Introduction: Bears in These Woods
Last week's market action was interesting enough that I am submitting this report before getting to a backlog of company-specific articles, both on techs and biotechs. The S&P 500 (SPY) dropped 2.1% Friday and 3.9% for the week. This ended a record run without at least a 3% drop set in 1995.
Right now, Fed policy may be most important to the markets, because it is taken in such a matter-of-fact manner. There is an increasingly worrisome lack of discussion about its dangers in the financial media. I've been an outlier: here's what I said in the introductory bullet points in a January 25 article, when stocks (SPY) were hitting one new high after another:
- The pro-business actions of Donald Trump have been thoroughly recognized by traders, but two future negatives may have been ignored.
- These negatives are the Fed's hostile stance, and the potential for declining profit margins, which are at very high levels per S&P.
In a sign of short-term caution, I pointed to how well a list of cyclical stocks had done since an article I wrote on them in August 2017, and said about their performance:
Clearly this is an unsustainable rate of increase, especially for mega-caps such as Home Depot (HD).
I made other points for bulls to consider. One was this:
What makes this tightening unique is the Fed's withdrawal of liquidity at an accelerating rate, the so-called reverse QE, aka quantitative tightening (pick your term).
Among specific cautions that I mentioned other than the Fed, perhaps the most important was this one:
Rising oil prices and rising interest rates, the opposite of the elixir that allowed markets to move up from their double bottom in H1 2016.
Also, I presented a chart of the moonshot since 2009 in the NASDAQ 100 (QQQ), I reported that I had been raising cash:
I have reduced a marked overweight tech position in view of the above parabolic chart and the various examples mentioned above.
Because of the importance of my concerns, I followed with a second article, listing many non-recessionary intra-year periods of corrections or bear markets associated with either Fed tightening (or withdrawal of extreme stimulus in the form of QE) or severe tightening by the bond market. I then moved toward a list of preferred investment choices, and listed cash first.
So, even though I have a bullish longer-term view of the economy (but it may be beginning a growth slowdown without a recession), the combination of numerous adverse factors hitting at once, with the Fed the most important, led me to emphasize this caution in two consecutive articles.
Promptly, the markets "cooperated" and along with sentiment suggest to me that this caution was well placed, leading me to provide additional comments for your consideration.
The liquidity squeeze may have begun: Softly at first
What matters is what I've been complaining about for almost a year, namely the withdrawal of funds from the banking system by the Fed's reverse QE program, also called quantitative tightening. Per Thursday's H.4.1 Fed release, reverse QE is finally showing in the Fed's numbers. From Table 1, Treasury securities held by the Fed declined yoy from $2.463 T to $2.445 T, or 0.7%. Overall reserve bank credit, a larger number, dropped almost as much on a percentage basis. Per Table 2, the drop-off was within T-bills, not longer-term securities. Apparently there has been the same sort of lag in settling of trades that was seen in QE 1 and perhaps the other named QEs. In any case, the yoy decline in the Fed's holdings of securities is accelerating.
This has rarely, if ever, been seen; the 1937 disaster comes to mind as an example the Fed will want to avoid. Since this was a long time ago, a comment on the (disputed) causes of this moderately great depression from the Cleveland Fed from 2015 in a publication on the general topic of excess reserves makes my general point (emphasis added at the end):
Here is where the more distant history of the Great Depression provides a cautionary lesson. In 1936, US banks' reserves had accumulated to record levels. Although there had not been a dramatic increase in the levels of loans, the Federal Reserve decided to "play it safe" and reduce the flexibility of the banks' options for using the cash by increasing the reserve requirement. Banks responded by dramatically reducing their loan portfolios. Milton Friedman and Anna Schwartz argued that this action caused the 1937 recession (A Monetary History of the United States, 1867-1960).
So the Federal Reserve has no easy policy choices, particularly in the absence of a large body of accepted theory on how banks can be expected to handle their oceans of cash under changing conditions. Perhaps the best thing to do is what they are doing, that is, to adopt an extremely watchful stance and wait.
Translation: The Fed is flying blind. So its base case should be to "hurry up and stand there."
Yet the Yellen Fed first followed the Bernanke Fed and complaisantly gifted the Obama administration with endless monetary steroids, then as soon as the Republican won the White House, the Fed acted as if it were part of the Resistance. The rate of change from taking a non-recessionary slow growth starting point (2012) and inflating the markets with over $1.5 T of new bank reserves (i.e. money) via QE 3 and then moving in only nine months to a combination of three interest rate increases and beginning to implement the reversal of QE 3 cannot, I have repeatedly suggested, be a positive for stock prices. Money/liquidity drive markets. Even if the underlying economic activity is the same, more money/liquidity drives higher prices.
Let's look forward and quantify matters by looking forward 12 months from now to Feb. 2019.
My estimate is that beginning with total Fed credit of $4.4 T now, the effects of reverse QE and increasing interest on excess reserves, as planned, would lower that by about $400 B. So, about a 9% decline. That amount would almost completely offset the amount of new credit creation by all commercial banks in the US, if they increased credit at today's approximate 4% rate, which is roughly today's rate.
Let me objectify that. In February, the Fed is going to let $12 B of Treasuries and $8 B of mortgage-backed bonds it owns mature. Under QE 1.5, which began in August 2010 and ended in September 2017, the Fed would have created out of thin air that much money, buying more of the same debt that matured. Now, you and I, and companies, funds, etc. have to take money out of our bank accounts (or money funds) to fund this $20 B of credit demand from the Federal government and mortgage market. This $20 B of cash will be converted to this 2-3% yielding assets on our balance sheets. It was previously available to be invested in financial assets, helping to create the seemingly unending bid under stock, bond and commodity prices. Now, and at steadily increasing rates, investors as a group are being forced to own boring bonds at today's low rates rather than "exciting" assets such as stocks or commodities.
That would pose some challenge to equities, but simultaneously, the Fed is making yields on cash competitive with inflation rates for the first time in many years. The yoy change in the Fed's preferred measure of inflation, core PCE is only 1.53%; PCE yoy is up 1.7% (click "Edit Graph" for a dropdown menu allowing yoy changes to be shown; click "Download" for "CSV" which shows the data series numerically). The last time that core PCE was above 2% was early 2012. The last time that core PCE was above 2.5% was 1993.
The combined, double barrel approach of the Fed is, directionally and quantitatively, as tough as anything since the Volcker tightening of 1981 in my humble opinion.
This brings the 2015 article from the Cleveland Fed into a modern focus. The specific techniques that the Fed uses now are different from what it used in 1937, but the point is that once again, the Fed is acting out of fear of an upcoming big inflation that has not arrived by its own measurements.
Thus, my previously-stated and ongoing focus on liquidity changes and the potential for drooping asset prices on balance.
To be sure, many other matters are different now from 1937, including governmental fiscal policy. The main point I'm making is based on the empirical and theoretical observation that getting the effects of Fed policy right takes an investor a long way in the correct direction. But the Fed is not "everything."
Continuing to focus on the Fed, the next two brief sections exemplify different reasons why its policies can be a big problem for the markets, with equity prices at high risk. Again, this is not the whole story, so please read on until the ending.
Stocks have reached an extreme
Two of many things that could be said:
1. The Shiller P/E is at 33.4 as of Friday, per Multpl.com, and about 10% higher than the 1929 peak.
2. The S&P Composite Index has reached bubble levels again by one analysis. From Doug Short:
This is problematic. There's lots of profit to be taken, if traders get cautious, and lots of margin debt that may be liquidated.
The employment data is more mixed than Friday's headlines read
There is lots of talk about a wage-price spiral. However...
...when I looked at the January employment report, which came out as always pre-open Friday, I went as always to page 10 of the PDF version, which gives the data (remember these are estimates, not absolute fact) on weekly hours and wages. What I saw was not scary at all from an inflation standpoint; yoy comparisons:
- Average weekly hours, down from 34.4 to 34.3.
- Average weekly earnings, up from $894 to $917 = +2.57%.
- Index of average weekly hours, up from 106.5 to 108.0 = +1.4%.
Whereas, headlines in the financial media focused on average hourly earnings, up 2.89%. But as ECRI points out in its Feb. 2 blog post, Up is Down:
Earnings growth has risen for an unfortunate reason: growth in hours has fallen faster than pay growth. The chart below [see their article for this chart] shows income growth slowing, and growth in hours worked slowing even faster.
Contrary to popular belief, such a slowdown is not a credible signal of an inflation upturn. And if the jump in wage growth pushes the Fed to be more hawkish, it could actually worsen the slowdown.
Since one thing that does not change is the number of weeks in a year, this multi-year chart shows the measured lack of aggregate wage inflation:
Where's the labor inflation?
Given strong GDP numbers the past three quarters and strong estimates for a very early read for the current quarter, maybe these numbers can be reconciled in productivity. Maybe the estimates that productivity gains are weak are all wrong. After all, the Internet age, iPads/iPhones, etc. should be boosting productivity big-time now, just as the spreading use of electricity did a century ago.
These sorts of topics simply require more time to sort out the aspects that do not fit. What all the data points to, though, is that the worry about wage inflation is misplaced and does not require the Fed to engage in this ramping tightening. This is especially my view in view of near-record high operating margins for corporations and near-record low labor share of GDP.
The markets may be showing early signs that the Fed tightening, both monetary and via interest rate hikes, could be draining liquidity from the markets (and the Fed may not care since it may think matters are frothy).
In addition, gold (GLD) bullion prices are below their 2017 high, which in turn was below its 2016 high, which in turn was below its 2014 high, which in turn was below its 2013 high, which was below its 2012 high, which was below its 2011 high. Is gold signaling inflation? It does not look like it.
Yet the Fed is fighting inflation.
Stock valuations and deviations from trend are at dangerous extremes at a time when the Fed is aggressively fighting a non-existent breakout of inflation.
Thus: the Fed is an important source of downside risk to the markets, even as economic performance appears good.
To conclude: what's next for the markets?
Concluding remarks: Fed versus the economy
In theory, and perhaps in practice, "normalizing" interest rates and reverting back to the Old Normal of little or almost no excess reserves should not especially alter the amount of goods and services that the United States produces. I'm hopeful that this proves correct. If so, then the final new point to introduce involves looking up to the first of the two charts in this article. The extreme stock market valuation shown around the year 2000 masked huge disparities. Bubble Internet stocks and highly leveraged telecoms such as Global Crossing were far above the 3 standard deviation level. Yet Old Economy stocks were trading at normal values, sometimes even depressed. March 2000 marked the top of the market for QQQ (then called QQQQ if I remember correctly), but it also marked the bottom of the market for numerous Old Economy sectors such as insurance stocks, metal-benders, and homebuilders (the list is long).
This is the main analogy that I conclude with. The Fed was tightening in March 2000, and continued tightening somewhat longer. But despite the (mild) 2001 recession and the non-recessionary 2002 bear market, March 2000 held as the bottom for such stocks as Toll Brothers (TOL).
So, on the one hand, precedent suggests a substantial chance that the SPY has lower lows ahead at some point this year. The traditional bottom has been in the July-October time frame, not the seasonally strong period that tends to last through April, often extending to June. On the other hand, individual stocks can and will trade normally. TOL closed Friday at $46.40, around 11X consensus current-year EPS estimates. Whether these estimates include the benefit of tax reform is not clear to me yet. So, TOL could be priced to rise, as it was in H1 2000, though it is off its crash and one-year bottom. Another value stock now is Apple (AAPL). Calendar year 2018 current estimates for AAPL are still close to $12. Adjusting for much of its excess liquidity, which it plans to return to investors, its $160.50 closing price Friday may adjust to more like $145. That would put it more like a "real" CY 2018 P/E of 12X, which is far below market. I'll have more on AAPL in a separate article. In contrast, a stock I like but suddenly may not have the best value in the market is Paccar (PCAR). Consensus shows its EPS peaking at $5.47 in 2019 but then declining in 2020 and declining again in 2021 to an estimated $4.93. PCAR closed Friday at $72.60. If consensus is correct, it is trading above 14X 2021 EPS, which may not appear cheap for a truck manufacturer unless one thinks that $5 EPS or so is unusually depressed.
In other words, it appears to me that traders may have again made excessive bets on individual stocks or sectors as they did in 1999-2000 while excessively curbing their enthusiasm for certain other names.
Thus I am both wary of the Fed, but in the intermediate and longer term, I believe that the Fed always gets around to being accommodative. I therefore continue to try to own the best values the equity markets allow, and maintain a constructive stance longer term on the US economy. Having raised cash ahead of this 3% correction, I'm looking to redeploy it carefully, and plan to discuss what look to be fundamentally attractive stocks in the days ahead.
In specific response to the article's title, for the author, the redeployment actually began Friday into the sell-off. Strategically, I am looking to be fully invested again by summer or early fall, following typical seasonal patterns and giving time for the investment community to get to know the Powell Fed and for other trends, and early responses to tax reform, to become clearer. The Great Recession is now history, and growth is back in style. The likely winner amongst asset classes: equities - if fairly valued. In the big picture, the most important thing, superseding volatility in asset prices is that fundamentally, the US economy has - I believe - largely healed, and should be able to tolerate policy normalization. For us as investors, it is possible that this process could be bumpier than what happens in the real economy. If so, that could present opportunities to buy further dips should they occur.
Note, the market could be volatile again to begin the week. This article is being submitted Sunday afternoon well before the futures markets give an early hint of what may lie ahead Monday and Tuesday.
Thanks for reading. This article has covered a lot of territory, and I look forward to any comments you may care to share.
Disclosure: I am/we are long AAPL, HD, PCAR, TOL.
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.