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Why The Smart Money Is Beginning To Worry About The Downside

A month or so ago, I was struck by Ray Dalio’s comments at Davos. He seemed fairly concerned and the major media outlets didn’t really pick it up.

“It’s the end of the supercycle. It’s the end of the great debt cycle.” -Ray Dalio

What does this mean? I think the simplest explanation is that over the past several decades we’ve gone from a nation of savers who paid cash for things including homes and cars to a nation of spenders who use debt like mortgages, car loans and credit cards to pay for things.

And it’s not just on the consumer level. It’s also happened at the corporate level.

“Corporate debt was $3.5 trillion– in 2007, arguably a period and– many would describe as bubbly. It’s 7 trillion now. So it’s gone from 3.5 trillion to 7 trillion. As you know, most of that mix has been in more highly leveraged stuff, Covenant-Lite loans– high yield, that’s where the majority of the rise has been. And if you look at corporations have been using it for, it’s all financial engineering.” -Stan Druckenmiller

Government debt has also grown to multiples of GDP around the world. But it can’t keep growing forever.

“In the past 20 to 30 years, credit has grown to such an extreme globally that debt levels and the ability to service that debt are at risk, relative to the private investment world. Why doesn’t the debt supercycle keep expanding? Because there are limits.” -Bill Gross

The debt boom over the past few decades has been a big economic stimulant. It reminds me of the steroids era in baseball. You take a great player, put him on the juice and he becomes a record-breaking home run machine.

But what happens when he comes off the juice? Have you seen a picture of Mark McGuire or Sammy Sosa lately? They are shadows of their former selves. Now that rates are zero and everyone has borrowed as much as they possibly can debt is no longer the super-stimulant it once was.

“The process of lowering interest rates causing higher levels of debt, debt service and spending, I think is coming to an end.” – Ray Dalio

The steroid era is over. So what are the implications for the economy and the markets?

“The implications are much lower growth, less inflation, lower interest rates, and less profit growth.” -Bill Gross

These are all symptoms that we’ve already witnessed since the financial crisis, right? Slower economic growth has been partially masked by rising asset prices and the wealth effect. Slower profit growth has been masked by the “financial engineering” Druck mentioned above. But that doesn’t change the fact that we are now facing a post-steroid era for the economy.

“We brought consumption forward and issued one giant credit card for the past 30 years. Now the bill is coming due. Investors need to get used to low returns, and low growth, inflation, and interest rates for a long time.” -Bill Gross

What’s probably most troublesome about the whole situation is that now that rates are zero or negative, debt levels have reached their maximum capacity and asset prices are already inflated (and spreads flattened), central banks no longer have the ability to ameliorate an economic slowdown by easing monetary policy.

“Central banks have largely lost their power to ease… We now have a situation in which we have largely no spreads and so as a result the transmission mechanism of monetary policy will be less effective. This is a big thing… So I worry on the downside ’cause the downside will come.” -Ray Dalio

With corporate debt levels twice what they were before the financial crisis, the covenants on much of that debt weaker than ever before and liquidity in the bond market disappearing, the next downturn could present a unique challenge for the Fed. And their traditional tool to address these sorts of challenges is now essentially impotent. No wonder Dalio is worried.

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Why Today’s Ultra-Low Interest Rates Are Actually Bearish For Stocks

There are plenty of pundits out there arguing that today’s record-high valuations in the stock market are validated by ultra-low interest rates (see Fed Model). The problem with this idea is it really only tells us how we got here. What investors should really care about is where we’re going and ultra-low interest rates are not at all bullish for future returns in the stock market.

In some respects, the idea that low rates should mean higher equity valuations makes perfect sense. If the 10-year treasury bond only pays 1.7% and the dividend yield on the S&P 500 is closer to 1.9% why wouldn’t I be more inclined to buy stocks? Good question! And this is probably why investors bid stocks up to astronomical valuations in the first place.

The major problem with this line of thinking is that it is backward-looking and it is no justification for valuations to remain high going forward. I’ll let Cliff Asness explain:

It is true that all-else-equal a falling discount rate raises the current price. All is not equal, though. If when inflation declines, future nominal cash flow from equities also falls, this can offset the effect of lower discount rates.

In fact, over time corporate earnings growth tracks very closely to the rate of inflation. This is why so many people like to say stocks are a good inflation hedge because they can typically raise prices to combat rising costs in an inflationary environment. But if that’s true then they also make a very poor deflation hedge as their earnings also must also fall when the rate of inflation does. And right now the bond market is pricing in the lowest levels of inflation since the financial crisis:

fredgraphChart via FRED

This would suggest that earnings growth going forward should also be very weak. In fact, we are already seeing this reflected in companies’ fourth quarter earnings reports and in the forward guidance they are now giving. Goldman Sachs reports that guidance is now the worst ever recorded. Forward earnings estimates are beginning to reflect this as they have been falling for almost as long as long-term interest rates have been:

Screen Shot 2015-02-02 at 1.02.58 PMChart via Humble Student

From this perspective, it’s very hard to make the case that low-interest rates are a valid reason to be bullish on equities. It may be true that low rates encourage increasing risk taking when investors compare alternatives to the “risk-free rate” of the 10-year treasury bond. This is where the Fed’s interest rate lever and quantitative easing have obviously been successful. But at some point, plunging interest rates like we have seen over the past year, are a sign that earnings growth could be rapidly slowing if not turning negative, a development not at all supportive of risk assets.

Historically, this may be represented by the fact that low interest rates have led to the worst forward returns for stocks. The chart below separates the market into five distinct buckets ranked by the level of interest rates. Bucket 1 reflects the lowest month-end 10-year treasury rates on record during the 1965-2001 period. It’s clear that the 10 year periods leading up to those low-rate environments were fantastic for stocks. The subsequent 10 years were not nearly so kind, as investors suffered losses after adjusting for inflation.

Screen Shot 2015-02-02 at 11.36.14 AMChart via Fight The Fed Model

There is also recent evidence in other countries that the idea of low interest rates supporting stock prices is faulty. Just take a look at Switzerland. This Swiss 10-year bond yield is now negative. Based on the idea that low rates justify higher valuations, one could make the case that an infinite price-to-earnings multiple for stocks would not be unreasonable in comparison. But what did the Swiss stock market do while their long bond yield recently plunged? It also plunged!

tumblr_nialaheKOR1smq3o4o1_1280Chart via JLFMI

The point is investors like to use low rates as justification for higher equity valuations. At some point, however, really low rates go from being benign to malignant for risk assets. No doubt low rates have supported risk assets in our markets for the past five years or longer. But the rapid decline over the past few months is now being reflected in company earnings. And investors may soon begin to question whether it still makes sense to pay record-high valuations in light of this.

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Are Stocks On The Verge Of Another Incredible 1999-Style Surge?

Over the past few months the “blow off” camp has gotten fairly crowded. First, Jeremy Grantham said that we are very nearly in bubble in the stock market currently. However, he believes that bubbles don’t just fizzle out. They usually end in an epic move that runs faster and farther than anyone could ever imagine. Specifically, he’s looking for valuations to come fairly close to what we saw back in 1999.

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Then, a few months later, David Tepper said that because this year rhymes (of course, history never repeats) with 1998 we could see a 1999-style surge in the stock market in 2015. Today, like in the late 90’s, money is being made too easy resulting in yet another asset bubble, he says. He is also looking for valuations that reach levels close to what we saw back in 1999 (according to him, today’s p/e is a mere 16 compared to 1999’s 40 but there are much better ways to measure valuations, in my humble opinion).

Recently, Richard Russell wrote a piece in which he revealed that he believes we are are only now entering the third phase of this bull market. He reminds us that gains in the third phase are usually equal to those of both phases one and two. Stocks have roughly tripled since the 2009 low (700 to 2100) so his expectation is about 3,500 on the S&P 500, almost 70% higher than its current level.

Just this week, Jim Rogers hopped aboard the “blow off” bus by saying he believes the stock market is probably due for some sort of decline but if stocks decline to any significant degree, the Fed will turn the printing presses back on and like never before sending stocks to ridiculous heights.

So we now have at least four respected pundits predicting an amazing “blow off” run for stocks. Know that I respect each of these individuals greatly and in their own right. Rogers is a hero of mine and I have as much admiration for Grantham’s work as for anyone in the industry.

Having said that, I strongly believe that the more popular a prediction becomes the less likely it is to come to pass. And this “blow off” thesis is getting fairly popular now. More importantly I’d like to try to examine what factors would have to align for this thesis to work.

First, the credit markets, which I have been watching very closely, would have to rebound. The high-yield market has been showing signs of weakness since mid-summer last year. This makes sense as that area of the bond market has about a 14% exposure to companies directly affected by the oil crash. Leveraged loans, however, only have a 4% exposure and have been just as weak as high-yield so we can’t just write off the waning risk appetites there to the energy sector. I believe both would have to improve significantly for stocks to have any chance of a “blow off.”

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Second, the global markets would have to avoid any significant fallout from the crashes in oil and in some emerging market currencies. There is a chance, though I have no idea how to put any probability on it, that there could be significant ramifications from the sharp moves we have seen recently in these areas.

Third, because sentiment and valuations go hand-in-hand, investors would have to become even more bullish than they are today. This would mean allocating an even greater percentage of household assets to equities, a statistic that is already fairly stretched and looks to possibly be peaking. It would also mean they would have to take on even more margin debt which, in relation to GDP (or inflation-adjusted, take your pick) is already far higher than what we saw at the peak of the internet bubble.

ALANMARGINDEBTChart from CrossCurrents via CNBC

Fourth, baby boomers would have to, at the very least, maintain their current equity exposure. If this retiring generation decides at some point that they have too much exposure to equities it could create an incredible headwind for the markets. In fact, the San Francisco Fed recently suggested the S&P 500 could finish as low as 1,290 a decade from now, 40% lower than its current level.

Finally, market participants must to continue to have full faith in powers of the Fed to manage not only the stock and bond markets but the economy and the dollar, as well. This is not a given. I believe that the Fed is not as powerful as the markets currently give them credit for being. If stocks began to fall in response to some dislocation in the currency or commodity markets the Fed may be hard-pressed to create a fix. Investors should have learned this lesson in 2008 when the markets essentially ignored every effort on the part of the Fed to reign in the financial crisis.

Ultimately, a number of things have to align nearly perfectly for the stock market to see another 1999-style surge. I do, however, envision one major possible driver of an equity blow-off. Should investors, both foreign and domestic, decide that Europe, Japan and emerging markets are not the best place for their money and that the US is the right place, we could see a continued surge in the dollar and increasing demand for our investment assets.

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But what might make them move so dramatically out of those markets? I think the most likely reason would be a dislocation in one or more of them. In that case, which asset class here would most likely benefit? Risk assets, like stocks and high-yield? Or risk-free treasury bonds? I believe investors looking for a safe haven would most likely pick the latter. This is one reason I wrote a couple of months ago that treasury bonds could be about to blast off. They have already risen 10% since then but in this scenario that could be only just the beginning.

As I wrote earlier, I have tremendous respect for these guys who are looking for a “blow off” in stocks. They could very well be proven right, yet again as they have many times during their careers. All in all, however, I think there are a lot of things that need to go exactly right for a “blow off” in stocks to materialize. What’s more likely, in my mind, is that we see a “blow off” in the bond market, something almost nobody expects right now.

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The Most Bearish Bear You’ll Find Anywhere: The FED

In a new economic letter recently released by the Federal Reserve Bank of San Francisco (h/t @dvolatility), a pair of researchers forecast a price-to-earnings ratio for the S&P 500 of a mere 8 in the year 2025 (due to retiring baby boomers’ waning risk appetites). This compares to 17 at the end of last year.

Let’s take this prediction out to its fullest conclusion. Assuming 3.8% earnings growth over the next decade (the long-term historical average according to Robert Shiller) we would achieve an earnings number of 156.76 for the S&P 500 in the year 2025.

Applying the 8.23 multiple to those earnings we get a price level of 1290 for the S&P 500. Yesterday the index closed at 2090. Ultimately, this research concludes then that stocks could very well witness a decline of 800 points over the coming decade, or about 40%, as baby boomers retire and shift their portfolios to a more conservative stance.

Have you heard a more dire prediction from ANYONE?

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Junk Bond Risk Appetites Imply Stocks Should Fall At Least 13%

I have been watching the junk bond (and leveraged loan) market very closely over the past few months mainly because risk appetites there have been closely tied to stock prices for a very long time. In fact, since the bull market was born in March of 2009 until this summer high-yield risk appetites (as measure by the ratio of the high-yield ETF to the 5-year treasury bond) and stock prices have had a 98% correlation coefficient.

sc-6Clearly, the chart above demonstrates that the strength in junk risk appetites led stocks off the lows back in 2009. Over the past summer, however, junk bonds started to lag stocks for the first time since the bull began (or lead lower, depending on your perspective). Since then the divergence has only gotten wider with each subsequent new high in the stock market:

sc-7So what’s going on? Why the sudden shift in equity risk appetites relative to high-yield?

Well, the popular explanation has been that the junk market has a much higher exposure to energy so the oil crash will have a much larger impact. For that reason, stocks are rightly “decoupling” from the junk market, or so it goes.

To me this argument sounds more than a little specious. The energy component in junk is about 14%. This compares to an 11% weighting in the S&P 500 so there’s a difference there, to be sure, but not a very significant one.

And as Howard Marks recently wrote, “It’s historically unprecedented for the energy sector to witness this type of market downturn while the rest of the economy is operating normally. Like in 2002, we could see a scenario where the effects of this sector dislocation spread wider in a general ‘contagion.'”

The energy boom over the past few years, driven by fracking technology, has been a major boon to the overall economy. The fact that fracking is now unprofitable means that boom is likely to bust. Believing that the boom was a positive but the bust won’t be is wishful thinking at best.

Interestingly, this morning T. Boone Pickens said he believed that weak demand was more to blame for the crash in the price of oil than excess supply. If this is the case it has much greater implications for the economy than if supply were the main culprit.

But setting the energy debate aside, investors should also consider the action in investment grade yield spreads which have widened, as well. They only have 6% exposure to energy so are much less exposed to the potential bust.

Leveraged loans are only made up of 4% energy. Still, risk appetites there have been just as weak as those in high-yield:

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To me, this all points to broader risk appetites responding to growing risks within AND beyond the energy sector or what Marks refers to as, “contagion.”

But why should these risks matter to equities? The answer is because high-yield bond investors and equity investors face the very same risks. What is the ultimate risk in owning a high-yield bond? It is the risk of the company falling into a situation where their income can no longer support their debt and they are forced to default.

The ultimate risk for equity investors is just the same. However, bond holders have seniority over equity investors. Equity investors, in fact, face even greater risk of loss of principal than high-yield or leveraged loan investors do because bond holders usually have some sort of covenants that hopefully ensure recuperation of their principal to some degree. This is not the case for equity investors.

You would think, then, that when bond holders begin pricing in greater risk of default equity investors should sit up and pay attention (at least some do). So I find it very fascinating that while investors in the debt markets are pricing in greater risks, equity investors feel comfortable in paying ever higher prices (accepting less and less “margin of safety”).

Historically, it’s equity investors that prove to be oblivious to the growing risks that high-yield investors begin to pay attention to rather than high-yield investors overreacting. As I’ve written before, high-yield spreads widened dramatically prior to equities topping in out in both 2000 and 2007 . In those cases, bond investors obviously proved to be fairly prescient. Today’s divergence between the two is even greater than those past episodes.

Given that the correlation between the two is so high and for good reason, it’s interesting to note that junk bond risk appetites now imply a level of 1800 on the S&P 500 (based on their daily correlation over the past five years of 98%), fully 13.5% below its current price. Now I don’t know how this gap will be closed, whether stocks will decline or high-yield risk appetites will recover or some combination of both. I do believe, however, that the bond markets are pricing in increasing risks that some have been warning about for quite some time and that the equity market, for the moment, is ignoring.

So who are these indiscriminate buyers in equities? It’s not retail investors. As Jason Goepfert pointed out in his letter last night, outflows from mutual funds and ETFs have been above average even for December, a month where we typically see outflows.

My guess is that it could be a various group of the dumbest of the dumb money. In that group I would include indexers who are value agnostic. (Don’t get me wrong; I’m a fan of roboadvisors but I recognize the risk their growing popularity poses.) I would also include algorithmic trading, which buys and sells stocks based on who knows what (a couple of words in the Fed statement?), certainly not any kind of traditional investment philosophy. Finally, I would point to foreign buyers who are desperate to escape the confines of their weakening economies, plunging currencies and falling equity markets at home.

Again, I’ll refer to the brilliant Howard Marks:

For the last few years, interest rates on the safest securities – brought low by central banks – have been coercing investors to move out the risk curve. Sometimes they’ve made that journey without cognizance of the risks they were taking, and without thoroughly understanding the investments they undertook. Now they find themselves questioning many of their actions, and it feels like risk tolerance is being replaced by risk aversion.

This is definitely now occurring the fixed income markets. In the equity markets I believe they are still, ‘moving out the risk curve without cognizance of the risks they are taking.’ But if Marks is right and we are now switching from a period of “risk on” to “risk off,” the widening in high-yield spreads (inverted) may have much farther to go:

fredgraph-2

And if that’s the case, 1800 on the S&P 500 may be only the beginning.

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