HUGE INSIGHTS: The Big Picture - Issue #3
HUGE INSIGHTS is our big picture investment newsletter designed to help traders and individual investors capitalize on thematic market opportunities that we uncover in our research. Our methodology considers the underlying fundamentals first, but also utilizes technical analysis, and employs systematic trend following techniques. Our goal is to educate our readers while helping them to generate consistent trading profits and manage risk.
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Overview
The bull market in stocks is showing the first real evidence of weakening since October of 2020. At that time it took Pfizer's announcement of a 95% effective COVID vaccine to re-energize the bull case. What will it take this time? Was the 5.2% peak to trough decline in the S&P 500 witnessed from the September 2nd high enough to break this bull market? How should we as investors proceed? Herein we examine all of the evidence at hand in search of the answers.
What Would Old Ben Do?
No, we’re not talking about old Ben Kenobi, or even Ben Bernanke for that matter. This discussion is focused on a decision-making technique developed by Benjamin Franklin.
Whenever old Ben was confronted with a complex decision that required him to take action – usually a decision that had serious consequences, but no obvious answer -- he would thoroughly examine all of the evidence at hand and make a list of all the reasons that favored a decision to move forward with the pursuit, all of the reasons that favored taking a neutral stance, and all of the reasons that favored abandoning the pursuit. When he had completed the analysis, he would cast his vote in the direction that the weight of the evidence had guided him.
Below is our attempt to use the Ben Franklin Decision Table approach in assessing the current state of the stock market.
Reasons To Be Bullish
1) Monetary policy remains accommodative. Following the September FOMC meeting that ended Wednesday, the Fed made it as clear as they could without actually saying it, that baring any change in the trend of the data, its “tapering” process will be announced in November, and launched in December. They further indicated that the Fed funds rate would remain unchanged through at least the end of 2022. While monetary policy will remain accomodative, there is an imminent withdrawal of liquidity on the horizon.
2) Fiscal policy remains simulative. The Biden administration and the Democratic majority in Congress have proposed an aggressive $1 Trillion bipartisan infrastructure spending bill that should get approval before year-end. In addition, they have also proposed an additional $3.5 Trillion in spending over 10-years to battle climate change and to boost the social safety net, which will need to get through the budget reconciliation process if it is to come to fruition. There is no guarantee that they will be successful in this pursuit.
3) Money on the sidelines. The savings rate in the US has reached 10%, and there is an estimated $4.5 Trillion in cash sitting in money market mutual funds earning a negative real return during what may prove to be the highest inflationary period since 1994. In addition, there is approximately $750 Billion in active or announced corporate stock buy-back programs on the horizon. Yet, companies have a tendency to issue nearly as much equity as they repurchase in new stock options each year, and as a percent of total market-cap, the amount of cash on the sidelines is near its all-time low.
4) There is no alternative to equities. Real Treasury yields are currently negative. Both investment grade and high yield corporate bonds have seen their spreads compress to near record lows this year. Real estate prices have soared to new all-time highs, while realized rental income has declined due to the COVID-related moratorium, pushing cap-rates to new all-time lows. Commodities have recovered from their COVID induced lows, and in most cases are now trading at the high end of their historical ranges, leaving their longer-term prospects in question. Finally, cryptocurrencies, while in some cases producing extraordinary returns this year, are highly speculative and subject to myriad known and unknown risks ranging from potential new regulations, to cyber security, to extreme market volatility. There will be no alternative to equities until equities ultimately decline.
5) The market’s trend remains positive. Despite the recent pull-back from all-time highs in the major averages, the S&P 500 index continues to hold above its intermediate-term trendline, defined as the 20-week SMA. A weekly close below that level would confirm a trend reversal, but the uptrend must continue to receive the benefit of the doubt until that time. A breakout to a new all-time high in the index would project an upside target of SPX 4800.
Reasons To Hedge
1) Dow Theory Non-Confirmation. One of the classic theories of the discipline of technical analysis is that key intermarket indexes and sectors should advance together and “confirm” one another’s progress during a bull market phase by posting new highs in near synchronicity. No intermarket relationship is deemed more important than that that exists between the Dow Jones Industrial and the Dow Jones Transportation Averages. By way of background, Charles H. Dow, founder of the Wall Street Journal in 1889, famously observed that when the Industrials were engaged in a sustained advance and making new highs, the Transports would confirm their bullish trend by also making new highs. But when the Transports failed to make new highs along with the Industrials, the bullish trend in the industrials would have a tendency to fail in short order. Dow deduced that if the producers of goods experienced an increase in demand, then the transporters of those goods should also see an increase in demand, and thus the market would surely reflect the underlying fundamentals in its pricing of those stocks. The two have been out of sync since May 12th.
2) Advance-Decline Line Divergence. The Advance-Decline Line represents the cumulative number of net advancing issues on the NYSE. The “all-issues” version includes NYSE listed preferred stocks, CEFs, and all manner of bond proxies. The “common stocks only” version includes only NYSE listed common shares. Historically, the A-D Line has tended to confirm a bullish advance in the major averages by posting a new high of its own in near synchronicity with stock index prices. The failure to do so, otherwise known as a negative divergence, has been followed by a trend reversal of at least 10% in the subsequent months without fail. The successful track record of this warning signal puts it among the most reliable of bear market indicators. While the S&P 500 made its ATH on September 2nd, the all-issues A-D Line peaked two months earlier on July 2nd; by comparison the common stocks only version topped on June 8th. Both versions of the A-D Line are now trading below their respective 50-day SMA.
3) Market Internals Diverging. When we use the term “market internals,” we are broadly referencing the market’s character based upon the breadth of participation, the strength of its momentum, and the demand for shares as a function of its net advancing volume. In the case of the S&P 500 index, it would be an understatement to simply say that the internals have been disappointing. Indeed, negative divergences were evident across the board as the S&P made its September 2nd high. The 5-week moving average of the percentage of net advancing issues turned negative last week, as did momentum -- as measured by the 5-week RSI oscillator. Advancing volume ended last week at just 28% of declining volume. The message from this measure is clear: The market is narrowing, on deteriorating momentum, as the supply of shares overwhelms demand.
4) Margin Debt Has Peaked and Is Reversing. A rise in the level of margin debt tends to coincide closely with bullish sentiment toward stocks. As the absolute level scales new heights, it reinforces the animal spirits that are driving stock prices higher. It acts as incremental liquidity for buyers. But once the rate of change (ROC) begins slow, it is oftentimes a harbinger of a looming peak in bullish sentiment. That occurred in March of this year when the ROC peak at 71% and has since rolled over. The absolute level of margin debt peaked three months later at $882B in June, and declined by $38B in July. The decline in the absolute level of margin debt is akin to a withdrawal of liquidity from the system. It reflects a directional change in the trend of investor sentiment from bullish-to-bearish. The decline in margin debt from a new all-time record high, typically precedes a market trend change from bullish-to-bearish as well.
5) Yield Curve Flattening. The yield spread between the 10-Year Treasury Note and the 3-month T-Bill has compressed by 35 bps, or about 20% from its March high. The spread between the 30-Year T-Bond and the 3-Month T-Bill has also compressed by 48 bps. This compression represents a flattening of the yield curve over the past 6-months. While the curve is still positively sloped, the demand for long-dated Treasury securities suggests that the market is not convinced of the economic recovery’s durability, and further suggests that there is little concern about inflation long-term. A flattening yield curve can accompany a decline in the stock market as asset allocations shift from risk-on to risk-off.
6) High Percentage of Stocks Down > 10%. According to research published by Morgan Stanley, despite the fact that the S&P 500 has remained in a durable uptrend, considerable damage has been done under the surface of the index. To put that statement into perspective, 56% of the constituents of the index are down 10% or more from their 52-week highs, led by the Energy sector, where 100% of the sector constituents are down at least 10% . Defensive sectors like Utilities, REITs, Health Care, and to a lesser extent Staples, have fared best -- averaging just 30% of their respective sector constituents down more than 10%. But the damage is far more significant among small-cap issues, where 90% of the constituents of the Russell 2000 are down 10% or more, and fully 55% of index constituents are down at least 20%. This condition is not characteristic of a bull market that is poised to extend its advance.
7) Cycle Composite Bearish. We’ve been monitoring the 2021 cycle composite since mid-year. The cycle composite line aggregates the one-year seasonal cycle, the four-year Presidential cycle, and the 10-year Decennial cycle. The cycle composite line peaked on August 6th, and is now pointed hard down into late October. Importantly, the month of September has historically been the worst performing month of the calendar year, but as we’ve shown in past publications, performance during September is especially poor during year one of the first-term of a new President, and incrementally poor during decennial years ending in the number “1.”
Reasons To Be Bearish
1) Debt Ceiling Impasse Ahead. The US government’s fiscal year runs from October 1st through September 30th. As such, unless a resolution is approved to raise the debt ceiling, a government shut-down could commence as soon as October 1st. This would require the government to immediately cease the funding and operations of all non-essential functions, and could ultimately result in a heretofore unthinkable default on its debt obligations.
2) FED Tapering Ahead. Most economist are now estimating a December start date for at least a $15 Billion reduction to Fed asset purchases of MBS and Treasury securities incrementally at each FOMC meeting through June 2022. The Fed Funds rate is expected to remain at 0-0.25% until at least 4Q22. But the Fed's dropped the term "transitory" from the September FOMC statement and their estimate of future inflation increased from 3.4% to 4.2% for this year. If the CPI remains above the 5% level beyond year-end, then these assumptions could prove too conservative.
3) Tax Policy Changes. The Biden administration has proposed a variety of tax code changes that will have a pronounced impact on the top 1% of earners in the US. But it will also reverse a substantial portion of the reduction to corporate tax rates ushered in by Republicans in Congress under the Trump administration. Recall that these tax cuts added a substantial boost to corporate earnings and earnings growth rates since 2017. If enacted, even a partial reversal of these cuts from 21% to 26%, could have a devastating impact on S&P op-EPS estimates for 2022 and beyond, which could in turn lend itself to a period of multiple compression.
4) Peak EPS Growth. According to BofA Global Research, Q2 EPS growth for S&P operating companies reached 89.7%. More than 86% of the companies reporting so far beat on the top line as nominal GDP growth reached 13% on an annualized basis during the period. Yet, the Atlanta Fed has recently trimmed its Q3 real GDP growth estimate from 8.7% to just 3.6%, suggesting nominal GDP growth of just 6.5%, for a 50% sequential decline. In our opinion, if this estimate proves correct, then we have most likely witnessed the peak in margins, sales growth, and by extension EPS growth. And as the street has been aggressively raising their estimates for the back half of the year, outsized EPS beats of the likes witnessed in Q1 and Q2 are very likely behind us as well. It will be difficult for fundamental investors to justify current valuation multiples without continued sequential growth improvement going forward.
5) Valuation Is Historically Extreme. Total U.S. Market Cap to GDP set a new all-time record extreme of 207% on September 2nd. That compares with its prior cycle high of 148% recorded in March of 2000. In addition, the Shiller Cyclically-Adjusted Price to Earnings ratio (CAPE) reached 39.5x vs. its March 2000 record high of 43.8x, and a historical average of 17.2x. The S&P 500 Dividend Yield is below the 10-year Treasury yield, while its Price-to-Sales ratio set a new all-time record high of 3.1x, exceeding the prior extreme of 2.0x by > 50%. To add insult to injury, the top seven stocks in the S&P 500, which now account for more than 25% of the market cap of the index, reached a peak weighted average price-to-sales of 10.5x this month.
Performance Review
On July 1st, in our inaugural issue, we suggested that the shares of the Fidelity Blue Chip Growth ETF (symbol: FBCG) looked attractive at $32.50. Today, it is trading at $34.16, for a gain of 5.1% vs. 3.0% for the S&P 500 over the same period. Our initial target was stated as $35, but given the change in market conditions, we recommend taking profits now. For those who wish to roll the dice and root for the bull case, we suggest raising stop-loss provisions to $33.50.
On August 24th, in Issue #2, we suggested going long the ProShares VIX Short-Term Futures ETF (VIXY), upon a daily close above $25, as a hedge against increased market volatility in the months ahead. So far, VIXY has yet to post a daily close above $25, but we still think that it could, and may do so in the days/weeks ahead. We will keep this idea open and raise the buy-stop level to $25.50, for a maximum 5% portfolio position, with a stop-loss provision at $20, risking just 1% of capital.
Conclusion
The bull case rests largely on technical conditions and policy support. A convincing breach of the market’s uptrend would quickly eliminate one very important leg of the stool. Monetary policy appears poised for imminent change. Whether it begins in December or in early 2022, the market knows that it is coming and will reprice equities accordingly. Fiscal policy is nearing an impasse. The political divisions in Congress will require careful legislative maneuvering by Democratic leadership in order to avoid a government shut-down, or worse. The likelihood that the current proposal moves smoothly through the process is low. It’s true that the amount of cash on the sidelines in absolute dollar terms is substantial, however, when considered as a percentage of total market-cap, it is very near its all-time record low. Finally, the fact that “there is no alternative to equities” has been clarion call of market bulls for the better part of the last two decades. At some point, it falls on deaf ears.
"The true investment challenge is to perform well in difficult times." ~ Seth Klarman, CEO, Baupost Group
Disclaimer
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