weaker than expected, and fell to its lowest level since June of 2009. On Thursday, the ISM Non-Manufacturing Index was also weaker than expected and showed a sharp drop from August.  After an initial decline, stocks rallied on the bad news, because the odds of another Fed interest rate cut rose dramatically. According to the CME, the odds of a rate cut at the Fed’s  October 30th meeting jumped to nearly 89% from 39.6% on September 30th.  On Friday, the employment report for September was released, and while it was slightly weaker than expected, stocks rallied again on the belief that the economy was not imminently headed into recession but was soft enough to warrant another rate cut. 

Despite a very volatile week, the S&P 500 decreased by only 0.33%, while the tech-heavy Nasdaq 100 rallied by 0.94% and the small-cap Russell 2000 fell by 1.33%. International stocks were mixed, the MSCI EAFE Index (international ex-US and Canada) dropped by 2.18%, while the MSCI Emerging Markets rose by 0.81%.   

In this “risk-off” environment, the safe havens performed well — gold rallied by 0.43%, and the U.S. Treasury long-bond (TLT) jumped by 2.46% this week. Despite aggression by Iran in the Middle East, an excess supply of oil drove crude prices down by 5.5% this week. Oil is currently 4% lower than it was before the attacks on the Saudi oil facility. While lower oil prices are always good for the economy, its weak performance given the escalation in geopolitical risk is surprising, and in our view, it is another indication that the global economy is weak. 

This week’s disappointing economic data shows the negative impact that the trade war with China is having on the economy. Unfortunately, the impeachment of President Trump has increased the uncertainty of favorably resolving the trade dispute. We assume that the Chinese believe that the impeachment crisis has weakened the President, so they are likely to demand a limited deal or wait until the next election. Also, with problems at home, we expect that the President will remain resolute to avoid additional criticism and require a significant agreement that resolves forced technology transfers, IP theft, government subsidies, and eliminates China’s trade barriers. 

This Thursday the trade talks resume in Washington. Hopefully, they are productive because, on October 15th, tariffs are scheduled to increase from 25% to 30% on $250 billion of Chinese goods. 

In addition to complicating the trade negotiations, we are concerned that the impeachment crisis and the politically divided country could negatively impact consumer confidence. This week’s ISM report showed that while the manufacturing sector is contracting, the service side (i.e., consumer sector) of the economy (despite being weaker than expected) is still expanding. We are closely watching Consumer Sentiment, which after reaching a cyclical high in May has fallen sharply and could portend weakness in the consumer sector of the economy (see chart below).
Finally, WeWork, the shared workspace company, which is one of the largest commercials real estate tenants in the U.S., officially canceled its IPO and decided to remain private. The IPO was pulled because investors balked at the significant corporate governance issues, the questionable business model, and the outrageous private market valuation. While private equity investors and management believed that WeWork was worth $47 billion, public stock market investors believed the unprofitable company was worth $10 billion or less. 

WeWork canceled the IPO, fired its founder and CEO and planned a massive restructuring, which will include many layoffs. WeWork controls nearly 6% of the NYC commercial real estate market and currently has more than $47 billion in lease obligations that are payable over the next fifteen years. Unfortunately, they only have leasehold commits of $4 billion with an average maturity of fifteen months.As of June 31st, WeWork had $2.5 billion in cash and a burn rate of $700mm per quarter. Since the new issue failed, management must cut its massive losses quickly, or WeWork will run out of money sometime in the first half of next year. 

WeWork’s fall from a $47 billion private equity valuation to a company struggling to survive is an extreme example of shifts in investor psychology. Sanguine privates equity investors believed that the company and led by its messianic leader was a technology company that would change commercial real estate, so it deserved a valuation of more than ten times sales manlig-halsa.se. Now, after reviewing its business model and financials, many investors and Federal Reserve President Eric Rosengren are concerned that WeWork’s size and flawed business model could be a systematic risk to the economy in the next recession. 

The current bull market is more than ten years old. Similar to the past two bull markets that peaked in 2000 and 2007, the current bull market was fueled by artificially low-interest rates and the Fed’s Quantitative Easing program that printed money to buy financial assets.  Historically, the central bank’s easy money policies led to financial booms and busts, and typically, there are very high profile market events that mark the end of the bull market. 

In hindsight, the AOL and Time Warner merger marked the end of the 2000 technology bubble, Sam Zell’s sale of his apartment REIT (Equity Office Properties) to Blackstone Group LP in 2007 marked the end of the housing bubble, and JPMorgan’s “take under” of Bear Sterns in 2008 marked the beginning of the financial crisis. 

WeWork’s fall ends the era of the Unicorn, the mega-billion dollar companies that were given outrageous valuation because of their “blitzscaling” strategy that pursued market share and hyper revenue growth at the expense of profitability. Also, we believe that WeWork’s failure is consistent with our view that the business cycle peaked last year and we are in a bear market.
Our View:The S&P 500 is within 3% of its all-time high, yet the business cycle is contracting, we are in a trade war with China, the President is being impeached, and geopolitical tension in the Middle East is elevated. Additionally, the yield curve is inverted (which has preceded every recession since WWII),  there are problems in the overnight funding market, and there were several high profile IPO failures that demonstrate a shift in investor sentiment and risk tolerance. 

We believe that investors are complacent and overlooking significant risk because they think the trade war will end soon, and the Fed can lower rates to stimulate economic growth. As discussed previously, we believe that the trade war will not be fully resolved until after the election. Also, we believe that the Fed is behind the curve and doesn’t have enough monetary policy tools to stimulate the economy.  Interestingly, the S&P 500 was up only 1.33% in the third quarter, despite two interest rate cuts by the Fed, and one cut and the start of another QE program from the ECB. 

In our view, the market offers a poor risk-reward – since stocks are expensive, there is a little upside if everything goes right, but significant downside if a recession occurs. Historically, the S&P 500’s average decline during a recession is more than 30%, and stocks dropped by more than 50% during the last two recession. 

Instead of watching the S&P 500, which is near an all-time high, and being driven by a few megcap stocks, we believe that investors should focus on the broad stock market (Russell 2000), which peaked in August of 2018, and the bond market, which historically has a better track record forecasting the economy. 
Our Tactical Allocation (six-month view) is negative. Stocks have dropped for three consecutive weeks, the sentiment is neutral, and market breadth is weak. The market is in a correction, and we will become more constructive, on a short-term basis, when the market is oversold, investors are pessimistic, and market breadth begins to improve. We expect a short-term bottom to coincide with the end of the stock market’s period of negative seasonality, which is typically near the end of this month. 

Our Strategic Allocation (six-year view) remains underweight equities, overweight bond duration, and gold. We continue to believe that the stock market offers a poor long-term risk-reward. The upside is limited due to overvaluation and weak earnings growth, while the odds of a recession and bear market are elevated.  The yield curve, which inverted in May, continues to indicate that the Fed is still behind the curve.  At the sector level, we remain overweight in the defensive, non-cyclical areas of the stock market, which is consistent with our view that the economy and inflation are slowing.

Do Stocks Have a Favorable Risk-Reward?

A Saudi Arabian Oil Facility Was Attacked, the Repo Overnight Lending Market Froze and There Was Another Setback in Trade Negotiations with China – Yet the S&P 500 Was Flat for the Week.

This week started on a volatile note when a Saudi Arabian oil facility was attacked and 5.7 mm barrels a day output was knocked out, which is more than 50% of Saudi output and nearly 6% of the world’s oil supply. On Monday, the price of oil spiked by more than 15%, which was its largest increase since the 1991 Gulf War. While geopolitical and economic risk rose in the Middle East, the overnight lending market froze, and the Federal Reserve had to inject hundreds of billions of dollars to stabilize the market. On Friday, the Fed announced that they expect to inject approximately $75 billion each day into the overnight market for the next two weeks. 

Also, this week, as expected, the Fed reduced short-term interest rates to 1.75%, which was a reduction of 0.25%.  This was the Fed’s second rate cut this year, which rolled back half of the Fed’s four rate hikes from last year.  Finally, on Friday, the Chinese announced they would not visit farms in Montana. Investors believed this was another setback in trade negotiations and sold stocks. 

Despite increased economic and geopolitical uncertainty, the stock market remained calm. The S&P 500 decreased by 0.51%, while the tech-heavy Nasdaq 100 and the small-cap Russell 2000 fell by 0.88% and 1.16%, respectively, this week.  International stocks also pulled back, the MSCI EAFE Index (international ex-US and Canada) corrected by 0.36%%, and the MSCI Emerging Markets dropped by 1.49%.   

In this “risk-off” environment, the safe havens performed well — gold rallied by 1.0%, and the U.S. Treasury long-bond (TLT) jumped by 3.9% this week. After a 15% jump on Monday, the price of oil closed the week up only 5.9%. 

This week the markets received bad news, yet investors remained calm, and the stock market was relatively tranquil. While it appears that Iran’s attack on Saudi Arabia’s oil facility will not lead to an immediate military response by the U.S., and oil production should be fully online by the end of the month, the geopolitical risk in the Middle East has increased dramatically. Economic sanctions against Iran are crippling their economy, and they have turned to a strategy of brinksmanship by attacking energy asset in the Persian Gulf to negotiate relief.  

Although the oil market has stabilized, Iran’s intentions are unknowable, and it is probable that there will be more attacks on energy infrastructure in the Persian Gulf.  This year, the low price of oil (oil is down by 21% year-over-year) has helped our sluggish economy overcome the headwinds from the Fed’s 2016 through 2018 interest rate tightening cycle, the trade war with China, and the global economic slowdown.   

We believe that any sustainable increase in the price of oil above $65 would be a sizeable year-over-year spike in energy prices, which would negatively impact economic growth over the next six months and likely lead to the recession that the yield curve is forecasting (see chart).
In addition to the turmoil in the Middle East, investors had to contemplate the significance of the problems in the overnight lending market. The repo market (repurchase agreement market), which provides overnight funding to major financial firms froze for the first time since the “Great Recession.” Although the Fed stated the problems in the repo market are technical, and due to issues of liquidity and not solvency, it is unnerving that they had to inject more than $100 billion into the market this week and expects to provide $75 billion each day until October 10th

The Fed never saw this problem coming, yet by injecting massive amounts of money, they expect the issue to be resolved. It is disconcerting that the market froze in a period of little financial stress. What happens when the next crisis hits, or if the Fed is wrong and there is a solvency issue?  While we don’t fully know what is occurring in the repo market, we believe it is more evidence that this is a high-risk environment — i.e., we have a dollar liquidity shortage and an inverted yield curve.
Our View: The S&P 500 is within 1% of its all-time high, yet we are in a trade war with China, global growth is weak, and tension in the Middle East is elevated. In addition to an inverted yield curve — which has preceded every recession since WWII – the overnight lending market froze, and the Fed will inject hundreds of billions of dollars to stabilize it over the next three weeks edmedicom.com

We believe that investors are complacent and overlooking significant risk because they think the trade war will end soon, and the Fed can lower rates to stimulate economic growth. In our view, the market offers a poor risk-reward – since stocks are expensive, there is little upside if everything goes right, but significant downside if a recession occurs. Historically, the S&P 500’s average decline during a recession is more than 30%, and stocks dropped by more than 50% during the last two recession. 

Instead of watching the stock market, which is near an all-time high, we believe that investors should focus on the bond market, which has a better track record of forecasting the economy. The 10-year U.S. Treasury yield has dropped by 1.25% (from 2.69% to 1.43%) this year, which led to the yield curve inverting in May.  This dramatic shift in interest rates indicates that bond investors are concerned that the Fed is too tight and economic growth is at risk.  Also, as expected, the Fed cut rates by 0.25% this week. Unfortunately, the market didn’t think it was enough – the dollar rallied, and the 10-year U.S. Treasury yield fell by 6bps.
Our Tactical Allocation (six-month view) is negative.  After a three week rally, the S&P 500 dropped by 0.51% this week. We continue to believe that investors are too optimistic, market breadth is weak, and stocks are in a period of negative seasonality.  Despite two rate cuts from the Fed and new QE from the ECB, stocks are down slightly since the Fed’s July 31st initial rate cut. Central bank stimulus and scheduled trade talks with China have not been able to drive stocks higher.  We believe that the market is priced for perfection, and poised for a correction. We will become more constructive, on a short-term basis, when the market is oversold, investors are pessimistic, and market breadth begins to improve.

Our Strategic Allocation (six-year view) remains underweight equities, overweight bond duration, and gold. We continue to believe that the stock market offers a poor long-term risk-reward. The upside is limited due to overvaluation and weak earnings growth, while the odds of a recession and bear market are elevated.  Also, we believe that the market is too complacent regarding the problems in the Middle East. In our view, any sustainable spike in energy prices would lead to a recession. At the sector level, we remain overweight the defensive, non-cyclical areas of the stock market, which is consistent with our view that the economy and inflation are slowing.
  • lmanley
  • September 23, 2019

Is the Trade War Over? Is it Safe to Buy Stocks?

Despite New Tariffs and Mixed Economic Data, Stocks Rallied This Week Because the US and China Agreed to Meet in October.

After falling 2.9% in August, the S&P 500 rallied 1.8% this week as investors ignored the September 1st tariff increase and mixed economic data, and instead bought stocks because the Trump administration and China agreed to another round of trade negotiations in early October.

The tech-heavy Nasdaq 100 and the small-cap Russell 2000 increased by 2.1% and 0.70%, respectively, this week.  International stocks also performed well, the MSCI EAFE Index (international ex-US and Canada) appreciated by 2.16%, and the MSCI Emerging Markets jumped by 2.6%.  In this “risk-on” environment, the safe havens corrected — gold fell by 0.9%, and the U.S. Treasury long-bond (TLT) dropped by 0.8% this week.

This week the S&P 500 rebounded despite mixed economic news. On Monday, the ISM Manufacturing Index fell below 50, which signaled that manufacturing was in a contraction. It was also the weakest reading since August of 2016.  Additionally, IHS Markit reported that their manufacturing index fell to 50.3, which was the lowest reading since September 2009.

While the manufacturing sector appears weak, the service sector, which represents nearly 70% of the U.S. economy, continues to perform well. On Wednesday, the ISM Non-Manufacturing survey showed that the services sector of the economy remained robust and grew at a stronger rate than investors expected. 

Finally, on Friday, the Bureau of Labor reported that 130,000 jobs were created in August. Unfortunately, economists were expecting a report of 150,000 jobs, and since 25,000 jobs were due to the temporary hiring of census workers, this was a disappointing number. On a positive note, wages increased by 3.5%, which was the best level in ten-years (see chart below).

Wages increases are at a ten-year high, but what is good for “Main Street,” may not be good for Wall Street,

The Trade War is Hurting Corporate Profits

According to Factset, analysts expect the S&P 500’s Q3 earnings to fall by 3.6% year-over-year. This will be the third consecutive quarter of year-over-year earnings declines.  Factset also indicated that declining corporate earnings were mostly due to weak international growth. In fact, Q3 earnings are expected to decline by 10.7% for companies that generate more than 50% of their sales outside the U.S., while companies with more than 50% of their revenue in the U.S. are expected to grow earnings at 0.4%.

Analysts expect Q4 earnings to rebound to 4.3% year-over-year growth in Q4, which will lead to 1.4% earnings growth for 2019.  Additionally, the S&P 500’s earnings are expected to grow by 10.7% in 2020. Based on these numbers, the S&P 500 sells at 16.8 times the 12-month forward earnings, which is 13% above its 10-year average P/E of 14.8.

We believe that earnings expectations are too high, and stocks will be vulnerable when analysts begin to reduce their earnings expectations in the coming weeks.  While the resumption of trade negotiations is positive, the tariffs remain in place, tensions are high, and any resolution (if at all possible) is many months away.

In addition to the trade war and the global economic slowdown, wages are growing at their highest rate in ten years. Tight labor markets, and accelerating wages will continue to pressure profit margins and negatively impact earnings growth. Unfortunately, what is good for “Main Street” is not always good for “Wall Street.”


Our Market View:

The S&P 500 is within 2% of its all-time high, yet we are in a trade war with China, global growth is weak, and earnings are expected to decline for the third quarter in a row. Additionally, interest rates have plunged this year, and the yield curve has inverted four months ago.  This dramatic drop in interest rates indicates that bond investors are concerned that the Fed is too tight and economic growth is at risk. Commodity prices confirm the bond market’s message of weak economic growth — over the past twelve months, the price of oil and copper have dropped by 23% and 6%, respectively.

While bond and commodity investors appear concerned about economic growth, equity investors seem ebullient — the S&P 500 sells at a premium valuation and near its all-time high cialis black 80mg canada. While the S&P 500 has performed well this year, it is up only 5.3% over the past 21 months. Furthermore, the small-cap Russell 2000 is down by 11.7% over the past twelve months, while the MSCI EAFE Index (international ex-US and Canada) and the MSCI Emerging Markets declined over the past year by 3.3% and 0.7%, respectively.

In our view, such narrow market breadth indicates that the S&P 500 is benefiting from a “flight to quality,” which we expect will end soon, as the economy continues to slow and earnings estimates fall. We believe that the market is already discounting the best-case scenario regarding a trade agreement and a Fed easing cycle, and the stock market will be vulnerable to any disappointment.


Sector Discussion

While the S&P 500 has rallied by 18.8% this year, we believe the more critical measure of the market’s strength is its performance over the last twelve months, in which, the S&P 500 is up only 3.5%.  Also, the leading sectors over the past year are the defensive, non-cyclical sectors (Utilities, REITs, and Consumer Staples) and Technology.  Also, five of the S&P 500’s eleven sectors have declined over the past year (Energy, Financials, Materials, Industrials, and Healthcare)

In our view, the sector performance of the market over the past twelve months confirms the message of the bond market and is consistent with a slowing economy, and a “risk-off” environment. We are especially focused on the disappointing performance of the financial sector over the past year — since it fuels growth and is a leading indicator of the economy.

The strength of the defensive sectors of the market over the past twelve months confirms the message of the bond market and is consistent with a slowing economy, and a “risk-off” environment.


Our Tactical Asset Allocation (three to six-month view) is negative: Despite a 2.9% drop in August, the S&P 500 has rallied for two consecutive weeks and is within 2% of its all-time high. The VIX (the volatility “fear gauge”) fell below 15 last week, which indicates that investor sentiment is too optimistic, while breadth is weak, and stocks are in a period of negative seasonality.

We believe that the market is in a correction, and we will become more constructive, on a short-term basis, when the market is oversold, investors are pessimistic, and market breadth begins to improve.

Our Strategic Asset Allocation (six-year view) remains underweight equities, overweight bond duration, and long gold: We continue to believe that the stock market offers a poor long-term risk-reward. The upside is limited due to overvaluation and weak earnings growth, while the odds of a recession and bear market are elevated. At the sector level, we remain overweight the defensive, non-cyclical areas of the stock market, which is consistent with our view that the economy and inflation are slowing.


In Summary:

Our long-term asset allocation remains underweight equities because the market is overvalued, the profit cycle is slowing, and earnings are poised to disappoint as global growth slows and profit margins compress.  In our view, the Fed tightened policy too much last year and the recent tariff increases will accelerate the slowdown in growth.  We remain concerned that the yield curve indicates that the Fed is too tight and a recession is probable within the next year.

As value investors, we will continue to underweight our long-term equity exposure until the markets offer a favorable risk-reward.

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  • lmanley
  • September 10, 2019