Third Quarter Review
Equities rallied during the third quarter (the S&P 500 was up 3.3%) as central bankers again intervened after Britain voted to leave the European Union. Safe-haven assets were flat to down (the U.S. 10-year Treasury bond was down 0.54% and Gold up 0.13%) during the quarter, as investors sold their safe assets and became more risk tolerant because of the additional liquidity provided by the central bank.
As a result of the June 23rd U.K. referendum to leave the European Union, the central bankers once again intervened in the marketplace. First, the ECB promised to ensure "price and financial stability" and urged central bankers to "better coordinate their policies". Next, the Bank of England ("BOE") reduced short-term interest rates to 0.25% (their first interest rate reduction in seven years), promised to purchase 60 billion pounds per month of government bonds and 10 billion pounds per month of corporate bonds, while offering a new 100 billion pound term-lending facility to the banks. Finally, on July 27th, the Federal Reserve left interest rates unchanged, citing global uncertainty.
Once again, investors focused not on the fundamentals (i.e., Brexit will lead to recession in the U.K. and significant economic uncertainty in the EU) but on the central bankers' promise to print money to buy more financial assets. After the June 27th market low, the mantra "bad news is good news" worked again as the S&P 500 rallied approximately 10% over the next eight weeks to an all-time high. While all risk assets performed well during the third quarter, the Russell 2000 and most foreign stock markets failed to confirm the S&P 500's new high.
Despite the difficult performance for safe assets during the quarter, we are confident that an asset allocation which is diversified and economically balanced (stocks, bonds, currencies and commodities) is poised to perform well in today's uncertain and unprecedented investment environment. Because we are late in this economic cycle and stocks offer a poor risk-reward, we believe it is prudent that investors remain focused on protecting capital.
Investment Outlook Summary
Equities continue to offer a very poor long-term risk-reward. For more than eight years, central banks, through their Quantitative Easing ("QE") programs, have deliberately inflated financial markets in an attempt to drive economic demand. This policy of "printing" money to buy financial assets drove valuations to an extreme level. We estimate that fair value for the S&P 500 is 1330, which is 37% below current levels. Additionally, we believe that prospective returns will be only 2.4% per annum over the next 10 years versus a historic 10.0% per annum return. Since stocks and U.S. Treasury bonds offer similar 10-year prospective returns, yet equities are significantly riskier, we remain underweight equities. The economic cycle peaked nearly two years ago, and the current slowing growth rate will continue to lead to disappointing fundamentals and weak corporate profits. Despite the S&P 500 reaching an all-time high only eight weeks ago, corporate profits, industrial production and gross private domestic investment are all contracting (i.e., in recession). While many hope that the economy and corporate profits will rebound next year, we see no monetary or fiscal catalysts on the horizon that would stimulate the waning economy. Historically, safe assets (U.S. Treasury bonds and gold) have outperformed equities during periods of slowing (or contracting) economic growth. Given the slowing economic growth and the more favorable risk-reward, we expect that safe assets will continue to outperform equities on both an absolute and relative basis. Central bankers and their effort to manage asset values have dominated the financial markets during 2016 - we believe the endgame is near. Currently, global central banks own $17.6 trillion of financial assets, which is 23.7% of global GDP. Despite the unprecedented level of financial asset purchases, global economic growth has been anemic for the entire seven-year expansion. In this current year, central banks have significantly intervened twice in the financial markets - in the first quarter due to a global growth scare and in the third quarter due to the Brexit. Instead of stimulating economic growth, their policies have led to: a misallocation of resources, inflated asset values, a lack of capital investment and wealth inequality, which helped foster the global populist and anti-globalism movements. Recently, it appears that the central bankers are slowly moving away from their financial repression strategies. For several months, the Fed has indicated it will raise interest rates soon, while the BOJ declined to increase the size of its balance sheet and the ECB floated a rumor it may tapper its QE purchases. If additional liquidity is not provided to the markets, we believe that the fundamentals will matter and mean reversion (i.e., lower asset prices) will occur. In the short term, the financial markets are in a correction and vulnerable to a sharp decline due to the central bank's actions and market-structure issues. In addition to inflating financial assets to a historic level of overvaluation, central bankers' actions have artificially reduced market volatility and created abnormally high asset correlations. Expensive financial markets with suppressed volatility and high correlations are a dangerous combination, especially when the economic cycle is decelerating. Additionally, an estimated $3.7 trillion is currently managed by quantitative investment funds that rely on volatility and correlations to drive their asset allocation. We are concerned that - similar to the "portfolio insurance" strategy that contributed to the 1987 crash - today's risk parity and quantitative volatility strategies could contribute to a sharp acceleration of selling across all asset classes.
Asset Allocation: As long-term value investors, our strategic asset allocation ("SAA") is driven by the market's long-term risk-reward. Currently, our SAA remains defensive and positioned to perform well during a period of slowing economic growth and rising market volatility. Our tactical asset allocation and risk management overlay - that are based on volatility and intermediate and short-term trends - have recently hedged some of our equity, long-term U.S. Treasury bond and gold exposure.
Current Asset Allocation:
Large Cap Equity
Long-term U.S. Gov. Bonds
Small Cap Equity
Int-term U.S. Gov. Bonds
Equity Hedge(small-cap and volatility)
NET RISK ASSETS
NET SAFE ASSETS
Equity Market Outlook: We remain steadfast in our belief that the equity market is historically overvalued and offers a very poor risk-reward. Despite a weak economy (during the second quarter nominal GDP grew at a recessionary 2.5% year over year) and a corporate profit recession, the S&P 500 has appreciated 6.8% over the past 12 months. In our view, the financial markets are disconnected from the fundamentals because of the unprecedented level of asset purchases by the global central banks. After implementing a negative interest rate policy and a significant increase in the size and scope of asset purchases in 2016, we believe that the central banks have reached their endgame and will only maintain or reduce the size of their balance sheets until the next recession occurs. This lack of incremental liquidity will make fundamentals matter (i.e., "bad news is bad news") and equities will be vulnerable to a significant decline as valuations and profit margins regress to normal levels.
In the first quarter of this year, the S&P 500 declined by 15% due to concerns about global growth. The central bank intervention was significant:
The ECB lowered short-term interest rates to negative 0.40%, increased its QE asset purchases from 60 billion euros to 80 billion euros per month and it expanded the program to include investment-grade corporate bonds. The BOJ cut short-term interest rates below zero, while it continued to purchase government bonds and equity ETFs. The Fed said that due to global concerns, it would be less aggressive in raising interest rates to a normal rate and it reduced its guidance from four rate interest rate hikes in 2016 to two.
Initially, investors were concerned about the global growth and deflationary pressures, so they reduced their risk exposure. The central banks responded by promising to purchase an additional 240 billion euros of government and corporate debt per year, while punishing savers by setting short-term rates below zero. Despite the disappointing fundamentals that precipitated the equity decline, the S&P 500 responded to the central bank's intervention by rallying 16.6% over the next 10 weeks.
Additionally, at the end of second quarter, Britain voted to leave the European Union and investors again became risk-adverse. The S&P 500 declined 6% before the global central bankers stepped in:
The ECB promised to ensure "price and financial stability" and urged central bankers to "better coordinate their policies". The Bank of England ("BOE") reduced short-term interest rates to 0.25% (the first reduction in seven years), promised to purchase 60 billion pounds per month of government bonds and 10 billion pounds per month of corporate bonds and offered a new 100 billion pound term-lending facility for banks, offering them very low funding. The Fed left interest rates unchanged at its July meeting.
After the Brexit vote, investors sold their risky assets due to the fear of a recession in the U.K. and economic uncertainty across the EU. Once again, the central banks reacted to the market dislocation by promising to purchase over $ 1 trillion of government and corporate debt per year, while cutting short-term rates to further punish savers. Again, despite the increased economic uncertainty and a probable U.K. recession, the S&P 500 responded to this increase in liquidity by rallying 10.1% over the next eight weeks.
It is evident that risk assets are no longer driven by the fundamentals (e.g., declining earnings, flattening yield curve), but the expectation of further liquidity provided by the central banks. Speculators believe that bad news for the economy becomes good news for stocks because the central bankers are forced to print more money to purchase more assets. While this dangerous game may work in the short term, fundamentals matter and eventually buying bad news will lead to significant loss.
It has been our belief that the central bankers are "pushing on a string" and their financial repression policies (negative real interest rates and large scale financial asset purchases) are creating the deflation pressure they are trying to prevent. Because the economic cycle peaked and growth is decelerating, the financial and economic problems will only continue to grow larger. We believe that the central banks' ability to intervene in the markets will be constrained because:
Central banks' balance sheets are too big. They already own $17.6 trillion of financial assets, which is 23.7% of global GDP, and they are currently purchasing over $225 billion of financial assets per month, which is an annualized rate of $2.75 trillion. Central banks are running out of qualified assets to buy. At the current 80 billion euro per month purchase rate there will be a shortage of qualified EU bonds to purchase within nine months. Negative interest rates tighten financial conditions, especially in the vulnerable financial sector. Financial repression, which helps Wall Street but hurts Main Street, has led to significant wealth inequality, economic stagnation and populist unrest.
Recently, the major central banks have indicated a potential shift in their monetary policies.
At its last meeting, the BOJ (whose balance sheet is 109% of GDP) indicated that instead of increasing the size of its QE program, it will attempt to steepen its yield curve by selling long-term bonds to buy short-term bills. The ECB hinted that it may tapper or reduce the size or its 80 billion euro per month QE program. The Fed has strongly indicated that they will increase interest rates by December, despite a profit recession, poor productivity and below target inflation.
It is uncertain why the central banks are suddenly reluctant to increase their monetary stimulus. We are hopeful that they realized that financial repression hurt the economy more than it helped and it led to wealth inequality and social unrest. Also, we hope that the central banks are resolute in their effort to "normalize" interest rates, and that their epiphany was not too late.
Chart 1: Market Capitalization to GDP - Stocks Remain Very Expensive
In a 2001 Fortune Magazine article, Warren Buffet stated that market capitalization relative to GDP "is probably the best single measure of where valuations stand at any given moment." Currently, stock market capitalization is 115% of GDP; this is significantly above the 50-year average of 65%. Based on this valuation measure, stocks would need to decline by 43% to be considered fairly valued.
Chart 2: Private Sector Net Worth Relative to GDP Has Never Been Higher
The central banks' easy money policies have driven most asset classes to historic levels of overvaluation. Since 1950, private sector net worth (real estate and financial assets) has averaged 377% of GDP. Currently, private sector net is 482% of GDP, which is 2.7 standard deviations above the mean.
While our bearish market outlook and defensive asset allocation has not changed much in nearly two years, neither has the S&P 500. Since corporate profits peaked in the fourth quarter of 2014, the S&P 500 has appreciated only 3.4 % (the S&P 500 increased from 2059 to 2130). Corporate profits, during that time, decreased by 18% (GAAP earnings declined from $105.96 to $86.53). Typically, profit recessions lead to bear markets. It is evident to us that the unprecedented expansion in central banks' balance sheets to $17.6 trillion of financial assets - which is equal to 27% of global GDP - artificially inflated asset prices. The more the fundamentals declined, the more financial assets they bought to artificially boost asset prices. It is clear these policies only "kicked the can down the road" and allowed the structural problems to increase in size.
Chart 3: S&P 500 and GAAP Earnings
Since Q4 2014, the S&P 500 is essentially flat, while GAAP earnings have declined 18%. In our view, stocks are detached from the fundamentals due to central bank activism and complacent investors. In the short term, excess liquidity and ebullient investor sentiment can drive stocks from their intrinsic value. In the long term, stocks are driven by the fundamentals. When the liquidity growth ebbs and sentiment sours, stocks will regress to the mean.
Chart 4: Corporate Profits to GDP - Despite a 18% Profit Decline, Margins Remain Elevated and Poised for Mean Reversion
Profitability has peaked for this cycle. Currently, corporate profits are 8.9% of GDP, which remains significantly above the historic average of 6.5%. We expect earnings growth will continue to disappoint investors as economic growth slows and profitability returns to a normal level.
In our view, stocks are overvalued, the economic cycle has peaked and the economic surprises will continue to be on the downside. Unfortunately, the central bankers have run out of tools and will no longer be able to artificially support prices. Despite their low yield, U.S. Treasury bonds have a similar 10-year prospective return than stocks, a better risk-reward and because they outperform during periods of slowing growth, we continue to believe it is prudent to underweight equities and overweight the safe assets (U.S. Treasury bonds, U.S. Dollar and gold) until the equity market offers a favorable risk-reward.
Economic Outlook: While the Fed and most Wall Street strategists believe that the economy and corporate profits are poised to recover next year, we expect that growth will remain sluggish and surprises will be asymmetrically to the downside. In our view, the economic cycle peaked and growth rates have been slowing for approximately two years. Economic structural issues - aging population, too much debt, technological change and increases in the tax and regulatory burden - have led to the weakest Post-World War II economic expansion.
Additionally, the Fed's financial repression strategy (negative real rates and printing money to buy financial assets) created a significant economic headwind because it caused consumers to save instead of spend, and corporations to buy instead of invest and build. The significant lack of corporate investment this cycle explains the poor productivity growth and will reduce the economy's future growth potential.
While this is the fourth longest economic expansion since World War II, it is also the weakest. Real GDP's peak growth rate this cycle did not even achieve the 3% historic average growth. The central bank's monetary solution of financial repression helped Wall Street (inflated asset prices), but hurt Main Street (stagnant or negative real wages). The economic cycle peaked nearly two years ago, and has slowed to a recessionary level. Unfortunately, with interest rates at historic lows and central bank's balance sheets already extended, our central bankers do not have the monetary tools they had during prior economic slowdowns.
Chart 5: Nominal GDP Peaked Two Years Ago
Nominal GDP peaked for this cycle at 4.9% in the third quarter of 2014. This cycle's peak growth rate was significantly below normal growth rates that averaged 6.5% since 1948. Additionally, in the second quarter of 2016 nominal GDP grew at only 2.5%, historically this is a recessionary level. Source: FRED
Chart 6: Private Sector Debt is 151% of GDP
Private sector debt (households and corporations) has averaged 110% of GDP over the last 65 years. While the current debt burden has improved slightly since the "Great Financial Crisis", it remains at 151% of GDP, which is $8.95 trillion above the mean.
Chart 7: Gross Private Investment as a Percent of GDP
Gross private investment is critical to improving productivity and growing the economy. Investment peaked in the first quarter of 2015 significantly below previous peaks. The lack of investment this cycle will lead to disappointing growth in the future.
Chart 8: Investment Spending is in Recession
Chart 9: Employment Growth Has Peaked Nearly Two Years Ago
Employment growth, which is a lagging economic indicator, peaked in February 2015 at 2.3%. Since nominal GDP is at a recessionary level and investment spending is negative, we expect employment growth will disappoint investors.
As we have argued for a long time, solid fiscal policy, not unprecedented monetary policy, is the solution to repair our economic problems. In our view, it is essential that central bankers "get out of the way" and let the markets work. Once the free markets adjust and clear, they will give investors and corporations valid economic signals and the confidence to make long-term investment decisions that will spur economic growth. Additionally, if simple fiscal measures are enacted, such as, simplifying and reducing the tax and regulatory burden, while adopting a rules-based monetary policy, we are confident that the significant pent-up demand from at least eight years of underinvestment would lead to very robust growth.
Short-Term View (three months): The markets have been in a short-term correction since the S&P 500 reached an all-time-high eight weeks ago. We are concerned that the broader market (the Russell 2000) and the global markets (FTSE All-World ex-US) failed to confirm the S&P 500's new high. Such divergences in the past have led to significant market corrections and bear markets.
Chart 10: Russell 2000, S&P500 and FTSE All-World (ex-US)
While the S&P 500 reached an all-time high on August 15th, the broad market and global markets did not confirm the new high. Historically, such divergences presage significant market declines.
Also, it appears that the actions of the central banks have suppressed volatility and led to abnormally high asset correlations. Expensive financial markets with suppressed volatility and high correlations are a dangerous combination, especially when the economic cycle is decelerating. Currently, an estimated $3.7 trillion is currently managed by quantitative investment funds that rely on volatility and asset correlations to drive their asset allocation. We are concerned that - similar to the "portfolio insurance" strategy that contributed to the 1987 crash - today's risk parity and quantitative volatility strategies could contribute to a sharp acceleration of selling across all asset classes.
Chart 11: The Correlation between Stocks, U.S. Treasury Bonds and Gold Are Dangerously Elevated
Diversification, which is a critical component of portfolio management, is dependent on low-correlated assets to minimize portfolio risk. Stocks, U.S. 30-year Treasury bonds and gold typically have low or negative correlations. Currently, correlations are high, which could exaggerate portfolio risk if the current market correction accelerates.
*Equities remain overvalued and offer a very poor long-term risk-reward. We estimate that stocks will provide a return of less than 2.5% per annum for the next 10 years (versus a 10.0% historic real growth rate), and fair value for the S&P 500 is 1330, which is 37% below current levels.
*The economic cycle has peaked, global growth is decelerating and the fundamentals are poised to disappoint. Investment spending, industrial production, and corporate profits are in recession, which bodes poorly for future growth prospects.
*By holding $17.6 trillion dollars of assets and setting interest rates below zero, central bankers have reached the limits of monetary policy. The Fed has strongly indicated that it will raise interest rates this year, while the BOJ is now attempting to steepen its yield curve instead of increasing its QE program, and the ECB has hinted that it may tapper their QE program next year. Equities will be vulnerable if liquidity growth has peaked.
*The financial markets are currently in a short-term correction. Market divergences, suppressed volatility and elevated correlations concern us that we could be at the beginning of a significant correction or the next leg down in the global bear market.
In this uncertain and unprecedented period, we believe that it is essential to rely on risk management and an asset allocation, which is economically balanced to perform well in any investment environment. Because equities offer a poor risk-reward and we are late in this economic cycle, we believe that investors should focus on protecting capital, until the economic cycle has troughed and stocks offer a favorable risk-reward.
All information disclosed in this statement is accurate and complete to the best of our knowledge. Past performance is no guarantee of future results, and there is no assurance that the firm or client's investment objectives will be achieved. This material has been distributed for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. All investments contain risk.
Disclosure: I am/we are long SPY, QQQ, TWM, VXX, TLT, MUB, TBT, GLD, GLL, UUP.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: All information disclosed in this statement is accurate and complete to the best of our knowledge. Past performance is no guarantee of future results, and there is no assurance that the firm or client’s investment objectives will be achieved. This material has been distributed for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. All investments contain risk.