Apparently Trump has the Midas touch! For the record, I prefer the idea that Trump will try things and risk going down swinging instead of managing the economy to not crash under his watch. The not crash approach is that of Japan, and I don’t think we want to turn the US into Japan for our kids. Better to take risks now for a better future tomorrow.
There’s a lot of ground to go over with what’s happened. I think it’s best to frame the discussion in the parameters of the four pillars of the market. Looked at through that lens, I think things become more clear. I do want to emphasize that a lot has gone on in the last three weeks, and I can’t cover everything. I’m just trying to give an overview of the main points. I’ll end up leaving out many things, and it’s likely that I’ve left out something important. Call it my best efforts.
The idea of the four pillars is that there are four basic things that affect the market: macro, fundamentals, technicals, and sentiment. Macro is the question of what is the economy doing. Fundamentals is the question of what are companies doing. Technicals are about price, and sentiment is about how people are feeling and acting towards stocks.
Macro– Generally, macro economic data has been on a long-term downward path, though hopes are now high that Trump’s fiscal stimulus will get things moving again. I’ll just tell you what I see. First, we’ve seen a reasonably long, gradual decline in GDP until the third quarter, where we saw a sequential improvement (what I’ve referred to as a countertrend bounce.) The market saw that and ran with it, and now the hope is that Trump can build on that momentum.
First, Trump doesn’t take office until 1/20/17. Then it will take time for his policies to take effect. For this quarter, we’re still coming off of the upswing of last quarter. The data points are generally bad, but not terrible, and to some extent you can tell stories (what we often call narratives) about it if you want to. For instance, people love to talk about the great labor market. Admittedly, this ignores weak labor force participation, but it is what it is. What I think is more important is that labor data is very late cycle. When the labor data is at its best that’s because businesses have been doing well and hiring for a while, and you should start looking for the next economic downswing. On the flip side, can optimism over the new President encourage spending? I’d say this quarter is fairly neutral with a somewhat bearish bias.
The first quarter of 2017 is more obviously troublesome. Comps (mostly year over year data comparisons) are tough, so it would be tough for the quarter to look good, particularly considering that the trend in economic data is pretty solidly negative right now. Q1 will be bad, but the good news is that it’s the last obviously bad quarter for a while. The following quarters are all kind of coin flips. Could Trump policies and animal spirits make the first quarter the relative bottom for the economy? I think you can make that argument, but that’s the most optimistic of the range of outcomes. The worst scenario is that negative trending data continues and the latest volatility accelerates, meaning that a recession is likely next year. How would that work?
Any time you make big changes on a big machine like our economy, you tend to have problems. Try to fix something over here and something over there breaks. I actually think that’s what’s going on right now- promises of fiscal stimulus are raising the dollar and rates and causing big headaches elsewhere, most notably in foreign countries. The Asian crisis in 1998 and a less-talked about but very damaging effect of the 2008 crisis looked like this – higher rates and a stronger dollar. Ice Capital did a nice job of showing that every crisis for the last 40 years or so was preceded by a jump in yields.
Fundamental- Fundamentals suggest that stocks are quite expensive on about every measure imaginable (about the only one that isn’t is to take the always overoptimistic forward operating earnings expectations at face value, comparing them to net earnings or trailing P/Es). What does that mean? Short term, not much. Expensive can always get more expensive. Remember 2000? Fundamentals are more about field position and scenario analysis. Where can we go from here? Expensive fundamentals and high debt are signs that we can’t expect businesses to broadly improve metrics. Could US Steel (X) benefit from the U.S. building a wall with Mexico? Absolutely. But does that mean we should expect S&P earnings to go up 20%? No. You have to figure out where it would come from. As things stand right now we have a lot of debt and debt service looks to be getting higher. We may get higher sales from stimulus, but that’s a minority of the economy – it’s just not that big a deal. Fundamentals tell us there’s little here to make fundamentals look better.
Technicals- I primarily live in the first two pillars- macro and fundamentals. It’s where a lot of our calls come from. I only tend to use technicals and sentiment as mean reversion tools. When stocks get overbought or oversold or sentiment gets extreme, I start to get interested. On both overbought and oversold technicals, we’ve seen some extremes. Generally, those extremes are pro-U.S. stocks and dollar and anti-everything else. The Russell 2000 is the most overbought since January of 2013, regional financials are the most overbought ever, and the USD is the most overbought since September 2014, Treasuries are the most oversold since June 2007, and global bonds are the most oversold since April 2000. That doesn’t mean these moves can’t continue, just that things are very stretched.
What do we do with that? I’d lean against the likelihood of them stretching further. Maybe they slightly reverse, rest, and continue, but when you see historic extremes like that, the betting line is that’s about as far as you go. So technicals say we’ve come a long way quickly, which tells me things are at least likely to take a rest in the short term.
I also want to point out again that there are two things working and nothing else. Domestic stocks are doing well and the dollar is doing well. Everything else – bonds, foreign stocks, and so on are doing the opposite. In fact, you can cut it even thinner- financials, industrials and (mostly) retail are doing well – the rest is hit or miss.
Sentiment- I traditionally haven’t found a great deal of utility in making quantitative sentiment judgments – those measures seem to flash neutral almost all the time. If you’re curious, SentimenTrader shows bonds as low risk due to negative sentiment and everything else neutral. They do admit that returns skew a bit negative when sentiment improves so much so quickly, but nothing dramatic. They also say that, based on sentiment, they’d be worried about financials, industrials, retail, and biotech. They’d be more constructive on consumer staples.
That may be interesting, but I still mostly rely on qualitative assessments of sentiment. Twitter is great for that sort of thing. How are people acting? What are people afraid of and embracing? Like with technicals, I find it is most remunerative to bet against extremes. I’d say people are celebrating and buying favored sectors hand over fist. You can also see that in ETF data, where money is pouring into stocks at a record pace and running out of bonds quickly. In short, there seem to be a lot of people on one side of the boat and people are unusually skittish – a dangerous combination.
What do we do with all this information?
I tend to go with scenario analysis. It’s not perfect- for instance, previous to the Presidential election I calculated the actual outcome (Trump wins – 60% probability, and market goes up – 20% probability) at 12%. Honestly, my suspicion was that estimate was too optimistic. Sometimes low probability events happen. Nonetheless, it’s useful to see the range of possibilities, and their likelihoods, to see what could happen.
As usual, I start with the big macro picture. What’s obvious? The most obvious thing to me is that the dollar and the risk-free rate (10Y yields) have soared. What will this do if it doesn’t reverse? The BIS (Bank for International Settlements) came out with a paper not long ago saying that the dollar is a good barometer of global stress due to international dollar funding needs and global interconnectivity. That’s one big reason why whenever we see a high dollar for the last few decades, something tends to break. Similarly, raising the risk-free rate tends to bring down the price of all other assets over time and raise default risk. We have a very over-levered world right now, and we just increased debt costs. That’s a big problem, particularly for entities that were already close to the edge. If you’re a foreign country that has dollar debt and yields just went up you have a double-whammy right now, which is why FX and foreign assets are doing so poorly.
As an aside, people are excited about financials right now due to the prospects of higher rates. I’d say not so fast – financials historically do poorly while rates rise because they’re sitting on a levered balance sheet that’s likely dropping as rates go up. They do better after things settle down – my personal thought is that today’s moves may make financials attractive in two years or so, but not right now.
The next most obvious thing to me is the likelihood that Q1 of 2017 will be a bad comp to Q1 of 2016. That tells me that the general trend is likely down. Maybe Q4 2016 has enough momentum from the counter-trend rally in Q3 to hold up, maybe not (I think the latter is more likely, but am open to both), but the economy will dip again soon unless something pretty unusual happens.
Fundamentally, stocks are stretched and there doesn’t seem to be a quick-fix to ignite sales. Long term valuation measures like the CAPE ratio show stocks as unusually expensive. Take those two pillars together and it’s hard to be too optimistic.
At that point I’d pause and say let’s try to prove the opposite scenario. How could things work out? It’s pretty hard to come out with a positive long-term answer to that. We’d need to see companies start investing instead of focusing on things like buybacks, people would need to have more money to put to work, balance sheets should be better, and so on. If the long-term looks pretty bad, what about shorter-term answers? I think there are always short-term possibilities. Maybe we just get continued optimism into year-end, so stretched technicals and sentiment get even more stretched. Maybe the tax holiday on corporate cash overseas happens quickly and leads to capex investment (instead of the generally announced intentions of further buybacks and the like). Maybe announced tax-cut plans lead to further spending. While I talk about Q1 being bad, further out is still a bit of a coin flip. There are a lot of new potential policies out there – maybe they can beat the odds and create improvement past then. If so, could investors choose to ignore bad data for the next five months or so in anticipation of things getting better?
These are all ideas (narratives), but they all seem kind of unlikely. The best two bets, in my mind, are ‘animal spirits’ and looking through the valley of a bad Q1. For animal spirits, it’s been a stressful several years for finance, and given a chance to run up performance to get that year-end bonus, why not bet it all on black? That’s a reasonable idea, but I’d feel better if this was a more broadly based rally. Instead, we see a very narrow rally with a lot of new lows along with the new highs.
As for ‘looking through the valley’ of more bad data, I think we have to give that a negative weight. My basic attitude is that anything can happen. I would say, however, that five months is a long time when you live through it. It’s also not like there are no potential problems out there. Anytime you make changes to a big system (like driving funding rates sharply higher and quickly sending the dollar to multiyear highs), you run big risks. The world looks very different than it did three weeks ago. What are the odds some people are badly positioned?
In conclusion, I think it’s useful to consider all angles. I do think things can work out to one extent or another, but that just seems unlikely and short-term.
This is where I think technicals and sentiment play a role. Macro and fundamentals don’t really change all that fast, but technicals and sentiment do and that helps shape the short term.
I think I already covered sentiment and technicals fairly well, so I’ll try to keep this short. With everything I look at, my emphasis tends to be on whether or not things are likely to get better or worse – I just think that’s the most effective way to figure out what can happen. Technicals and sentiment are currently quite stretched. They can go further, but that would be unusual. One way to look at that is to consider catalysts. What’s on the slate that can change things? What new information can come out?
First, I do want to be upfront and say that it’s usually easier to cite concerns than opportunities. Concerns get focused on and potentially priced in, while opportunities can be things that don’t happen or just aren’t as bad as feared.
That said, there are some things to focus on. There are elections in Italy that may (and right now it looks like they will) put them on the path closer towards leaving the EU. That will cause more problems and chaos.
I think the most important thing to consider is what follow-on problems recent dislocations may cause, with the most important being the dollar and the risk-free rate. One of the most important books I’ve ever read to influence my thinking is Henry Hazlitt’s Economics in One Lesson. The basic idea is that you have the obvious or intended effect of something, but then you have the unintended consequences, which can often be more important in part because no one expected them or focused on them.
People are pointing to the risk-free rate and dollar going up as good things. Honestly, they have a point – that’s what tends to happen in an economy that’s improving. I’d say the basic problem is correlation and causation- a rising dollar and inflation happening don’t cause a good economy- they are just potentially indicative of an improving economy. Rates and the dollar improved in 1983, but it also happened in 2008. In one of those situations (1983), the economy could handle it, in the other (2008) it couldn’t. Which are we looking at now? (Hint – John Hussman says we’re currently 4x the 1982 stock valuations.)
People can feel free to disagree with me, but I come out of this exercise fairly negative. There are bullish scenarios, but they lean short-term in nature, meaning that if you are willing to wait patiently, things should come your way sooner or later. I’d also say that I have a tendency to take my estimates and blunt them a bit. If I initially think something is 90% likely and the mass of traders are at something more like 50%, I’ll move to 80-85% based on the strength of their arguments.
Specifically, I’d say there’s an 85% chance that the economy slows, based on comps and where we are in terms of an economic cycle. Timing is a bit tough, but if we don’t see this by the time first quarter data gets reported, I’d probably have to lower that number.
Fundamentally will we improve? Versus expectations that’s going to be tough. Analysts are expecting a big jump. Does that matter? Good question. I look at the numbers both ways – versus expectations and versus straight comparison on past numbers. I think the straight numbers are more important, but expectations can have an effect. For instance, right now expectations are setting a very high bar as sentiment is high. That means sentiment is likely to get incrementally more negative than it usually does. Wrap that all together along with the positioning and planning of companies and it’s going to be really tough to drive gains purely from financials for the overall market. Thus, fundamentals are quite likely an overall negative contributor to the market.
The best hope for bulls probably lies in technicals and sentiment, but that is both short term in nature and mean reverting over time. That means that technicals and sentiment can be positive, but considering current positioning, probably not for very long.
So what may happen? From the perspective of the rest of 2016, I’d say there’s a 45% chance that the market trends down or maybe drops 10% or more. There’s been a lot of pricing in of bullish ideas, even though, if anything, potential outcomes skew somewhat negative, and that creates elevated potential for reversion. There’s a 35% chance we trade fairly flat, but some of the big moves of the last few weeks revert a bit, so bonds and the like outperform. We’ve had some huge, historic moves on what at this point is little more than storytelling and conjecture, so that could get undone a bit, particularly after the December Fed meeting. There’s a 10% chance we trade fairly flat but continue the trend of bonds selling off and bullish sectors outperforming. Momentum can be a powerful force in the short term, though bonds continuing lower will further raise the chances of something ultimately breaking. There’s a 10% chance that we take the bullish overall performance of the last three weeks in the market and continue up. Again momentum can be powerful in the short term.
Into next year, in the beginning we’re fighting tough comps and a new President that will take some time to ramp up (traditionally the first 100 days are where the tone is set.) That will likely make the first bit of the year tough to forecast, but people can put new money to work at the start of a period and animal spirits may still prevail. Fundamentals may be bad and no one cares, or they may be good and no one cares. Hard to say for sure. The real problem is that continuing higher rates at some point should be bad across asset classes. If you can get a risk-free 2.5%, does the market really want to take a chance on expensive stocks?
Given that, I think it’s really hard to see continued gains. We’d probably need to see really stretched technicals and sentiment stretch even more (to be fair, longer term technicals aren’t nearly as stretched as short-term technicals). I admit it’s hard to say exactly what the downside would look like – I’ve never figured out a model to determine that with any real precision. Maybe we drift down 10%, maybe we plunge 50%. Maybe there are multiple air pockets. Honestly, I don’t know. I am pretty comfortable making directional judgments, but it is difficult making magnitude judgments.
So what do we do with all this? How do we act? I’d say two things. I always love to buy good long term ideas and I love to buy what people are selling. When you can do both at the same time, that’s great. Right now, looking at potential outcomes, it pays to stress safety and that’s just what people are selling hand over fist. Great. In particular, I think consumer staple stocks are pretty interesting – they didn’t participate in the recent yield frenzy as much as other areas, so now they don’t have the ‘trapped’ owners that recent popular areas risk having (utilities are also interesting as they’ve come down so much.)
The longer term (1-3 years out) is interesting to speculate on, though it’s little more than speculation because things are changing so fast. Will we see higher rates? Will we see a crash first, then higher rates? Trump has traditionally been a fan of debt, so it’s a reasonable speculation. Will that (and a recession that the man himself said was likely to happen during his administration) sink a lot of assets? We’ve seen a lot of assets levitating for a while, so could that happy time be done? Am I way too pessimistic and we’ll avoid an official recession, somehow accelerating things? We’ll see in time.
I never ‘know’ what’s going to happen. I’m just trying to play the likely odds in an advantageous risk/reward manner. That requires being fairly cold and calculating. I recognize that our tilt toward safety just had a pretty poor few weeks during the Trump rally. The thing is, that already happened. When driving do you look through the rear view mirror? Looking ahead, I believe emphasizing safety is the most logical thing to do, so that’s our plan.
As per usual, we will continue to monitor things on an ongoing basis. As more information comes in we will adjust our outlook. I will say that in the market you only get a few good opportunities to get your positioning right. For instance, I think the last great opportunity was almost a year ago surrounding the last rate hike in December 2015. Now we have more upheaval where you can make decisions. A year from now, or even a few months from now, when you review this time, think about what you did and why you did it. I always need a good reason to act in the market. I think I have it, and will be very comfortable explaining my reasoning going forward, right or wrong. A lot of people seem to be scrambling and panicking right now, and being late to a panic party is something I’d strongly advise against.
I just want to emphasize one last time that what I have written here is a big oversimplification. There’s simply so much to consider that I could write a book on this period. As it is, this is how I’m spending a Saturday to give this simplistic explanation. Of necessity, I’ve left a lot out. I haven’t mentioned the highly variable yield curve actions of the last few weeks and how that’s problematic in the narrative the market is selling, or rising defaults already happening, or dislocations from a Trump Presidency, or a thousand different things. There just isn’t time to give all the detail.
So here it is. I think the odds of downside, probably near term, but particularly over the next five months, are likely underweighted by the market. The higher dollar and higher rates are putting a lot of stress on the system, and the odds of something breaking are high. While data can change things, at this time I think it makes a lot of sense to stay safe – hold cash and safe stocks, emphasizing staples and utilities. I can’t call a decline with certainty, but I can say this is what the prelude to a decline looks like.