The Greenspan Put Is Coming

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Includes: DIA, QQQ, SPY
by: Artur Bremski, CFA

Summary

With markets in turmoil, inflation all but non-existent, and global GDP growth stalling, the FED’s next significant move will be to follow many other central banks and ease.

The current macroeconomic climate does not support current asset valuations.

Reiterating on earlier market neutral positions and believe allocating to treasuries and a net short equity position will yield positive results.

With markets in turmoil, inflation all but non-existent, and global GDP growth stalling, the FED's next significant move will be to follow many other central banks and ease. As interest rates have only moved up by a quarter percentage, it is likely quantitative easing or negative interest rates are coming. Most major market participants are now aware of this, opinions on whether it is a good idea are divided. At Davos, some attendees were calling for global central banks to stop easy money policies and let economies correct. In this note, we explain why this is unlikely and how we will take advantage of the FED's next move.

Household net worth, debt, business spending, and QE

One of the main purposes of quantitative easing was to inflate asset prices. The idea is: when asset prices increase consumers feel confident and start spending, businesses hire and invest, inflation rises, and the economy normalizes. Our analysis shows only moderate correlation between household net worth and future consumer spending (Chart 1). The correlation between net worth and consumer spending peaks out at ~0.60, with consumption lagging net worth by two months. One of the reasons for the moderate, not strong, relationship is that financial assets comprise an ever increasing share of net worth. As most financial instruments are marked to market daily, changes in market price cause wild swings in consumer and business sentiment (Chart 1 and Chart 2).

Chart 1: Change in net worth and household spending

Source: FRED, Vital Data Science Inc.

Chart 2: Composition of net worth

Source: FRED, Vital Data Science Inc.

As we've pointed out in a previous note, many American consumers have been left behind by an economy with global supply chains, knowledge sector growth, and the rise of low wage and temporary work. Instead of the intended purpose, easy money policies have artificially inflated asset prices. Haunted by the great recession and left behind by the economy, consumers have focused on deleveraging and saving instead of spending, which is one of the reasons why inflation has not taken off. As consumers deleverage, businesses have taken on debt. Instead of using the debt to invest in the future, they have used it to artificially inflate earnings per share through share buy-backs (Chart 3). Large share buy-backs mask the fact that earnings and sales in S&P 500 firms have declined throughout 2015, pointing to weakness in the global economy. Some market participants are beginning to tire of the financial engineering and beginning to push for change - one reason why short-term-focused activist funds are starting to fall out of favor.

Chart 3: S&P 500 share buy-backs

Source: FactSet

Internationally, corporate and government debt binges have fueled over capacity in China which is now experiencing slowing growth as a result. As China was the main driver of global GDP growth out of the great recession (Chart 4), and a large consumer of commodities (Chart 5a and 5b), we can expect the global economy to slow.

Chart 4: World and China GDP

Source: World Bank, Vital Data Science Inc.

Chart 5a and 5b: World and China Imports/Exports

Source: World Bank, Vital Data Science Inc.

In short: today's macroeconomic climate does not support current asset valuations. Investors are irrationally buying assets at high valuations because they believe that easy money policies support high asset prices and/or the macroeconomic climate will eventually catch up to the market. Central banks are easing monetary policy in an attempt to push economies to catch up with asset valuations and keep asset valuations high. Since consumers are deleveraging, monetary easing is having a limited impact on the real economy.

What happens next

At Vital Data Science, we analyze the global economy and asset prices several ways. One process we go through is to collect hundreds of thousands of economic indicators, reduce and extract features, then summarize the global economy in a three-dimensional visualization (Figure 1). While this tool oversimplifies the complexities and interactions in the global economy, it is useful for spotting long-term trends. Our representation shows the economy peaked early 2015 and has been in decline since. We extracted features from this representation and built a model using the features as variables. We found markets lag our bull/bear indicators by 12-18 months. Back-testing showed the model was ~70% accurate in predicting market swings. This model is currently predicting a bear market.

Figure 1: Three-dimensional representation of the global economy

Source: FRED, Vital Data Science Inc.

Another approach we take is to run an algorithm through the macroeconomic statistics we collect and develop indexes representing areas of interest in the global economy. We train a model on the indexes and forecast market movements. Our model, when back-tested 20 years, is 87% accurate in predicting major market swings. This model is also predicting a bear market.

We believe that current distortions in the global economy have deviated from historical patterns in two key ways:

  • Increased interdependence in global economies through global supply chains; and
  • worldwide acceptance of unorthodox central bank policies like quantitative easing and negative interest rates.

Models based on historical information cannot accurately reflect these new dynamics without a significant adjustment of forecasted results. Taking all of this into account, our current base case global macroeconomic scenario is:

  1. The US is not immune to the global slow down and the heat experienced at the tail end of 2015 will cool by the end of the first half of 2016.
  2. The Greenspan put is coming. You can call it the Yellen put. The FED will not raise interest rates, it will lower them, and then return to quantitative easing or negative interest rates by 2017.
  3. US equity markets will swing wildly but trend flat to negative in 2016, before the end of the year a bear market will be evident.
  4. Consumers will continue to deleverage and save through 2017. Normal spending growth will return when debt burden returns to normal levels. Then the next cycle will begin.
  5. Investors and corporate management teams will begin to adjust to the deflationary deleveraging phase in the global economy and financial engineering will peak in 2016, then begin decreasing in 2017.

The world is becoming increasingly turbulent: conflicts in the Middle East, tension between Russian and the West, and tension between China, its neighbors, and the United States all have economic implications. Global political turbulence perpetuates the monetary policy race to zero and below, and increases the time required to work through global economic imbalances (i.e. oil supply/demand). In our view, this is the largest risk in the global economy over the long term.

Strategy

Our belief that current global economic distortions cannot be accurately reflected by existing economic models, which are trained using historical data, without significant adjustment of forecasted results, was the driver of our earlier market neutral strategy idea. Currently, we see success coming from beginning to move away from market neutral and into a net market short position. We see the buffering impact of global central banks policies having a decreasing effect in supporting asset prices going forward and believe that it will take a number of years for the real economy to catch-up to current asset valuations.

Positions

In our note on December 2015, we highlighted three pair trade ideas. We continue to believe that these positions will yield success. To take advantage of our global macro view, we also highlight other ideas below. Table 1 summarizes our position ideas and results to-date. To-date, our position has yielded a small loss, in the same period the S&P 500 dropped 7.5%.

Table 1: Update on existing positions

Source: Vital Data Science Inc., Morning Star

To take advantage of our global macro view, we believe positions in US treasuries, and a net short position on the S&P 500 will yield success going forward. An example portfolio is shown in Table 2. We will optimize this portfolio as the direction of the global economy becomes more clear, in future notes. The next important checkpoint for us is the FED's March meeting.

To take advantage of our global macro view, we believe positions in US treasuries, and a net short position on the S&P 500 will yield success going forward. An example portfolio is shown in Table 2. We will optimize this portfolio as the direction of the global economy becomes more clear, in future notes. The next important check point for us is the FED's March meeting.

Table 2: Vital Data Science Inc. example portfolio

Source: Vital Data Science Inc.

Summary

In summary, today's macroeconomic climate does not support current asset valuations. Investors are irrationally buying assets at high valuations because they believe that easy money policies support high asset prices and/or the macroeconomic climate will eventually catch up to the market. Central banks are easing monetary policy in an attempt to push economies to catch up with asset valuations and keep asset valuations high. Since consumers are deleveraging, monetary easing is having a limited impact on the real economy.

As current global economic distortions cannot be accurately reflected by existing economic models, which are trained using historical data, without significant adjustment of forecasted results, a market neutral strategy is prudent. However, we see the buffering impact of global central banks policies having a decreasing effect in supporting asset prices going forward and believe that it will take a number of years for the real economy to catch-up to current asset valuations. Therefore, we recommend moving to a net market short position.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

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