The Ground Is Shifting Below Our Feet

by: Clarke Long


The S&P 500 is fundamentally weak and being surrounded by lethal variables.

The yield curve has become a ticking time bomb with asymmetric reflexivity forming between the Fed and the bond market.

Markets are dramatically underpricing structural and political risk.

Unless you’ve been living under a rock, it’s almost impossible that you don’t already know about the ever-growing list of issues facing the US stock market. These issues are alarmingly vast and include record margin debt, stock buybacks, corporate insider selling and gross overvaluations to name just a few. The question though, is what will cause the top to happen? At the end of the movie Margin Call (spoiler alert) during Kevin Spacey’s final speech to his troops before they have to fire-sale their entire mortgage portfolio, he has a fantastic line:

Obviously this is not going down the way that any of us would have hoped, but... the ground is shifting below our feet... and apparently, there’s no other way out.

Spacey, the morally grounded permabull throughout the film finally capitulates in the end, finding himself caught between a rock and a hard place. This is what will bring the bull market to an end – when the market finds itself trapped in a vulnerable position. While Spacey was able to make it out by the skin of his teeth, US equity markets probably won’t be as fortunate.

On nearly every fundamental level, the S&P 500 looks dangerously weak right now; and not just because of the aforementioned problems, but because objective analysis tells us that the market is at best on shaky footing and at worst incredibly overvalued. If a fundamentally weak market was the only complication, there wouldn’t necessarily be cause for alarm, but it currently finds itself being surrounded by lethal variables and thus in an extremely vulnerable position. Trapping the market are two sets of growing variables (uncertainty and by extension excessive variables are the enemies of growth). On one side, we have what I think is the most troubling of the groups, a set of circumstances revolving around the yield curve; we will call that Variable Group 1. On the other side, we have an alarming number of new variables within the realms of geopolitics and domestic fiscal policy – we’ll call that Variable Group 2.

I am going to talk about three distinct topics at length: The Fundamentally Weak S&P 500, Variable Group 1: The Ticking Yield Curve, and Variable Group 2: Trump’s Law – Not Murphy's

I want to make it clear though, that I am not recommending to short the market right now. I will be posting another article on that topic soon.

The Fundamentally Weak S&P 500

There’s Something Unusual Going On With Corporate Numbers

Recently, there’s been some resurfacing chatter about the complexities of adjusted earnings and if they should be a cause for concern. It was reported by the AP in 2015 that between 2010 and 2014 adjusted profits for the S&P 500 came in $583 billion higher than net income. Just a few months ago though, MarketWatch came out with a great article that provided a closer look at the alarming consistency of this trend. They reported that for the 2,600 companies they reviewed, there was a staggering $1.1 trillion worth of adjustments that applied to GAAP income statement results in 2016 alone.

At the heart of the issue is the ability of corporations to report non-GAAP earnings, and to a large degree, determine for themselves how they define and value their assets, liabilities, recurring charges, one-time situations, etc. Further rumblings that the notoriously grey area FASB Rule 157 for Fair Value measurement, which essentially allows not just banks, but any corporation to value their illiquid assets differently during times of unusually illiquidity (i.e. market panics), is starting to show that it may have the potential to do more harm than good (SunEdison (OTCPK:SUNEQ) anyone?).

It’s pretty well known that you can gin up earnings, but you can’t fake revenues and operating profits; those two metrics are commonly referred to as economic earnings because they are just that – a barometer for true income in terms of real value. Logically then, we would need to show that revenues and operating profits are validating the rise in corporate earnings and thus to a large degree a rise in the stock market. The problem, unfortunately, is that it appears they aren’t.

Not Good Under The Hood: Dollar Figures, NOPAT and Invested Capital

When you’re trying to understand value on an absolute basis, it’s very useful to take a peek at the hard dollar metrics, so let’s take a look at some of the figures for the S&P 500 on a longer-term time frame:

As you can see from the first chart, we’re up roughly 30% in terms of dollar operating earnings from peak-to-present day. That figure taken by itself doesn’t seem that bad, but it’s still way behind the S&P 500’s more than 50% increase. What should be of serious concern though, is the paltry increase of less than 6% in nominal dollar revenues from pre-crisis peak-to-present day. Take a look at the table I put together using some very rough numbers I gleaned from a quick glance at the charts:

S&P 500

Operating Earnings ($ per share)

Revenues ($ per share)

S&P 500 Index

As of June 2017




Pre-Mortgage Crisis Peak




Percentage Increase




It would appear that there seems to be a disconnect between the picture that corporations are painting versus what they’re actually earning. In addition, we’re seeing alarming trends developing in both invested capital and NOPAT.

NOPAT (Net Operating Profits After Tax) has been in a bear market over the last several years, and at best in sideways trend for the last two. That fierce uptrend in invested capital though, that’s normally a healthy trend for an economic expansion – if it yields real economic value. Clearly, the problem is that it’s not, and with no apparent end in sight for the invested capital trend, it would appear that investors are coughing up more cash for less returns.

These two issues, dramatically lagging long-term revenues and a substantial divergence between invested capital and NOPAT, are not necessarily cause for alarm in-and-of themselves. But paired together, they point towards a much higher likelihood that there will be a fundamental/value capitulation in the stock market sooner rather than later. Like gravity, these trends are guaranteed to have an end at some point – and the trend is currently showing signs of exhaustion.

Variable Group 1: The Ticking Yield Curve

The 800 lb. gorilla in the room that scares equity investors more than anything else is the inverted yield curve in the Treasury’s market, and rightfully so. When the yield curve inverts, it isn’t just an arbitrary indicator that predicts recessions – it’s extremely bad for the average American. If long-end yields are getting pushed down, that means the overall market is not willing to invest in short-to-medium term projects; this manifests itself in a sell-off of short-term debt. When this happens, yields for short-term business loans, basic corporate financing, they all become extremely expensive as short-term rates shoot up. It’s not hard to see how an inverted yield curve is almost a sure-fire predictor of a recession and market downturn in the US.

The Futures Treasury Market Is Showing Alarming Activity

A market that I love to watch is the US Treasury Futures. If you buy the notion that an inverted yield curve will be the writing on the wall for stocks, then you should be watching what the market is saying about where it thinks the yield curve will go.

Just like regular bonds, futures work the same way mechanically. As bond prices go up, yields go down – as bond prices go down, yields go up. The above screenshot is just a sample I took on June 14th, the day of the Fed rate hike announcement. Take a look at the four pink boxes though – they show a trend of higher price movements as you go further down the line. The 30-year went up more in price than the 10-year, and the 10-year more than the 5-year, etc. If you’ve been watching these Treasury futures for the last couple of years or so, you’ve been noticing this very unusual trend of a widening spread. On the up days, the longer end of the curve (30- and 10-year’s) has usually been up much more than the shorter end (5- and 2-year’s) on a percentage basis and vice versa. This is not anecdotal or speculative, this has occurred in the recent past and is occurring persistently as we speak.

In the above chart, we have the price of four treasury futures compared to each other on a percentage basis since 2015. The green is the 2’s, the blue the 5’s, the red the 10’s, and the purple the 30’s. In May of 2016, highlighted by the red circle, something interesting happened. The entire market started to move in near lock-step on a percentage basis. One month later, they started to invert on a percentage basis and continued to do so for a few months, denoted by the section between the two red vertical lines. Please note that I am not saying the yield curve inverted, I am saying that the percentage changes between the different maturities inverted, which seems to be pointing towards at the very least the possibility of a yield curve inversion. What is particularly troubling, however, is the state we are in right now for 2017. Starting in March of 2017, denoted by the black circle, the price of bonds on a percentage basis once again inverted, but this time the spread is the largest we’ve seen in years. While that by itself isn’t alarming, what should be is its combination with the diverging trends. On a percentage basis, the shorter end 2’s and 5’s are declining, while the longer end, the 10’s and 30’s, are increasing. What this means in English is that the future’s market is as of recently betting on an inversion of the yield curve. The unique combination of the breadth of the spread and the diverging trends leaves very few other interpretations.

Does this mean anything, though? It’s pretty much financial law that in the US an actual inverted yield curve in the bond market is the harbinger of death for stocks, but do futures actually matter? After all, on a relative dollar basis, the futures market is nothing compared to the actual Treasury market. History shows, though, that it would be wise to heed its warning.

The chart above with the three large red shaded circles is a long-term chart of the Treasury Futures market. The glaring similarity between them are the spread of the yield curves at different points in time. In all three instances, they display a period of convergence and become extremely tight before widening substantially. Take a closer look at the X-axis though – it appears when this market displays an extended period (1-2 years) of tightening, a stock market sell-off ensues. I believe strongly that this is the canary in the coal mine for US equities.

There’s A Fundamental Disconnect Between The Fed And The Bond Market

The preeminent M.O. when dissecting yield curves is to look at a dynamic yield curve, one that plots all the different maturities onto one curve and makes a nice and easy picture to read. I believe, however, that it’s much more helpful to glean clues from looking at each maturity individually; by the time the dynamic curve is actually flattening or inverting across all maturities simultaneously, it’s probably too late to act. With that being said, I want to show you five charts that tell a very interesting story about the real-time state of the yield curve:

Chart 1: The Federal Funds Rate

Chart 2: The US GOV 2-Year Yield

Chart 3: The US GOV 5-Year Yield

Chart 4: The US GOV 10-Year Yield

Chart 5: The US GOV 30-Year Yield

Look at where I placed all of those red circles – they aren’t random. They represent each of the four Fed rate hikes going back to December 2015. Please note that the yellow lines are not meant to be precise trend lines, they simply illustrate the general overall slope of the trend to a rough degree. On the surface, it would appear that the yield curve is in the early to middle stages of inverting. Why is the yield curve showing early signs of inversion, though? I’m of the conviction that it’s because we’re currently watching two 800 lb. gorillas go head-to-head before our eyes.

The reality is that the Fed can only control so much of the yield curve – they have direct control over the shortest of maturity durations, but other than that the yield curve at different maturities is pretty much decided by the market. I won’t even go into how much of a behemoth the bond market is – but suffice it to say, bond buyers represent trillions of economic investment capital globally, when it speaks all should listen; and herein lies the problem. We now have two financial behemoths (the Fed and the bond market) that are diametrically opposed in their perceptions of the economy and financial markets – and it appears as if both sides are becoming more entrenched in their respective views.

Asymmetric Reflexivity Is Forming Between The Two Behemoths

Very briefly, if you are unfamiliar with George Soros’ theory of Reflexivity, I recommend you Google it a bit, it’s great stuff. You can think of the self-fulfilling prophecy idea as a very basic version of reflexivity.

Since 2008, the Fed has had the following general stance towards markets:

'We’re going to let the data guide our interest rate policy. Simultaneously though, we’re going to be crystal-clear in forecasting our rate intentions to markets. This should prevent miscommunications between us and the markets, and therefor reduce or eliminate the risk of interest rate policy harming the economy if we happen to find ourselves too far ahead or too far behind the curve'.

Obviously, that’s a simplified version, but essentially that has been their M.O. and continues to be. In a nutshell, the Fed seems to think that even if they’re wrong about the timing of rate increases that they shouldn’t do too much damage. So we have in one corner the Fed, which has its own perception of our economic reality and subsequently acts on it by raising rates. After raising, the economic data continues to improve and things keep looking better – thus, the Fed breathes a sigh of relief and continues the process. Conjecturally, it appears that the Fed is caught in its own reflexivity loop where it raises rates, sees good data and then continues to raise. In the other corner, however, we have the bond market which is showing us that it’s perceiving economic reality very differently from the Fed.

What’s so troubling about those five Treasury charts are the stark differences in trends. What we should be seeing at a very minimum is a changing of the trend at this stage. The longer end of the yield curve should be rising too, or at the very least the slope should be turning from negative to flat and then eventually to positive. We’re seeing the exact opposite of that though, we’re seeing the 10’s & 30’s not only not go flat, but making lower lows and lower highs for 2017. Everyone has their own theories as to why – I honestly couldn’t tell you. Some of the obvious ones that come to mind though would be:

  • The bond market is nervous about the structure of the economy, being that we’re in uncharted territory both monetarily and fiscally.
  • There is an unprecedented level of capital floating around globally courtesy of international central bank accommodation. Classic reach-for-yield theory says that fund managers aren’t paid to sit on cash, so they have to buy something. Why not long-term US debt?

It doesn’t really matter why the bond market disagrees with the Fed – what matters is that it appears as if it’s caught in a reflexivity loop of its own. The fact that long-end rates continue to drift lower as the Fed continues to raise is quite simply astounding, leaving me to believe that the market may be buying up 10’s and 30’s simply because that’s been such a great trade and continues to be. In classic reflexive fashion, once the trend is firmly established it’s typically the self-reinforcing momentum of the price movements themselves that cause the market to surpass rational norms.

Variable Group 2: Trump’s Law, Not Murphy’s

A good trader and/or investor should always be apolitical. I’m probably fortunate to be a typical Millennial in that I’m skeptical of politics in general. Skip this section if you’re politically on one side of the fence or the other – it won’t be of any use to you.

Aggressive And Reckless

I have a favorite adage: underpromise and overdeliver. Those three simple words believe it or not are one of modern society’s most crucial ingredients for growth and success. You need look no further than the last several years of the bull market, or most bull markets for proof. Wall Street analysts set low earnings expectations, companies handily beat and their stock price jumps. If you’ve ever tried this approach at your job, setting low expectations and surpassing them, you probably know what I’m talking about; it’s the true eighth wonder of the world – expectations are everything. The reason I believe Trump poses a dramatically underestimated risk has nothing to do with his agendas that may or may not materialize, or whether or not his policies will be effective or not. It’s that his personality is the exact opposite of underpromise and overdeliver – it’s overpromise and underdeliver, and that is always a recipe for disaster.

Ray Dalio had a great line in Davos at the start of the 2017 that hit the nail on the head: it is yet to be seen if Trump is “aggressive and calculating or... aggressive and reckless." While there really isn’t a definitive answer to that question yet, anecdotal evidence tells us it’s the latter and not the former.

My sense is it’s a bit more complicated than putting Trump into a binary category of one or the other (calculating or reckless) – he seems to be a combination of both. The best way I can describe my read on it is that he’s genuinely trying to be rational and deliberate in his approach to things. But then we see far more flashes of his old-school “ya fired” self, where he shoots from the hip on Twitter, digs in his heels and spends a considerable amount of time focusing on the media's perception of him.

As the list of foreign figures ‘loyal’ to Trump and his America First policy dwindles, it’s becoming increasingly alarming that he continues to form political rivalries internationally on both security and economic issues on multiple continents. Paths unfolding like this make me much more inclined to believe that while Trump wants to be aggressive and calculated, he will eventually revert back to his inherent predisposition of aggressive and reckless – it’s just in his nature.

Markets Are Dramatically Underpricing The Trump Risk

It’s pretty much an accepted norm that we are in totally uncharted waters from a domestic financial perspective. Nominal fiscal deficit is running at record highs, the Fed's balance sheet is exponentially larger than anything we’ve ever seen, relatively subpar economic growth, etc. Negative interest rates abroad and unprecedented economic activity by foreign central banks are also having unknown affects on US equity and debt markets. With all of these issues in mind, it begs the question: why in the world would anyone, let alone the market herd in general, think it would be a good idea to tinker with the system in even the slightest way right now?

Think about the potential sweeping changes that are being talked about on the Hill and/or by Trump: interest deduction elimination, dramatic individual tax-bracket changes, a plethora of changes to the corporate tax code – the list is vast. Irrespective of how much good or harm you think Trump’s changes will do, the fact is that there are going to be a lot of them. Not Trump, not Yellen, not Einstein himself if he were alive could tell you what kind of unintended consequences the introduction of variables en masse will have on the economy and fragile stock market.

After election night, it appeared expectations were too low, then the stock market had a tremendous run up post-election into record territories. Expectations came down a bit and markets started to focus on whether Trump’s policies would be either on base runs or home runs – never seeming to factor in the possibility of a strike. Equity markets don’t seem to be pricing in the possibility of Trump striking out in my opinion. Why is it so impossible to imagine him striking out? The issues he’s facing are vast and complex, and he’s essentially a swing happy batter that has never played in major league government before. Markets shouldn’t be asking ‘to what degree will Trump be successful?’; they should be asking ‘is Trump going to yield zero-sum results when it comes to the stock market and the economy – and if so, how likely is it we find ourselves way up the creek?’

Let me conclude this article by stating that I don’t know when the market top will happen – no one does. All I can do is present to you the reader, all the facts, theories, anecdotes and conjectures that I have. It’s a bizarre economy we live in, one in which objective analysis tells us there are enormously clear-and-present dangers enveloping the markets on all sides. Yet the markets seem to have a completely different perception of the environment – a perception that I think the bottom cartoon strip hilariously embodies. They say a picture’s worth a thousand words, and I think this one is apt in my conclusion. If this isn’t the definition of euphoria, I don’t know what is.

Disclosure: I am/we are long VXX.

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: I am currently long VXX calls and long SPY puts. I am a Full-Time Trader and run my own proprietary portfolio. I trade across a variety of asset classes and across a variety of timeframes simultaneously. In addition, my strategy involves dynamic hedging of my positions and thus frequent adjustment of my portfolio's net long/short position. This can and does change at different points in time based on my evolving perception of the market. Please do not attempt to initiate positions that you believe I may be employing - I could very well be net long or net short at any point in time. Nothing in this article should be construed as investment advice or as a recommendation to buy or sell any securities. I am not an investment advisor.