The post-Great Recession order may be changing. Bad news may be bad news as liquidity available to the financial markets may be tightening.
Here's the reversal I am sensing:
When I began writing on the Internet, I observed in Q1 2009 that the palpable fear about the economy - as judged by Depression-era magazine covers - was not matched by the reality I saw out my window, where life went on normally. Thus it was that I had sold most of my Treasuries into the December buying panic and was worried not about deflation but inflation. Having been a gold (NYSEARCA:GLD) investor from about 2002 or 2003, and having gotten out near the top in early 2008, my question was whether GLD was a safe buy yet, with the recession still raging. (It was a good buy, and I missed the bottom, getting back into GLD in September 2009.)
But one thing I was confident of was that this was no Great Depression. There was not going to be any real deflation. Inflation was still the worry, with all the money that was being printed. That was reflected in my blogging and investing.
Now, close to eight years later, I feel as though matters have been spun around as close to 180 degrees as events can be. Everybody's placid, the media's calm, stock valuations are at late '90's levels - yet I see disorder almost everywhere. So unlike 2009, my concern is more about a recessionary burst of deflation. Not that I'm predicting deflation, but it seems as though everyone is so "into" the coming inflation and the alleged bond bubble, the data I look at and the prism with which I've been viewing the economy since the Great Recession makes me more concerned about rising deflationary forces.
Before getting to the updated fundamentals, here are some technical reasons that make me nervous short term.
Some technical warning signs
1. Deutsche Bank (NYSE:DB) cracks again
When DB makes a new low, breaking down from a 2+ month trading range that already incorporated a prior all-time low, the alert trader says 'uh oh.'
No matter what Chancellor Merkel said about a bail-out, the government will be there if needed. But there's something going on here that we may not be able to suss out from our trading desks. DB cracking to new lows is, simply, a warning sign: danger may lie ahead.
2. It's not just Deutsche
As Bloomberg reports:
The key in this report is that the problem is not with the US (emphasis added):
Big holders of Treasuries are selling for a variety of reasons, but they're all tied to each country's economic woes. In China, the central bank has been selling U.S. government debt to defend the yuan as slumping growth leads to more capital outflows. Japan, the second-biggest foreign holder, has swapped Treasuries for cash and T-bills as prolonged negative rates in the Asian nation pushed up dollar demand at local banks.
Oil-producing countries like Saudi Arabia have been liquidating Treasuries to plug their budget deficits following the collapse of crude prices.
3. China again
Bloomberg again with more non-cheery news:
China's smaller banks have never been more reliant on each other for funding, prompting rating companies to warn of contagion risks in any crisis.
This is all looking familiar - elevated risk. (It's not always this way.)
4. T-bill rates are too low
This confirms that caution is - suddenly - not just in the air but in the markets.
Specifically, T-bills are listed at 0.17% on Bloomberg's feed, for the 3rd day running if I remember correctly. This indicates a worrisome flight to safety by smart, very smart and knowledgeable money. The Fed is paying 0.5% on excess reserves, and is targeting the Fed funds rate so that on Thursday, the effective FFR was 0.4%.
Why, then, are investors hiding in three-month T-bills at such a low rate?
That's not propitious.
5. The Donald surges
The Donald is Eris. He is Brexit. He is a black swan. (At least, that's how the markets see it.) He is Smoot. He is Hawley. He will deficit spend; that will force the Fed to tighten. Stock and bond prices will fall.
Hillary is the Washington consensus choice; it's nolo contendere. Even Bush 41 is with her. And Michelle and Bush 43 are best buddies.
Yet Bloomberg's poll out Monday shows the Donald up 2 over "her" when Johnson and Stein are included (as they will be in almost every state). Plus, there's the feeling that a la Brexit, his insurgent, anti-establishment strength is understated in the polls.
The Bloomberg poll matches the essential tie seen in the weekend's WaPo/ABC poll.
The Trump surge adds to the need for Rolaids for money managers who have put their eggs in a continuation of the same old, same old basket.
6. A bad egg
This is another small warning of a potential major market top, where psychology can change.
Egg Supplier Cal-Maine Scraps Dividend as Price Drop Spurs Loss
Cal-Maine Foods Inc., the largest U.S. egg supplier, scrapped its quarterly dividend payment after a drop in prices helped push the company to a larger-than-expected fiscal first-quarter loss.
The Jackson, Mississippi-based company had a net loss of 64 cents in the three months ended Aug. 27, compared with a net income of $2.95 a year earlier, it said Monday in a statement. The average of four analysts' estimates compiled by Bloomberg was for a 33-cent loss...
Egg prices have tumbled [58%] in the past year as supplies increased, partly in reaction to the impact of the 2015 avian influenza that hurt U.S. production.
So there was a price spike, now times are tough. In a market that actually felt fear, this stock would be clobbered as traders feared the worst (note CALM is very well-capitalized with little debt; it's not going to collapse as a business).
The stock is down, but take a look at the multi-year chart. The 10-year low is $4. The five-year low is $15. CALM was excited for nine years, going straight up. Now it's at $39.
This is a classic sign of a market that has curbed not its enthusiasm, but its fear.
And that's scary. As usual, there's nothing to short here, but who needs to buy this name now until it sells off more?
More broadly, signs I see of a possible deflationary recession are accelerating just as more and more seers such as the Fed, ECRI and gold traders are forecasting rising inflation.
Let's examine, just using recent data points.
Fundamentals may be pointing to a major economic and market top - and a deflationary one
1. Insurers feeling the deflation
There are two, not just one reports on this out of Bloomberg. First,
a. BOE Warns Insurers to Stop Cutting Prices to Win Business [and it's not just London]:
The London insurance market shouldn't keep cutting rates to secure business because it may not be adequately pricing the risk it is taking on, the Bank of England said.
The key challenge for the industry, which has endured 10 years of falling prices, is to avoid "the winner's curse of underpricing,"
10 years of falling prices? Some inflation...
Second, apparently there are some credit worries:
About half of 315 insurers surveyed globally are looking to increase cash holdings in coming months, up from 36 percent last year, according to a BlackRock study released Monday. Companies have been stung recently by alternative investments such as hedge funds, and have been turning to other illiquid assets such as real estate, infrastructure and timber to generate returns as interest rates have remained persistently low.The appetite for risk declined since last year, BlackRock said.
This is just what happened in 2007. Losses in mortgages led to a decreased "appetite" (really, capacity to take on) risk. That's how a recessionary spiral begins. Credit losses mean that the marginal buyer is not there when expected. (CALM stockholders, beware?)
2. States seeing shortfalls may lead to cutbacks in spending
In one report, the Nelson A. Rockefeller Institute of Government states:
State corporate income taxes declined by 9.2 percent in the fourth quarter of 2015, compared to average growth of 5.3 percent in the four previous quarters...
This is the time period in which the Fed raised interest rates.
In another, e-mailed to me from the same organization, and dated Sept. 23, the title is:
Poor Performance in State Tax Revenues:
Weak Growth in the First Quarter, Declines in the Second Quarter
... According to preliminary data, state tax revenues declined by 2.1 percent in the second quarter of 2016. Declines were widespread, affecting about half of the states. Those declines came at a time when most states had already adopted 2017 budgets. They may leave many 2017 state budgets with holes to fix.
State personal income tax revenues grew 1.8 percent on a year-over-year basis in the first quarter of 2016, down from the 8.1 percent average for the four previous quarters. Overall, 16 states reported quarterly declines in personal income tax collections...
Growth was also weak in state sales tax collections, which increased by 2.4 percent in the first quarter of 2016, a slowdown from the 3.6 percent average for the four previous quarters. Most of the weakness in sales tax collections was caused by slow growth in taxable consumption...
State tax performance was also poor in the corporate income tax, which declined by 4.5 percent and the motor fuel tax, which only increased by 1.9 percent...
"The outlook for state budgets in the 2016-17 state fiscal year, which began on July 1st in forty-six states, remains gloomy," wrote study authors Lucy Dadayan and Donald J. Boyd.
(The full report is lengthy at 30 pages.)
Deflationary signs are seen, as this was before the recent slowdown.
The above summary makes clear why this news is so serious, because, again, it describes how recessions in fact begin. One thing leads to another:
In many states, 2017 forecasts were prepared before the negative April income tax surprises. Therefore, state forecasters may make downward revisions in their next official forecasts for fiscal 2017.
So it's not just some gloom, it's the possibility that the states have to spend less or increase taxes.
3. CFNAI consistent with ongoing recession
Next, the Chicago Fed's National Activity Index was weak in August. What matters more than the negative 0.55 reading is the trend, which ZH shows in a way that proves there has been no real "recovery" for anyone in Washington to boast of, in comparison to (say) the '80s and '90s, when there really was growth that went on and on and on:
Look at how almost the entire post-Great Recession period looks like a mild recession. The major exception occurred in 2013-4 = the QE 3 period. That's why the commentary from "Tyler" was:
For 19 straight months, the smoothed average of the Chicago Fed's National Activity Index has been in contraction. This is the longest period of contraction without a recession in the 49 year history of the indicator...
The obvious conclusion is, maybe it's an ongoing recession, just a mild one. But when the three-month moving average shown goes beyond one year, the comparisons begin lapping themselves.
4. Consumers uncomfortable and getting more so
Also seen on Thursday was an update on the Bloomberg Consumer Comfort Index. I reported on the prior week's data, which continued lower. From Econoday:
Consumer confidence readings have been respectable but flat with the consumer comfort index now heading south. The index fell 0.9 points to 41.3 in the September 18 week following the prior week's even steeper 1.8 point drop from 44.0. And it was roughly the 44 line where this index had been trending coming into September. Soft readings for consumer confidence hint at softness in the labor market, a suggestion however that jobless claims data, which are moving lower, are not confirming.
Now, 41.3 is probably worse than "soft." Language matters, and soft-pedaling the slowdown/recession is part of the way the media has helped keep the SPY high.
This number, and the trend, are both either mildly recessionary or consistent with a growth slowdown (near-recession).
5. LEI weak, especially where it matters
Finally, also from Thursday, the Conference Board reported that its leading economic indicators declined by 0.2% in August. This was its commentary:
"While the U.S. LEI declined in August, its trend still points to moderate economic growth in the months ahead," said Ataman Ozyildirim, Director of Business Cycles and Growth Research at The Conference Board. "Although strengths and weaknesses among the leading indicators are roughly balanced, positive contributions from the financial indicators were more than offset by weakening of nonfinancial indicators, such as leading indicators of labor markets, suggesting some risks to growth persist."
The strength in financial indicators may mean little; they are so manipulated that the days when they meant something (yield spread analysis) may be long gone. Whereas, weakness in leading indicators [plural] of labor markets is more reliable.
Maybe more important, look at the trend in the LEI (from Econoday, same link as above):
The LEIs, plotted interestingly on a month-on-month graph, follow the QE pattern. They rise into the late stages of QE, peaking around October 2014, then arc downward.
I find this discouraging precisely because it's surprising. For years, I've been pointing out how QE led to surges in stock prices and various economic statistics, and how the Taper or cessation of QE led to drops in interest rates. It makes me wonder if it's baked in the cake to get worse from here without yet another QE or some other dramatic action. I don't know what's coming, but I don't like the implications of this chart.
6. Transportation weakening as well
a. Domestic freight weak
This also fits with the pre-recession or mild recession scenario. If consumers are cutting back, then less "stuff" gets moved around. In that vein, I get a monthly e-mail or two from Cass Information Systems (NASDAQ:CASS), which tracks various transportation-related metrics. This is picked up regularly by the blogger Wolf Richter, who shows one of their latest graphs on shipments that fits the same pattern as the LEI:
Look at the top two lines. They are 2014 and 2013, the QE 3 years. That's no surprise anymore. 2016 is not good at all.
This is seen in pricing as well. This is his brief introductory commentary and then the CASS graph (my bolded emphasis):
With freight volume in this precarious position, the freight expenditures index dropped 6.3% in August year-over-year, to the lowest August since 2010:
Again, one sees 2016 at the bottom and, reflecting the then-new money-printing effects, 2013 rising as the tsunami of money forced its way into the system, rising further to peak in 2014.
b. It's global
One sees the same with a Dutch bureau that monitors world trade and world industrial production (graphs at link).
This shows that global trade went into a funk after QE 1 ended; partially revived with QE 3; and is back to slight negativity now - basically a disaster. Industrial production in the developed nations, the ones actually implementing QE, is also horrible post-QE.
7. Discretionary spending still below 2008 levels
This is eerie. On a monthly basis, you can see the problem. Gallup tracks what amounts to discretionary spending every day, and reports in daily, aggregating its numbers monthly. Here are August's, from September 6:
As usual, QE 3 sent spending way up, but since then, it's over three years and spending is flat as can be.
Worse, August's average daily spending was $6, or 6%, below that of August 2008. That was the 9th month of the Great Recession. Here we were, eight years later, and with 20% cumulative inflation in groceries, consumer staples, restaurant meals, etc., all the things one spends money on, and nominal spending was below that of what was becoming a harsh recession.
Here's what's getting me even more concerned. The 14-day data as of Sunday was $84. That compares with about $90 around the same date in 2008. So now we have lapped the collapses of the GSEs as September 2008 began; the collapses of the banks; the collapse of the stock market. And we are still 6-7% below discretionary spending in what was the 10th month of the Great Recession.
Here's what the higher incomes have been spent on: rent, health insurance, higher automobile prices, etc.
But those are necessities. Where we get our sense of well-being is being able to afford some fun stuff, some luxuries. And with real discretionary spending down apparently 20% or more when adjusting for inflation from the midpoint of the Great Recession, all the happy talk about the best jobs market in decades has to fade away.
What does all this mean for equities?
I really believe in not predicting what will happen. It's all about how one positions one's money and that of one's clients. Then, what will be, will be.
My view is that this is increasingly looking like a very late-cycle pattern, with some stagnation and a little inflation. Therefore, stagflation. However, matters such as DB are red flags to this former bull. Right now, my species is chicken.
The basic reason I'm buying no dips and keeping a laddered bond portfolio is that there is no valuation bottom in sight. Earnings keep slipping, and per Multpl.com, the SPY at a current $215 is at 24.9X TTM EPS. The Shiller P/E is higher. The historical median P/E is 14.6.
There are now too many signs of illiquidity, some of which were referred to above. To be clear, what I showed were headlines that were found on Bloomberg.com in the ordinary course of checking the data and daily news over just the past few days, plus seeing if the usual bearish blogs had anything meaningful to add (this time they did).
As another of countless examples, take Mylan (NASDAQ:MYL). It's in the news again today for allegedly having misrepresented the profitability of EpiPen. Per standard sources, MYL trades at 26.5X TTM EPS. It has no dividend yield. Except for EpiPen, profits from which are under assault in a variety of ways, it's just another generic house. This stock could trade way down at any time, and I mean way down. The same goes for stock after stock. Many of these stocks will never repay investors their market cap, especially their adjusted market cap taking into account net debt. MYL, for example, has a market cap of $22 B but an enterprise value of $29 B at a stock price of $41. With Teva (NYSE:TEVA) apparently hoping to bring a generic EpiPen to market by 2018, and with the general generic drug cycle having flown high for a long time, MYL could begin losing money.
Among the large caps, a further weakening of the global economy, a crisis involving DB, a spike in defaults in oil companies, etc., could lead to investors focusing even more on return of capital, not return on capital. If that happens, as in 2008-9, dividend stocks that have been trading with Treasuries in price can diverge and trade like industrial entities again. You just do not know.
All this is occurring at a classic time, the end of a two-term presidency. It happens over and over, going back to Harry Truman handing the Oval Office and a brewing recession to Dwight Eisenhower. JFK took office in a recession. Richard Nixon took office as one was beginning. Jimmy Carter took office just as a vicious non-recessionary bear market was about to begin. Ronald Reagan took office in a pre-recessionary period that quickly turned into the Great Recession of the '80s. George W. Bush took office as the 2001 recession was about to begin. And we know about the Great Recession.
Finally, the markets themselves provide the actual real world data I need to stay calm and lightly invested in stocks, mostly pharma/biotech stocks with staying power. To wit, it is now just about two years since QE 3 ended; we knew it was ending by now in 2014. So we can see how relatively weak stocks have been versus bonds (return on capital weak versus return of capital).
For the past two years, the price change of a zero coupon T-bond ETF (NYSEARCA:ZROZ), which has a duration perhaps equal to that of the SPY, is 26%. The SPY is up 9%. The most popular T-bond fund, which has a shorter duration than ZROZ because it owns conventional interest-bearing bonds (NYSEARCA:TLT), is up 18%, an intermediate number as expected.
Both ZROZ and TLT have been paying higher dividends than SPY in addition to outperforming it.
That outperformance was about flat over the past one year, only because of the collapse in the SPY last summer combined with the collapse in interest rates.
After recovery of the SPY, the outperformance has continued this year. ZROZ is up an amazing 23%, clearly the quietest major bull market around; SPY is up 6%, and TLT is up an intermediate amount, 14%.
To complete the comparison, going back 10 years, when there was no ZROZ, TLT has about matched SPY in price while probably yielding about 1.5-2% more in dividends. In other words, except when the Fed has been pumping QE money into the markets (and economy), the boring long bond has beaten the glamorous SPY; and the more exciting zero coupon long bond has destroyed the SPY.
Concluding thoughts - no market for newbies
Ultimately, stocks move with liquidity - which is waning post QE 3. And that's despite "QE 1.5," the reinvestment of maturing bonds at the Fed. Since I'm not a short seller, the asset allocation choice looks easy to me (note: I'm ready to be wrong!). The Fed and the Federal government via deficit spending have been supporting the US economy. No one anticipated that the economy would merit even one round of QE, much less 3 plus the ongoing QE 1.5. Yet here we are, and the pre-recessionary or even mildly recessionary pattern is here in so many ways it can no longer be denied. The "bulls" have now taken to calling it a (mere) manufacturing recession, but manufacturing accounts for 35% of the economy, counting indirect effects. Then there are the services attendant to manufacturing, such as transportation (there are many others).
Even beyond the question of recession, a very slow-growth economy has trouble maintaining a 25X P/E in my view. At some point, investors may feel as though they cannot trust the Fed, or other investors, to "be there" if they want to sell. Since the classic time for the Fed to show some backbone and reward savers a bit (penalize us less!) is on the changeover of presidents, I continue to see the current period and the next year or two as providing elevated risk of a share price downturn. I see less risk of a runaway bull, because if revenues and profits turn up, the Fed will certainly tighten with alacrity. So that would mitigate the upside at today's valuations, absent another 1999-type bubble.
Given all the above, I'm staying mostly hunkered regarding equities. My view: let's see how all this plays out; risk is elevated and may be increasing; thus, no need to be a hero here.
Submitted Monday, 2 PM, SPY at $215.
Disclosure: I am/we are long TLT,ZROZ.
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.
Additional disclosure: Not investment advice. I am not an investment adviser.