Picture above: Alice asked Ralph where the market was going. Ralph answered, "To the moon Alice, did you see Elazar Advisor's Fed liquidity spree chart with the yellow line? To the moon Alice!"
You can see on his face the disappointment that it hasn't happened yet. Alice, though is quite content either way, she's in cash, as you can also see. Disclosure, we think Ralph misinterpreted our chart. We know from his show, The Honeymooners, his trades didn't always work out. We really meant to infer the chart looked peaky and risky but I guess he, like many bulls, were looking at it saying, "to the moon."
Here's the famous chart the star of The Honeymooners was referring to.
Our report (In Fed We Trust) showed how the 08 crash could have been spurred on by the Fed and the next crash may also. One key was the above chart. The green line is the market (NYSEARCA:SPY) and the yellow line is the Fed's "liquidity spree" designed to drive funds to banks, the consumer and the market. (See Is The Fed Buying Stocks for the data)
Based on the above chart, you would think that the market would follow it all the way to the moon. But it's still sitting near last year's highs, down here on earth.
We heard from many followers and commenters that it's at "ATH" (All Time Highs) and for that reason it has to go higher. It may.
We want to show what, we feel, has it artificially inseminated and what can cause it to break.
Four Reasons Why The Market's Still Up
1) Elazar's yellow line in the chart above
2) Overstated Fed Model
3) Low rates driving banks and all to chase lower quality returns
4) Because it's up
One, Elazar's Yellow Line
The unbelievable amount of liquidity (first chart above: yellow line) that the Fed has pumped into the economy should be holding up the economy. That said it's slowing.
An economy awash in liquidity should have been driving results for quite some time. The economy is gasping, at best, and if any of these above two charts go any lower, we are in a recession, despite the mounds of Fed liquidity.
That is a fair first reason why we haven't dropped fast, yet. The underlying liquidity is holding up levels despite grinding fundamentals.
Why we don't buy it?
We think the yellow line may be coming down. We see, not expect, the economic numbers slowing. We see, not expect, earnings and other important fundamental measures slowing. We do think, in the end, fundamentals, not pure liquidity, will reign. And that liquidity may come down too.
The Fed Model
In simplicity, if the Earnings Yield is better than the Treasury's 10 year yield the market is cheap.
As the 10 year yield goes lower stocks are relatively cheaper and a perceived better investment (Risk aside).
Here's the 10 year.
That lower yield, when compared to "the fed model" is propping up stocks.
We'd guess there are plenty of quant models that figure in this formula in some way. Every time the market goes down they have a signal to buy. (That's our take of course). But capital is not infinite (unless you are the Fed) which means at some point these investors supporting the market run out of capital and can no longer swim upstream.
There are issues with the E (earnings) in the numerator of the yield. We think it's overstated.
On the face of it the earnings yield on next year's (2017) numbers look strong (y-charts). Versus the 10 year yield of 1.7%, it shines.
But that's assuming earnings grow next year.
But earnings were down last year 17%. Expecting up double digits next year may be rich. Wait a minute the 17% was GAAP earnings so maybe we shouldn't look at it. Wait a minute, maybe that's meaningful too. Maybe we should look at GAAP?
Maybe, to be more conservative we should assume earnings should be flat next year, maybe down. And to be more conservative, let's play with the GAAP number. You know, "generally accepted accounting principles." Or should we use not-so generally accepted accounting principles (NSGAAP). Which one do you want to use when determining what to do with your money?
[As an aside, I'm about to get personal here, let's say your tax accountant calls you up and says "Mr. Reader, this year, for your tax return I don't want to use accepted accounting principles, I want you to use not-so accepted accounting principles (NSGAAP, Elazar coined), I'll call them non-generally accepted accounting principles, or, for short, non-GAAP."
I have a question for you, it's multiple choice. Do you:
A) Fire him on the spot
B) Consult your spouse then fire him on the spot
C) Fire him on the spot and then consult your spouse
As far as the famous generally accepted Elazar principles (GAEP) the correct answers are A, B AND C. You all win.]
So with that exercise behind us, I want us to move away from generally not-so accepted accounting principles (NSGAAP) and back to generally ACCEPTED accounting principles (GAAP). Are you with me?
If we switch to approximate "accepted," for the sake of quick math I'm using ZeroHedge's (cited above) famous 25% and chopping next year's numbers by that amount. We're taking NSGAAP estimates and converting them to GAAP, with quick math based on 2015 numbers which are in.
We're not done. (Sounds like a late night Ginsu 2 commercial for buying a knife set) (We don't vouch for this seller. We just show you what we're talking about, maybe they'll have a lucky sales day thanks to this report).
In fact I am so confident that we can cut these estimates, I am going to use this Ginsu knife you see right before your eyes, and I am about to CUT these estimates. Let's see how easy. (You can use any knife really, butter knife, it's not so hard).
To arrive at Ginsu estimates, follow me down the left side of the above chart and then you can do this yourself.
We take current S&P estimates for 2017. We then make them flat to last year. Remember last year was down so expecting down is probably better. Add to that the economy is slowing and oh, our little yellow line that inched downwards (first chart way above) all have us concerned.
Stay with me. We are now going to GAAPetize these numbers. We take ZeroHedge's proprietary / famous 25%, (S&P GAAP numbers in 2015 were 25% lower than NonGAAP numbers...and remember we already fired our accountant for trying to pull a fast one by pitching us on NSGAAP) which we agree with and we bring down the NSGAAP (not-so GAAP) numbers to, let's say it altogether...
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES.
You're all doing great.
And, maybe flat earnings is aggressive given our yellow line. Let's go to down earnings. Can we do that? Can it happen? Definitely. It's already happening. Analysts are bringing their numbers down every day (Factset).
What are we left with? We have an earnings yield of 3.7%. That's based on 2017 GAAP EPS down 5%, if you agree with EPS down 5%. That could also be aggressive.
The only time in recent history the earnings yield was lower was 2008 (Y-Charts).
But the 10 year is keeping the market up using the Fed model. But which E are people using, NSGAAP, GAAP, up 15%, down 5%. We think GAAP down 5% is fair, not conservative, not aggressive, fair.
Fed Model Keeping People In
Now, fairly, since we're looking for reasons of what's propping the market up, even that 3.7% is 200bp above the 1.7% of the 10 year. That's relatively high. That is, we think unfortunately, keeping people in.
That took us long enough, but hope you walked away with a nice set of S&P earnings chopping knives.
Why we don't buy it
One thing is special to know about the Fed model is that the yield of the S&P 500 and the 10 year move together. That's the point of the model.
Do you remember which way we showed yields are going? Remember the lower highs? They are going lower. That means the stocks that investors are buying based on the Fed model have earnings that are also going to go lower.
As a fundamental analyst, we hate that prospect. That's not a good prospect. That's a reason to get out.
We can't buy the Fed model because of the 200bp gap. We're focused on earnings going lower taking values with them.
Low Rates Driving Higher Risk Purchases
This is another reason the market is still up. This is similar to the Fed model reason where low rates drive investors to riskier assets.
The Fed is trying to get us to invest in risky assets.
But wait, I'm confused, really.
Aren't they raising bank capital standards, saying everybody has TOO much risk? But wait, yet they are keeping rates low, saying invest in risk.
Did I just hear myself say that?
I've asked the biggest banks in the world this question and they are also miffed. "Good question, no answer."
Fed To Banks: Raise capital to lower risk
Fed To Banks: Low rates, invest in risk
Those two operatives seem incongruent, to say the least, no?
I'm totally lost now. What's the Fed saying? What do they want? Do they want us to take risk or reduce risk? The banks are the most important part of that equation. Which is it? Please Fed tell us.
Reader, please o please, answer us that one question, lower rates, higher capital requirements, where are we? Please, make it make sense to us all!
We think the Fed has to be worried about too much risk out there, which is why they are forcing the lever of that chain, the banks to increase safety standards. The rates down are because they are stuck for many reasons which all the commenters said correctly. We're stuck. That's not good.
Rates are increasing the risk tolerance while the Fed is saying risk is too high (for banks, which is our linchpin).
The end game for us, if the Fed is saying watch out, don't buy into their prices. The yield is not showing us how much risk there is out there. Stress tests and living will exercises show us, through Fed action, however, there is risk out there.
Why Else Is The Market Still Up?
Because It's Up
How many people have used the acronym ATH (all time highs). We hear you but fundamentals look as though they are ATP (all time peak). We'll see who's right but the simple fact is the market is flat for a year. That is not necessarily bullish.
This could be keeping investors and quants in. They have to be in because they have to match their index returns. That's also an unsafe scenario. It means when it goes down everybody needs to get out together.
We saw that long long ago in a land far far away, where everybody needed to get out in unison. You probably don't remember, it was probably before your time, January 2016. Ask your grandparents. It probably couldn't ever happen again.
With the amount of the Fed's spending spree the market should be much higher. Ralph's moon prediction has not materialized. His call made sense to us but it didn't happen. That it didn't happen means we may have countervailing forces at play. Among them are slowing growth, earnings, liquidity, dollar, and the yellow line ticking down.
We think the question is not what's holding the market up but rather why isn't it up much higher? But it's not.
We continue to be bearish until we have fundamental factors leaning us to another reality.
(Below is a picture of Ralph looking for the market but it didn't make it to the moon. All he found was this flag)....
(Really the picture is astronaut Eugene Cernan saluting the US flag, which we thoroughly respect and admire. We liked the picture though for our story line though.)
Good luck and please be in touch. All of your comments teach US a ton and give us the best ideas for what to write next!!
Elazar Advisors, LLC specializes in earnings and predicts, analyzes and reacts to earnings and earnings events as well as developing current company and macro stories with a hedge fund perspective.
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Disclaimer: All investments have many risks and can lose principal in the short and long term. This article is for information purposes only. By reading this you agree, understand and accept that you take upon yourself all responsibility for all of your investment decisions and to do your own work and hold Chaim Siegel, Elazar Advisors, LLC, bestideas, their related parties, and its authors harmless. #in, $spy, $qqq, $iwm, $vxx, $ycs, $fxe
Disclosure: I am/we are short ES, BUT AS WE'VE WRITTEN, THAT CAN CHANGE ANY TIME.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.