For now, the bullish bias remains strong as a barrage of weaker than expected economic data from GDP to manufacturing and employment give hope the Fed may forestall their “tapering” plans. But, as we will discuss in a moment, we think the bulls may be correct for a different reason.
However, in the meantime, the “stairstep” advance continues with fundamentally weak companies making substantial gains as speculation displaces investment in the market. Thus, while prices remain elevated, money flows weaken, suggesting the next downturn is roughly one to two weeks away. So far, those corrections remain limited to the 50-dma, which is approximately 3% lower than Friday’s close, but a 10% correction to the 200-dma remains a possibility.
While there seems to be little concern relative to the market’s advance over the last year, maybe that should be the concern given the sharpness of that advance. I will discuss the history of “market melt-ups” and their eventual outcomes in an upcoming article. However, what is essential to notice is the corresponding ramp in valuations as earnings fail to keep up with bullish expectations.
Significantly, investors never realize they are in a “melt-up” until after it is over.
At the moment, the bullish trend continues, and we must respect that trend for now. However, there are clear signs the advance is beginning to narrow markedly, which has historically served as a warning to investors.
Of course, as we repeat each week, while we are pointing out the warning signs, such does not mean selling everything and going to cash. However, it does serve as a visible warning to adjust your risk exposures accordingly and prepare for a potentially bumpy ride.
We have noted the rising number of Fed speakers discussing the need to begin “tapering” the Fed’s balance sheet purchases in recent weeks. With employment returning well into what is historically considered “full employment,” surge in job openings, and rising inflation, the need to taper is evident. As noted in our daily market commentary:
While the Fed may have some wiggle room short-term, the trimmed-mean PCE will catch up with PCE over the next month.
The point is that the Fed is now getting pushed into needing to tighten monetary policy to quell inflationary pressures. However, a rising risk suggests they may be “trapped” in continuing their bond purchases and risking both an inflationary surge and creating market instability.
That risk is the “deficit.”
As discussed recently, the current mandatory spending of the Government consumes more than 100% of existing tax revenues. Therefore, all discretionary spending plus additional programs such as “infrastructure” and “human infrastructure” comes from debt issuance.
As shown, the 2021 budget will push the current deficit towards $4-Trillion requiring the Federal Reserve to monetize at least $1 Trillion of that issuance per our previous analysis.
The federal debt load will climb from $28 trillion to roughly $140 trillion at the current growth rate by 2050.
The problem, of course, is that the Fed must continue monetizing 30% of debt issuance to keep interest rates from surging and wrecking the economy.
Let than sink in for a minute.
If that is indeed the case, the Fed will not be able to “taper” their balance sheet purchases unless they are willing to risk a surge in interest rates, a collapse in economic growth, and a deflationary spiral.
Since the beginning of this year, we have penned several articles stating that economic growth would ultimately disappoint when fueled by an artificial stimulus. Specifically, we noted that “bonds were sending an economic warning.” To wit:
The disappointment of economic growth is also a function of the surging debt and deficit levels, which, as noted above, will have to be entirely funded by the Federal Reserve.
On Thursday, both the Atlanta Fed and Morgan Stanley slashed their estimates for Q3 growth as economic data continues to disappoint.
Notably, there were significant downward revisions to consumption and investment, declining from 2.6% and 23.4% to 1.9% and 19.3%, respectively. However, as we noted previously, such is not surprising as “stimulus” leaves the system, and the economic drivers return to normalcy.
As stated, Morgan Stanely also slashed their estimates:
As we discussed previously, these two downgrades were playing catchup to our previous analysis and Goldman’s downgrade two weeks ago. To wit:
Investors should not overlook the importance of these downgrades.
In our post on “Peak Economic And Earnings Growth,” we stated that corporate earnings and profits ultimately get derived from economic activity (personal consumption and business investment). Therefore, it is unlikely the currently lofty expectations will get met.
The problem for investors currently is that analysts’ assumptions are always high, and markets are trading at more extreme valuations, which leaves little room for disappointment. For example, using analyst’s price target assumptions of 4700 for 2020 and current earnings expectations, the S&P is trading 2.6x earnings growth.
Such puts the current P/E at 25.6x earnings in 2020, which is still expensive by historical measures.
That also puts the S&P 500 grossly above its linear trend line as earnings growth begins to revert.
Through the end of this year, companies will guide down earnings estimates for a variety of reasons:
Such will leave investors once again “overpaying” for earnings growth that fails to materialize.
Our current model allocation remains primarily unchanged. However, we did increase our longer-duration bond holdings again last week.
As discussed with subscribers, we manage risk exposures to reduce volatility while still participating with the market’s advance. As a result, stock selection has been key to carrying an overweight cash position and outperforming our benchmark index.
As noted above, internal measures continue to deteriorate, suggesting a rising risk profile to the markets. Unfortunately, investors continue to ignore these warnings due to the “fear of missing out.” Given we manage the retirement assets of clients, we do not have the luxury to do so.
If you are trying to navigate the market cycle currently, you can do things to improve your “survival rate.”
The increase in speculative risks, combined with excess leverage, leaves the market vulnerable to a sizable correction. But, unfortunately, the only missing ingredient is the catalyst that brings “fear” into an overly complacent marketplace.
Currently, investors believe “this time IS different.”
“This time” is different only because the variables are different. Of course, the variables always are, but outcomes are always the same.