HUGE INSIGHTS: The Big Picture - Issue #40
Into the Storm
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Executive Summary
Trade War: The Wrong Side of History
Investor Sentiment: Caveat Emptor
Geopolitics: Korean Barbeque and a French Roast
Market Analysis & Outlook: Storm Warning
Conclusions & Positioning: Gimme Shelter
Trade War: The Wrong Side of History
Willis Chatman Hawley was a 13-term Republican congressman from the State of Oregon. He served from 1907 to 1933 in the U.S. House of Representatives. Hawley was born on a farm in Benton County, Oregon in 1864. He attended country schools before entering college at the age of 16. In 1884, he graduated with a bachelor of science degree from Willamette University in Salem. In 1888, he completed his law degree from Willamette University College of Law. In 1890, he completed his masters degree in education and joined his alma mater as a professor of history and economics. He became president of Willamette University in 1893 and continued in that role until 1902. Following his career as an educator, Hawley engaged in a variety of business ventures before entering politics in 1906.
Reed Smoot was a five-term Republican senator from the State of Utah. He served from 1903 to 1933 in the U.S. Senate. Smoot was born in 1862, the son of Anne Mauritzen Smoot, the fifth wife to polygamist, Salt Lake City mayor Abraham Smoot, who fathered 27 children between his six plural marriages. Smoot’s family moved to Provo, Utah when his father was called by Brigham Young to join the hierarchy of the Mormon Church (LDS). Smoot attended the University of Utah, but graduated from what is now Brigham Young University in 1879. After completing his education, Smoot served as a missionary to the LDS in England. He returned to Utah and married in 1884. There he became a successful businessman in the Provo and Salt Lake City area. In 1895, he became increasingly involved in the hierarchy of the LDS, and was ordained an apostle and a member of the church’s Quorum of the Twelve.
Smoot first became involved in the Republican party in Utah in the 1880s, but he didn’t run for the Senate until 1901 — a race he lost. He ran again in 1903 and was elected. Smoot’s election sparked a bitter four-year battle in the Senate on whether or not he was eligible for public office due to his leadership affiliation with the LDS. Many Americans were suspicious of the LDS church because of their polygamous practices. Following the investigations, the attempt to expel Smoot from office failed and he was allowed to keep his seat in the Senate.
Hawley and Smoot are probably best known as the co-sponsors of the Tariff Act of 1930. The legislation was designed to implement protectionist trade policies in the United States, and was signed into law by President Herbert Hoover on June 17th 1930. The act raised U.S. tariffs on over 20,000 imported goods. Tariffs under the act were the second highest in U.S. history, exceeded by only the Tariff Act of 1828. The act prompted retaliatory tariffs by many other countries resulting in a 61% decline in American exports from 1929 to 1933. Many key agricultural products were hit hard by this decline including cotton, wheat, tobacco, and lumber. Historians have argued that the decline of farm export prices caused many U.S. farmers to default on their loans, thus worsening the effects of the tariffs themselves, and leading the U.S. to sink deeper into the great depression.
But Mr. Peabody, didn’t Ben Bernanke spend countless hours over his eight years as Fed Chairman trying to convince the American public that the great depression was the central bank’s fault? Yes Sherman, but the central bank was only partly to blame. Let’s set the Wayback Machine to the late 1920s and have a look for ourselves.
By the late 1920s, the U.S. economy had made exceptional gains in productivity because of electrification, which was a critical factor in mass production. Another contributing factor to economic growth was motorcars, trucks, and tractors replacing horses and mules. But, about one quarter of farmland had been devoted to feeding horses and mules. This was now freed up, contributing to a surplus in farm produce. Although nominal and real wages had increased, they did not keep up with the productivity gains. Smoot contended that raising the tariff on imports would alleviate the overproduction problem. But the United States had actually been running a trade surplus on manufactured goods. Agricultural exports had been falling and were in a trade deficit, but the value of agricultural imports was only about half the value of manufactured imports.
As the global economy entered the first stages of the Great Depression in late 1929, the U.S. sought to protect both its manufacturing jobs and its farmers from foreign competition. In that spirit, Smoot championed another tariff increase on imports in 1929, which ultimately became the Smoot–Hawley Tariff Bill. In his memoirs, Smoot made it abundantly clear:
“The world is paying for its ruthless destruction of life and property in the Great War and for its failure to adjust purchasing power to productive capacity during the industrial revolution of the decade following the war.”
Smoot was chairman of the Senate Finance Committee. Hawley was chairman of the House Ways and Means Committee. During the 1928 U.S. presidential election, one of Republican candidate Herbert Hoover’s core promises was to help beleaguered farmers by increasing tariffs on agricultural products. Hoover won, and Republicans maintained comfortable majorities in the House and the Senate during 1928. The House passed a version of the act in May 1929, increasing tariffs on agricultural and industrial goods alike. The Senate debated its bill until March 1930, with many members trading votes based on their states’ industries. The conference committee then unified the two versions, largely by raising tariffs to the higher levels passed by the House.
In May 1930, a petition was signed by over 1,000 economists in the United States asking President Hoover to veto the legislation. It was organized by the renown monetarist Irving Fisher. Automobile executive Henry Ford also spent an evening at the White House trying to convince Hoover to veto the bill, calling it “an economic stupidity,” while J.P. Morgan’s CEO, Thomas W. Lamont, said he “almost went down on his knees to beg Hoover to veto the asinine Hawley–Smoot tariff.” While Hoover joined the economists in opposing the bill, calling it “vicious, extortionate, and obnoxious” because he felt it would undermine the commitment he had pledged to international cooperation, he eventually signed the bill after he yielded to influence from his own party, his Cabinet (who had threatened to resign), and business leaders. In retaliation, Canada and 11 other countries raised their own tariffs on American goods after the bill became law.
At first, the tariff seemed to be a success. According to historian Robert Sobel, “Factory payrolls, construction contracts, and industrial production all increased sharply.” However, larger economic problems loomed in the guise of weak banks. When the Creditanstalt Bank of Austria failed in 1931, the global deficiencies of the Smoot–Hawley Tariff became apparent. U.S. imports decreased 66% from $4.4 billion (1929) to $1.5 billion (1933), and exports decreased 61% from $5.4 billion to $2.1 billion. GNP fell from $103.1 billion in 1929 to $75.8 billion in 1931 and bottomed out at $55.6 billion in 1933. Imports from Europe decreased from a 1929 high of $1.3 billion to just $390 million during 1932, and U.S. exports to Europe decreased from $2.3 billion in 1929 to $784 million in 1932. Overall, world trade decreased by some 66% between 1929 and 1934.
Unemployment was 8% in 1930 when the Smoot–Hawley Tariff Act was passed but the new law failed to lower it. The rate jumped to 16% by 1931 and 25% in 1932–1933. There is some contention about whether this can necessarily be attributed to the tariff. It was only during World War II, when the American economy expanded at an unprecedented rate, that unemployment fell below 1930 level. Imports during 1929 were only 4.2% of the U.S. GNP, and exports were only 5.0%. Monetarists, such as Milton Friedman, who emphasized the central role of the money supply in causing the depression, considered the Smoot–Hawley Tariff Act to play a relatively minor role. But the Smoot-Hawley Tariff Act also contributed to a further loss of confidence on Wall Street. According to the U.S. Bureau of the Census, the dutiable tariff rate peaked in 1932 at 59.1%, second only to the 61.7% rate of 1830.
As it became clear that the Smoot-Hawley Tariff legislation was going to be passed, foreign complaints grew louder. By the autumn of 1929, more than 30 countries and colonies had officially protested to the U.S. government. Back in March 2018, as the U.S. was moving towards a more protectionist trade policy, White House National Trade Council Director Peter Navarro predicted that no country would retaliate against America “for the simple reason that we are the most lucrative and biggest market in the world.” Meanwhile, opponents of President Trump pointed to the 1930s as a cautionary tale of the unintended consequences of protectionist policy. As Robert J. Samuelson put it, “the ghost of Smoot-Hawley seems to haunt President Trump.” The U.S. was an important market during the inter-world war period as well, but that didn’t prevent retaliation against U.S. protectionism then.
At the time, however, there was little doubt in policymakers’ minds that Smoot-Hawley had provoked widespread retaliation. A League of Nations document (1933:193) stated:
“The Hawley-Smoot tariff in the United States was the signal for an outburst of tariff-making activity in other countries, partly at least by the way of reprisals. Extensive increases in duties were made almost immediately by Canada, Cuba, Mexico, France, Italy, and Spain.”
Other countries that were particularly badly affected by the legislation and were either contemplating retaliation or had already retaliated included: Argentina, Australia, New Zealand, Switzerland, Paraguay, and Uruguay. The countries concerned raised tariffs on particularly important U.S. exports, while there were calls for boycotts and other measures targeting American goods. Some countries retaliated without formally responding to the U.S.
Peter Navarro was mistaken in 2018, and economic history suggests that this should have come as no surprise. Trade data suggest that the U.S. faced widespread retaliation against Smoot-Hawley, and that the impact was large. While retaliation may indeed have been costly for the countries concerned this did not dissuade them. You see Sherman, history shows that no matter how lucrative your market, the use of tariffs does little more than hinder global trade and quash economic growth.
Investor Sentiment: Caveat Emptor
Few are aware that journalist Charles MacKay’s 1841 masterwork, Extraordinary Popular Delusions and the Madness of Crowds, was originally published as a three volume set. Even though McKay’s observations didn’t include the Roaring ‘20s — nevermind the Dot-Com bubble — we think that the events of the past two years might provide enough new material to fill a fourth volume — or at least an addendum. Below we provide a comprehensive review of the many investor sentiment gauges that we’ve followed over the years and that we’ve found to be important measures of crowd behavior, which at extremes have tended to coincide closely with major turning points in the trend of the stock market. The evidence shows clear signs of mass-hysteria developing.
To begin, according to data from Yale University professor Robert Shiller, real home prices in the U.S. have risen disproportionately since 2012 relative to real building costs, population growth, and changes in interest rates. While the median U.S. home price has pulled back modestly from its all-time record level of April 2022, it remains quite extended relative to its long-term exponential growth trend. As U.S. residential real estate is the backbone of consumer loan collateral, one must now assume that current debt-to-asset ratios grossly understate the amount of leverage in both the banking system, and the shadow banking system. To say that there is a housing bubble in the U.S. would not be fair to bubbles. Indeed, excesses in the U.S. housing market today exceed that which caused the 2008 great financial crisis (GFC) by a fairly wide margin.
Moreover, numerous online sources including Zillow, RedFin, and Realtor.com — just to name a few — provide real-time estimates of market value for homes based upon tax records, closed sales, and listing prices of comparable homes in every major city in the U.S. Regardless of whether or not the data is accurate, when homeowners regularly see information that consistently reinforces the idea that their home’s value is steadily rising, it instills confidence to take financial risks that they might otherwise avoid. This could include making large purchases on credit, such as a new car or boat, or making a major home renovation. But it can also result in homeowners allocating 401(k) and other investment assets more aggressively than they might normally. In some cases, homeowners have been known to borrow against their home equity to increase their exposure to stocks and other risky assets or derivatives.
The chart above illustrates that “risk-on” ETF flows — so-called because they represent assets, style box categories, or sectors that are considered to be high beta exposures — have surged to the highest level in the past eight years. In this case, those flows have gone into junk bonds, low quality small-cap stocks, and financials, which are all highly cyclical in nature. While the shift to a more cyclical, higher beta equity tilt is partly a reaction to recent election results, one must wonder whether investors would be so bold if they did not already have the perceived cushion of big gains in their existing stock and real estate holdings. To be sure, 2024 saw the best post-election rally on record.
But does a new, supposedly pro-growth administration fundamentally warrant a record allocation to the 3X leveraged-long S&P 500 index ETF, or more broadly speaking, record exposure to all leveraged ETFs — now approximating $120 billion? We think this is less a function of a new administration, and more a function of mass-hysteria that has been steadily built-up over the past two years.
But could some of this allocation to leveraged ETFs actually include short exposure designed to hedge long-term positions? Absolutely. Not everyone is insane. Just 92% of those involved! According to Jason Goepfert of Sentimentrader.com, there are nearly $12 in leveraged long ETF index assets for every $1 in leveraged short ETF index assets. This is the highest ratio since the January 2022 market high. Importantly, there have only been four days over the past 14 years where the ratio of leveraged long ETFs-to-leveraged short ETFs has ever been higher.
Another method of speculation that has gained popularity in recent years is the use of short dated options. As of last week, total U.S. speculative option volume (call volume minus put volume) reached its highest net long extreme since January 2022. One metric after another shows that stock flows and long positioning today are near the most crowded levels on record, and among the most levered and unstable in history. At this point, even a moderately cautious view is considered to be deeply contrarian. Beware of complacency!
Not to put too fine a point on it, but according to the Conference Board’s latest survey of consumer expectations,
“Consumers became even more optimistic about the stock market: 56.4% of consumers now expect stock prices to increase over the year ahead, another record high for this measure. Only 21.3% expect stocks to decline.”
This is partly due to the excessive media coverage surrounding the potential for “Gen-AI” to dramatically increase productivity in the years ahead. And while that remains to be seen, the promise has been enough to incite mass-hysteria around this investment theme. A recent Barron’s cover story illustrates our point. “The Nvidia Way” details the fairytale story of how a struggling videogame chipmaker became the most valuable company in the world. But, based upon the work of the late, great Paul Macrae Montgomery, the creator of the “Magazine Indicator,” when stories of this nature make the cover of a major news or financial publication, it tends to coincide with the end of a trend — not the beginning. In our view, it is fitting that this story has resurfaced again on the cover of one of the investment industry’s most trusted financial journals, only three days before the company was slated to report its third quarter results on November 20th. Expectations for NVDA to beat and raise again were sky high. When the company beat, but guidance failed to impress, the stock topped the very next day and as of Friday’s close, is now about 6.8% lower.
Market concentration actually reached its zenith in November 2023. One-year later, it still stands near its highest level in 100 years. Much as was the case in March 2000, at the height of the Dot-Com mania, the success of a few leading companies, driven by a perceived breakthrough technology, has captured the imagination of an entire generation of investors — and its not just retail.
The Goldman Sachs Sentiment Indicator measures stock market positioning across retail, institutional, and foreign investors versus the past 12 months. Readings below -1.0 or above +1.0 indicate extreme positions that are significant in predicting future returns. The current reading shows that these cohorts are collectively holding the highest long position in U.S. equities of the past 12 months at 2.3 standard deviations above the mean. Prior readings this year in which positioning exceeded 1 standard deviation above the mean resulted in a subsequent drawdown of between 5% and 10%.
This is no surprise, as positioning tends to coincide closely with positive or negative responses within sentiment surveys of investors and their advisors. Most of the surveys that we follow have either reached or come very close to optimistic extremes within the past couple months. Specifically, Market Vane’s Bullish Consensus index, which tracks the buy and sell recommendations of major brokerages firms and commodity trading advisors, is approaching a 20-year high of nearly 75% last seen in January 2018. The S&P 500 index fell 10% over the subsequent weeks after hitting that level the last time.
Sentiment among advisors — investment analysts and strategists like ourselves that publish reports and newsletters professing their investment opinions — are also approaching past optimistic extremes. The percentage of advisors now declaring themselves to be bullish has reached 62.9%, marking the eighth consecutive week in the danger zone above 55%. Bears have now fallen to just 16.1%. Readings below 18% have tended to mark past market tops. Bears reached a low of 14.9% in July, which preceded a 15.7% decline in the Nasdaq 100 over the subsequent 18 trading days. Today, the bull-bear spread has expanded to 46.8%, marking the 3nd consecutive week in the danger zone above 40%. The spread reached 49.3% in July following 10 consecutive weeks above 40%. Looking back to the period between the March 2020 low and the January 2022 high, we witnessed the bull-bear spread make a lower high as the S&P 500 posted its then all-time high. Today, we can observe a potential similar development. A negative divergence between price and sentiment extremes has historically tended to mark the point of recognition among the wisest investors that the trend is about to change.
The NAAIM Exposure Index illustrates the weekly survey results of over 200 of the largest active money management firms in the U.S. A week ago, professional money managers were just about as bullish as they could be without using leverage. The November 27th survey result showed that the average active money manager is now 98.9% net long equities. The index has only been higher on a handful of occasions over the past two years — maxing out last March at 103% net long. It too is now diverging negatively relative to its July extreme as price scales new heights.
Surveys and positioning aside, there are several more objective measures of sentiment that may be worth considering as well. The Citi Panic/Euphoria Model (aka the “other P/E”) just hit a fresh new 52-week high last week. This model was developed by our long-time friend and colleague, the late, great Tobias Levkovich. The model uses a proprietary weighting of seven measures of investor sentiment including options positioning data, the price of crude oil vs. its 12-month average, the AAII allocation to cash, the copper/gold ratio, the equity risk premium, and a mystery ingredient that Tobias never divulged to anyone outside of his core research team (they were sworn to secrecy). Our old friend Scott Chronert has since taken over responsibility for maintaining the model. The latest reading comes in at a lofty 0.59. Readings above 0.40 support a better than 80% probability of stock prices being lower one year later.
The Euphoriameter, developed by Callum Thomas at Top Down Charts, combines three key gauges of investor sentiment: aggregate surveyed bulls, the forward 12-month (FTM) price/earnings ratio, and the CBOE Volatility index (VIX). The theory is that when the percentage of bullish investors surveyed is high, in conjunction with a high FTM p/e ratio, and a low VIX, it suggests that investors are not only voting with their mouths, but also with their wallets. They are not just stating their bullish attitudes, they are also paying historically high prices for stocks, without hedging their bets. As of month-end November, the Euphoriameter reached a new all-time record extreme — exceeding one standard deviation above it near 35 year mean.
Everyone is all-in on stocks. Even permabear Dave Rosenberg has turned bullish! And while we could go on illustrating our point with another dozen or so studies on the subject (and we will in the Market Analysis & Outlook section behind the paywall), perhaps more important than who is buying stocks at the all-time highs, is who is selling stocks at the all-time highs? The answer is corporate insiders! This cohort represents C-suite executives and directors of publicly traded companies. They are, by far, the most well-informed investor class by definition, given their access to material nonpublic information about their respective companies. Insiders sell for many reasons, but they only buy for one — and that is because they think the stock is going to go up.
Insiders are subject to a host of rules and regulations and their trading activity must be reported to the Securities and Exchange Commission (SEC) in a timely manner or they may face stiff penalties, and in some circumstances, even prosecution. As such, most insiders set-up what is known as a Rule 10b5-1 plan, to establish a predetermined process for selling their company stock in regular increments, in order to avoid any suspicion that they are acting on material nonpublic information. On occasion, insiders may exercise their right to sell their stock outside of the safety of the 10b5-1 plan. When they do so, they are taking a risk. So there better be a good reason, like buying a new yacht, or a second home in Hawaii, or maybe even a new company (in the case of Elon Musk). Generally, these are one off events and insiders don’t all do this at the same time. So, when we observe new record highs in both the net value of insider stock sales and the ratio of insider sellers-to-buyers, such as occurred over the past month — a month that constitutes the best post-election stock market rally in the U.S. history — we must ask ourselves the question: “What do these corporate insiders know, that we don’t know?” The answer may simply be that they know their stock is not worth what the market is willing to pay for it today.
Case and point, let’s take a closer look at Ajit Jain, Vice Chairman of Insurance at Berkshire Hathaway — the eighth largest company in the S&P 500 index. In his 2017 annual letter to shareholders, Warren Buffett praised Jain for his business acumen stating:
“Ajit has created tens of billions of dollars of value for Berkshire shareholders. If there were ever to be another Ajit, and you could swap me for him, don’t hesitate. Make the trade!”
Berkshire Hathaway Class A (BRK/A) shares posted an all-time record closing high of $724,040 on November 29th, only slightly exceeding its September 3rd high of $715,910 by just 1.1%. On September 9th, Jain disclosed that after accumulating BRK/A over the past 38 years, and never selling a single share, he decided to liquidate more than half of his aggregate Berkshire Hathaway stock holdings, selling 200 shares of BRK/A at an average price of $695,418. The sale was worth approximately $139 million. Either he’s worried about the stock’s valuation or he’s buying one hell of yacht!
Warren Buffett himself personally owns 227,416 shares of BRK/A, representing 15.1% of the company, and 31.6% of the voting interest. While Buffett is not selling his personal shares (he has been donating his shares to charities annually since 2006, and has given away 56.6% of his original BRK/A shares), he has been aggressively selling down the equity exposure of the company over the past two quarters. Berkshire’s cash allocation has now reached a record high of $325 billion, or approximately 28% the company’s total assets. This is the company’s highest allocation to cash since at least 1990, and well-exceeds Berkshire’s cash hoard preceding the GFC.
To achieve this level of liquidity, Buffett put a hold on future stock buybacks and sold 600 million shares of AAPL equating to approximately $180 billion. This translates to about two-thirds of his peak AAPL holdings. He also dramatically reduced his holdings in Bank of America this year to below the SEC filing threshold of 10%, thus allowing Berkshire to exit quickly and quietly if desired. The moves suggest that Buffett has adopted a clear “risk-off” posture. At face value, we must assume that he is simply following his own advice:
“Be fearful when others are greedy. But be greedy when others are fearful.”
Geopolitics: Korean Barbeque and a French Roast
Last week, two of the United States’ key allies experienced political pandemonium at the highest levels of government sending shockwaves through the western world. On Tuesday, across the Pacific ocean, in Seoul, South Korea, President Yoon Suk Yeol declared martial law throughout the nation and mobilized the army to quell alleged anti-state activities by his main opposition party. Six hours later, Yoon lifted the decree after Parliament voted to block it. Two days later, on the other side of the Atlantic, in Paris, France, prime minister Michel Barnier resigned after far-right and leftist lawmakers joined forces to topple his government only three months after it took office. In an encore to political extremism from the 1930s, newspaper excerpts discussing each event read as though they’re describing upheavals in a third world country — not the twelfth and seventh largest economies in the western world.