The Horizon Is Behind Us

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Includes: DIA, IWM, QQQ, SPY
by: Grant Dossetto
Summary

Credit peaked in July, leading cyclical indicators soon followed, and economic data in November.

Stocks are ignoring macro and global data due to tidal surge in corporate buybacks funded by corporate bonds.

What causes this bubble to pop?

What is left of the dwindling syllabi haven't found their way to the back row on the first day of Finance 101 when students hear with certainty the maxim that the markets are future discounting mechanisms. By the time a student leaves the ivory tower they will hear the markets are naturally efficient, as close to perfection as we know in pricing tomorrow today. This claim is dubious when discussing the smarter bond and credit markets, it seems at times laughable when talking about stocks. Still, stocks began correcting well before the recession that began in March 2001. They peaked in October 2007, two months before the NBER dated the beginning of the Great Recession. There is fair criticism that the Federal Reserve deserves a lot of blame for creating the conditions that caused the crashes that occurred with the last two market peaks but markets still maintained future discounting properties in the face of it all, even with central planning interference. I believe that the economy has already entered recession, that hindsight will label the recession's beginning in November 2014 and markets have settled the day I am writing, months later, within the margin of error of all-time highs. The following paragraphs will explore the data used to make the recession call, why markets have been blunted from discounting the economic deterioration, and the consequences of it.

To widespread fanfare, the BLS reported 257K new workers in January. Upward revisions to previous months pushed job gains in November to 423K, the most in any month this millennium. That doesn't sound recessionary but it ignores the difference between leading and lagging economic indicators. Employment is a classic late cycle indicator. Investing because of good news on the job front will leave an investor in a world of hurt just as selling bad employment news will cause a Homer Simpson-esque "D'oh!" Credit is where the smart investors look. When it rolls over, they begin to sell. Using JNK or HYG, junk bonds rolled over in July of 2014. It was last summer that investors first began to become more discerning about what their money was going towards and they had good reason. Even with government bonds at low yields (the depths of 2013 only got the 30 year treasury up to 4%), junk bonds traded at historically tight spreads. This led to record low yield for the average junk issuance. Euphoria is supposed to lead to skepticism and a peek under the hood warranted fear.

The shale revolution relies on wells that have a depletion rate of up to 45% meaning that a well drilled produces barely half its initial production a year later. For fracking operations to be successful in the Eagle Ford in Texas or the Permian in North Dakota, constant rig drilling is needed. The four years of oil near $100 a barrel brought projects online that require generosity to be called marginal. These high cost projects required even more rigs and drilling. Look at the Baker Hughes rig count data for confirmation of this explosion. The constant capital needs and depleting returns on existing wells meant that shale E&P names were engaged in something akin to paying off your credit card with a different credit card. A consumer in dire straits eventually loses access to new credit through reduced maximum limits and rejected applications. Shale companies suddenly found the product they were selling cut by over 50% in six months. The tapering of QE3 hit economically sensitive commodities and emerging market projects first. The 15 year super cycle came to an end abruptly. Capital expenditures, compared to other industries, had grown at much higher rates and the impact of the commodity crash hit credit disproportionately hard. Spreads exploded as the average energy junk bond went bidless. It was only a matter of time before the problems in corporate junk bonds spread to consumers.

Using data from the former ICSC/Goldman index and Redbook, YoY retail sales growth peaked on Labor Day at over 5%. By comparison, this week's Redbook growth was just 2.1% (against weak comps related to last year's polar vortex). Revolving credit has never come back from the 2007 highs but non-revolving credit exploded as subprime auto loans became fashionable among investors in the search for yield. Subprime loans saw double digit growth in 2012, 2013 and 2014 to ever less creditworthy borrowers. The Wall Street Journal recently ran a feature news piece on soaring subprime auto delinquencies. One in twelve subprime borrowers who took out loans in Q1 of 2014 were delinquent by November, as little as 8 months later. Revisions to Q3 GDP brought it from 3.5% growth to 5%. Most of the upward revision was increased consumer spending related to a reduction in the personal savings rate. The BEA, part of the Department of Commerce, showed the PSR fell from 5.1% at the end of June to 4.5% in September. For comparison, there was no similar fall in the PSR in Q3 of 2013. Just as we saw at the end of 2007, the consumer had no choice but to tap out and reduce personal credit exposure. The Christmas shopping season kept retail sales afloat until November but December was an unmitigated disaster. Durable goods broke, autos have broken, mortgages for home purchases touched 20-year lows at the end of last year before a slight uptick. The MBA shows mortgages at +1% YoY, once again against terrible easy comparisons (the economy was falling by 2% in Q1 last year).

We have seen inventory growth decline throughout the second half of last year but companies now find themselves looking at the highest inventory to sales ratio since Lehman. Cyclical industries have rolled over, credit is drying up to the consumer, sales have stalled, and global growth is nonexistent. The obvious result is a seizure in economic activity. The Baltic Dry Index, measuring the rates charged to transport goods overseas is at a record low. The weakness in trade is confirmed by reported export declines in China, India, and America in the past two weeks. The knock-on effects are already being felt and it will get worse before it gets better. Layoffs at US Steel (NYSE:X), Deere (NYSE:DE), and Caterpillar (NYSE:CAT) are quantifiable drawbacks to a commodity crash. The salaries at those manufacturing companies are above the national average. Houston has benefited from the oil boom more so than any city in America. Developers flocked there as a result. There are more housing starts in Houston than the entire state of California. The Wall Street Journal reported that the Houston metro area has 18.5 million sq. ft. of commercial real estate in development. That is higher than the next two cities on the list (New York and San Jose) combined. By comparison, Chicago has 6 million. With oil companies announcing cuts to capex by 45% or more, it seems impossible that the glut can be absorbed without a cratering in price. With 30K oil and gas layoffs announced just in the month of January, it seems doubtful that there are enough creditworthy buyers to fill the new residential neighborhoods at record average selling prices. Foreign currency volatility has jumped to levels not seen since Lehman and, before that, the Asian Crisis of 1997-98. I have little doubt that the strong dollar is being used as a convenient excuse by some but lower earnings guidance is coming across sectors. EPS estimates for 2015 are down from 2014 now. The S&P trades at over 20x forward earnings, not seen since the bubble of 2000. On a median basis, markets are more expensive than their 2000 peak. How has this happened into a deteriorating economy?

QE3 ignited it, causing the stock market to boom 40% even as underlying economic growth fell below 2% and earnings growth was in the single digits. IPOs surged in a replay of 2000. Twitter (NYSE:TWTR), FireEye (NASDAQ:FEYE), GoPro (NASDAQ:GPRO), the list goes on. More of the companies make money than in the dot com bubble but that doesn't change silly valuations. The post IPO surges were artificial, caused by a small float and pounced on by momentum chasers. These shooting stars eventually crumpled under their own weight. Twitter is still $30 below its peak last March. FireEye is $50 lower in the golden age of cyber security. GoPro went from just shy of $100 to the low-$40s this week. Amazon is trading lower than it did 14 months ago. Tesla is lower than 11 months ago - Yelp (NYSE:YELP), Pandora (NYSE:P), Rocket Fuel (NASDAQ:FUEL), El Pollo Loco (NASDAQ:LOCO), Shake Shack (NYSE:SHAK). That isn't to say these companies are fairly priced. You could easily make the case that they represent a return to the bad days when we were numb to horrific valuations.

The attention grabbing names aren't the reason for stocks' current valuations though. The Russell small cap index returned nothing for all of 2014. It tried to blow up in October and was held up essentially by the other indexes, the Nasdaq returning another whopping 17% after its 40% gain in 2013. It doesn't explain the S&P's best performing sector for the year being utilities. Apple's stock didn't rebound from the 2013 lows (around $50 a share) because of improved performance, that came later. No, the relentless grind higher in "safe" names has been driven by ever increasing corporate buybacks and dividends in lieu of capital expenditures. It is why news of a billion franc bond offering by Apple this week yielding .25% has led to an explosion in the share price of 5%. Central bank currency wars and rate cuts (over a dozen countries in 2015 alone) have led to a surge in corporate credit issuance. IG bond yields have held up quite well in the face of junk bond underperformance. It is a paradox then, how credit can view as riskless the funding of the riskiest behavior companies can engage in. What stops it? Does it stop?

The answer to the second question is a resounding yes. Just ask IBM (NYSE:IBM) or Caterpillar how reducing capex and increasing buybacks and dividends offsets secular decline. IBM used debt whereas Caterpillar used FCF but the results have been the same. The future results will be the same as well. If either company does stumble upon an uptick in the business cycle/organic growth opportunity, neither has the ability to fund that project with cash on hand and will have to raise funds with new debt or share issuance. They are in this position because they bought back stock 20% to 30% higher than current levels, an idiotic misallocation of capital. Whoever they go to for funds in the future will remember this. At some point, P&G (NYSE:PG), Clorox (NYSE:CLX), Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT), Intel (NASDAQ:INTC), the utilities (already laden with record debt as a sector) will find themselves in a similar position. The real question is what will get us to that point. The simple answer, probably nothing. These scenarios eventually crumple under their own weight and no one is there to call the top. What was special about March 10, 2000 or October 11, 2007? There was no news flow, no earth shaking event. The market simply couldn't ignore reality any longer.

Besides the deteriorating macro picture, what other trends are ongoing today that could cause momentum in corporate credit to sag and snap? Gundlach and Buffett have already reduced their exposure to stocks by the most since the last crash. Other hedge funds, judging by performance, have done similarly. The retail "dumb money" seems to be all in at this point looking at ETF inflows to domestic equity, investor sentiment surveys, and Rydex asset fund summaries (take a look at assets under management in bear funds!). Corporate buybacks are the only fuel left. Sovereign wealth funds will be forced to be net sellers as commodity profits dry up. Dollar strength will force itself to be respected as well. To me though, the real driver of the next leg down will be abandonment by insiders. Former darlings, cult stocks really, Facebook and now Tesla have seen healthy insider selling. Apple too. Bill Gates just dumped Microsoft stock again, nearly 40 million shares gifted or sold since the November high. High level Apple executives dumped at any price causing a flash crash in the stock in December. At some point the river of those in the know, in combination with the macroeconomic rains we are currently experiencing will overflow the levee of the bondholders who are actually stockholders. Then, in fear, the bondholders will see the storm clouds aren't on the horizon, the horizon is behind us. It won't be just energy credit that goes bidless then.

Disclosure: The author is short FB, QQQ, IWM.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.