- US market is overvalued due to non-fundamental factors involving Central Banks.
- Current Fed policies are causing stagflation which has eliminated disposable income for the average consumer.
- Valuations are rich even in an environment of weakening earnings.
My pessimistic outlook on Western economies and stock markets has been a common theme since the inception of the Pardini Report. Our strategy has been hedged for more downside risk, and we have recommended short positions in a market where it seems like this strategy would not work due to the "Bernanke put" that states the Fed will guarantee stocks will never go down in a meaningful way. This thinking is misguided and dangerous for serious traders and investors. In this week's letter, we focus on the macro case against US stocks and why we maintain a defensive outlook when the market is facing new highs.
Just about every market factor outside of hopes tied to Fed policy is bearish. The real economy is not growing, real living standards amongst 90% of Americans are declining, and this slowdown is reflected in poor earnings. The catalysts for this bull run of easy money and institutional corruption causing multiple expansion is shaky at best. Technical indicators also are overbought, and sentiment is over bullish. With our 2014 price target for the S&P 500 below 1600, our outlook is negative for most developed market stocks. The crash of 2014-2015 will be brutal and come to surprise most market experts despite the signs being obvious for anyone looking at fundamentals beyond FOMC guidance.
The first factor we will address is the Fed and the endgame for quantitative easing. Any way this Fed experiment ends is bad for global equity markets. If the Fed never quits printing and keeps rates down indefinitely, the Fed will lose its credibility of being independent of political pressure. The result of this reputation damage will be high inflation and a weak dollar. Strong performance of commodity prices in 2014 so far are early signs of this eroding credibility. Inflation will hurt real earnings, as the lack of wage growth will limit the ability to pass higher costs to consumers. High inflation will also recreate the stagflation environment of the 1970s that was bearish for stocks due to high commodities prices, declining disposable, and high nominal rates attracting capital to bonds.
If Janet Yellen takes a stand against the current asset bubble and rising inflation expectations, the market will likely crash as well, but at a faster pace. There is close to a 90% correlation of the Fed balance sheet and US stock prices, so any reversal in money creation will devastate markets. Even with the money supply just stopping its increase for brief respites in 2010 and 2011 resulted in a flash crash, and a 19% sell off before the announcement of Operation Twist. Tapering will be completed by September. Fears of the end of easy money will be enough to trigger a sell-off.
Even though December's taper announcement triggered optimism in the stock market, it actually was a clear warning to stockholders. Through his testimony, Bernanke set the course not just for tapering $10B this month, but actually reducing asset purchases by $10B each month pending a serious downturn in economic data. Since economic data historically lags market movements and monetary policy shifts, any downturn will not be seen quickly enough to scare the Fed into delaying tapering. Besides, if the Fed turns back from tapering now, it will erode the credibility of the Fed's independence from political pressure and cause a lack of confidence in the US dollar and monetary policy as a whole.
Interest rates will rise in either scenario. The combination of increased inflation expectations, higher sovereign default risk, or tightening policy will be the catalyst. Not all of these will happen, but the probability of at least one happening is near certain. Higher rates makes stocks less attractive versus bonds, increases the financing costs of traders on margin or highly levered companies, lower housing prices, and also will trigger more consumer defaults. The most likely catalyst for the downturn will be either higher interest rates in Europe, the US, or Japan. The Japanese are likely to be the first with a crisis, because interest rates on the ten year only need to rise to 2% to cause a fiscal crisis and 3% to trigger an outright default.
With the Fed having no real control of the economy, their policies have done nothing to create real organic economic growth. Quantitative easing only has exaggerated the structural imbalances of the economy since the year 2000, and have sown the seeds for the next bust and the social tension that will succeed it. The reason I go back to 2000 instead of 2008, is because the dot com bust was a turning point for not only the beginning of the great convergence of living standards, but also the dawn of politicians and central bankers attempting to stave off this trend by using easy money and generous social programs. The real reason why "main street" and the US economy outside of limited sectors such as the energy and technology industries has failed to recover is due to the declining competitiveness of American labor in a global economy. This has led to those who were previously able to earn middle class incomes with limited specialized skills to become obsolete in the labor market or become forced into low paying work. Also, with living costs rising faster than take home pay, the average American consumer is in the red just to pay basic bills. Even using generous assumptions, I concluded that the "middle class lifestyle" is out of reach to over 50% of Americans. Rents have increased considerably since my 2011 study, which makes this problem even worse. Factoring in external debt such as student loans, underwater mortgages, or credit cards, this number may actually be even worse.
The bottom line is that the American consumer is broke and has no disposable income. Without disposable income to spend or save, there is limited capacity for real private sector growth and therefore the US economy continues to stagnate even with sustained cheap credit. The only solution to this problem is to either allow a major deflationary bust to lower the prices of basic goods such as housing, energy, and government spending to more "affordable" levels for current wage levels (which may include a haircut in US treasuries) or allow real standards of living to fall stealthily through inflation. Both outcomes would be bad for the banking system and the stock market. Since the former solution would cause a politically unacceptable direct admission of Americans' quality of life falling down to "third world" living standards, the latter option has been pursued. However, since central banks do not have the power to distribute inflation equally, the result has been the current asset bubble because the wealthy investor class is the only group with any spare money remaining after the 2008 financial crisis.
Economic data is confirming this. Personal spending rose in January despite no gain in incomes. National savings levels are back at five-year lows and pending home sales are down 8.7% month/month in January 2014. Durable goods order has also fallen significantly along with consumer confidence.
Western governments have attempted to solve structural decay amongst the middle class by allowing consumption to continue through credit. This temporarily allows people to keep their current standard of living without wage growth, but once the business cycle turns results in severe losses of jobs, assets, and wealth from debt defaults. As a result, the outcome of using the Fed as an economic stimulus have been disastrous. Two major asset busts (with a third one coming soon), real incomes of the average American falling 20% since 2000, global economic inequality at record highs, and the Arab Spring uprisings have all been outcomes created by easy monetary policy amongst the largest central banks. All QE does is boost asset prices as wealthy individuals are forced out of fixed income investments due to negative real rates of return. Banks have no incentive to lend to small business because low rates eliminate the reward from such a risk where it's safer to park the money in Treasuries. Credit spreads are narrow enough for this to make sense
This weakening has now also started to affect earnings adversely. Earnings and revenues misses from supposedly stable blue chips such as Johnson & Johnson (NYSE:JNJ), MasterCard (NYSE:MA), and IBM (NYSE:IBM) has confirmed this deterioration. Even high growth stories such as Yahoo (NASDAQ:YHOO) and Amazon (NASDAQ:AMZN), have reported bad quarters and show a deceleration in revenues. Net of banks, earnings growth has been negative since Q3 2013, and earnings growth rates have consistently underperformed analysts' expectations. Top line growth has been even harder to find as revenues were down on the S&P 500 since June 2013 with that trend continuing with this quarter's earnings season. Revisions have been 80% negative by companies' guidance reports, which is the highest level since the 2008 financial crisis. Earnings growth since 2010 has been primarily driven by two factors: financial engineering and reducing headcount for efficiency gains. With large cap corporations running at record lean levels (based on earnings per employee) and interest rates are rising which limits new refinancing. Top line growth has been weak since 2012 and the lack of revenue growth will likely show up in the form of disappointing earnings releases.
Since earnings growth has been tepid since 2011, the bull rally has been mostly fueled by multiple expansion over increased profits. As a result, valuations for US stocks have reached rich levels only seen in 1929 and the late 90's tech bubble. The P/E ratio of the S&P 500 is currently at 19.55, which is 30% above its historical average. As seen in the chart below, valuations adjusted for changes in the business cycle (Shiller P/E) are at highs only previously seen in 1929 and the tech bubble. Valuations of small cap stocks are even more overextended. The P/E ratio of the Russell 2000 is 86, which is over three times its historical average of 25. Dividend yields have also fallen considerably. At 1.9%, the S&P 500's dividend level is the lowest seen since 2000. In fact, May 2013 was the crossing point where dividend yields on stocks fell below the ten-year treasury yield. As a result, stocks no longer have favorable prices on a yield basis as well as a valuation basis. Valuations at such high levels price in perfection for company performance and leave very little upside potential for investors.
Despite these negative signs, market sentiment has become the most optimistic since the late 1990s. Speculative capital has boosted the valuations of business fads such as social media companies, marijuana stocks, UK, Canadian, and Asian based real estate, Bitcoin, and Tesla Motors to the point that these assets have negative expected returns or generate negative yields. Bullish sentiment is nearly unanimous amongst both retail investors and investment professionals. Margin debt on stock purchases is at all-time highs, 75% of newsletters are bullish, the average hedge fund is leveraged long, and bullish option speculation is at all-time highs. This indicates that all the money is on one side of the market. Since economic fundamentals do not confirm such market euphoria, this is a strong contrarian sell signal.
Technicals for US stocks are finally setting up for shorts, as medium-term signals are catching up to foreboding long indicators. Fourteen-day RSI readings are overbought on the monthly time frame for both the S&P 500 and Russell 2000. 2014's slow start of the market is the worst since 2008 and a negative January has seasonal implications for the rest of the year. Momentum indicators such as the MAC-D, Force Index, and stochastics measures have turned bearish.
The only concern is the risk of a counter trend rally. The Dow is the only major stock index to place a lower high, but lower lows within the daily, weekly, or monthly price patterns have been established. Seeing the markets fail to make new all time highs off the next dip or breaking the low of the previous dip will be strong signals to enter or increase short positions.
I have been placing short sales on S&P 500 (NYSEARCA:SPY) and Russell 2000 (NYSEARCA:IWM) futures over the past two weeks, and this week's technical breakdown confirms the shift in trend that we have been anticipating. However, the ride down will be filled with volatility.
Overall, the combination of a deceptively weak economy, technical overextension, and the unsustainable path of central bank policy explain our bearish outlook on the US stock market. It would take a currency crisis or high inflation to preserve current nominal levels of stock prices. We have remained largely market neutral for 2014, which has been successful. However, we do have an existing short position in S&P 500 futures. In addition to shorting the S&P 500, we plan on adding shorts in Russell 2000 futures, and individual companies or ETFs overvalued or weak sectors such as France, India, social media, global homebuilders, and/or Western banking stocks once technical signals are provided to do so.
Additional disclosure: I am short the S&P 500 via futures and looking to place Russell 2000 shorts within the next 72 hours if they are not already placed by the publication of this article. I also am short French equities via EWQ.