The Speculative Mania Is Broken, A Bear Market Is Imminent

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Includes: DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, HUSV, IVV, IWL, IWM, JHML, JKD, OTPIX, PPLC, PPSC, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWL-OLD, RWM, RYARX, RYRSX, SBUS, SCAP, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, USSD, USWD, UWM, VFINX, VOO, VTWO, VV
by: J. Lawrence Manley, Jr., CFA
Summary

Equities offer a poor risk-reward and are on the verge of a bear market.

The economic expansion is decelerating and the economy is vulnerable to a policy error or external shock.

The market structure has changed since the last bear market and poses a systematic risk.

First Quarter Review

During the first quarter of 2018, the S&P 500 declined by 0.76%. Despite the market's modest decline, volatility increased dramatically, and the market had its first significant correction in two years. The quarter started strong as investors continued to celebrate the significant overhaul of our tax system and the prospect of a stronger economy. Record inflows into equities drove the S&P 500 higher by 7.4% in January. Unfortunately, the euphoria ended in February as investors worried that an acceleration in the inflation rate would force the Fed to tighten monetary policy more aggressively. During March, equities declined again due to the fears of an imminent trade war with China. The S&P 500's peak to trough decline in the first quarter was 11.84%, which was the first correction of more than 6% since the Brexit decline of June of 2016.

Also, the technology sector - the bull market's leading sector, which represents 23% of the S&P 500 - performed poorly in the quarter as investors became concerned that the aggressive business practices of Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG) (NASDAQ:GOOGL) and Twitter (NYSE:TWTR) could lead to increased regulation and slower growth.

For the nine-year bull market to continue, it is critical that the technology sector and specifically the FAANG stocks (Facebook, Amazon, Apple, Netflix, and Google) maintain their leadership position, since significant changes in leadership typically indicate the end of a bull market.

We believe that the sharp market correction ended the speculative blow-off that we discussed in our last letter. In our view, this final blow-off (the S&P 500 appreciated by 6.6% in the fourth quarter and by 7.4% in January before the sell-off) and sharp correction are the beginning of a more significant decline, which will eliminate many of the speculative excesses that have accumulated. We expect that a close below the February low will lead to another leg down, which will end the historic nine-year bull market.

We performed well during the quarter and had a positive return despite the sharp market correction. Our asset allocation remains defensive and consistent with our view that risk assets are overvalued, the market offers a poor risk-reward, and the business cycle is decelerating. As value investors, we continue to believe that we are in the final stage of a historic asset bubble, and until the asset bubble deflates, we will focus on preserving capital and providing positive absolute returns.

Investment Outlook Summary

Equities offer a poor risk-reward and are on the verge of a bear market

  • The Fed's unprecedented QE program drove risk assets to a historic level of overvaluation. We estimate that fair value for the S&P 500 is 1450, which is 45% below the current valuation
  • The Fed is raising interest rates and selling their bond holdings, which will tighten financial conditions, increase market volatility and create a headwind for equities
  • The sharp first quarter correction ended a speculative blow-off, and we believe that the 9-year Fed-induced asset bubble is poised to deflate
  • The market's leadership (technology and FANG stocks) is under distribution, which increases the odds that a bear market is imminent

The economic expansion is decelerating, and the economy is vulnerable to a policy error or external shock

  • Instead of addressing the structural imbalances that led to the last recession, the Fed "kicked the can down the road" by artificially lowering interest rates to encourage debt accumulation and prop-up risk assets
  • The nation's debt burden has never been higher, the Fed is raising interest rates, and the President is pursuing Populist policies that may negatively impact the economy
  • Economic growth is slowing, and the excessive debt burden coupled with the estimated $1 trillion budget deficit could turn an economic slowdown into a severe recession

The market's structure has changed since the last bear market and poses a systematic risk

  • The excess liquidity provided by the Fed's QE program, coupled with the proliferation of passive and quantitative investment strategies created a self-reinforcing feedback cycle that suppressed volatility and drove the market higher at an accelerating rate.
  • The sharp February correction ended the speculative blow-off. We are concerned that a close below the February market low will lead to aggressive selling and potentially a negative self-reinforcing feedback cycle - similar to "Portfolio Insurance," the 1980's quantitative strategy that accelerated the 1987 crash.

Asset Allocation: As long-term value investors, the market's risk-reward and the economic cycle drive our strategic asset allocation. Currently, our equity exposure is hedged, we are underweight fixed income, and we are overweight gold and commodities. Additionally, we increased our "tail risk" position, which should profit from any major market dislocations. We are positioned to perform well in a period of decelerating economic growth, increasing commodity inflation and rising market volatility.

Current Asset Allocation:

Long Equity (SPY, QUAL)

35.0%

Long-term U.S. Gov. Bonds

10.0%

Short Equity (QQQ, IWM)

(30.0%)

Emerging Market Bonds

0.0%

International Equity

0.0%

Municipal Bonds

0.0%

Emerging Markets

0.0%

Gold/Currency

15.0%

Equity Tail Risk Hedge

(5.0%)

Commodity

5.0%

NET RISK ASSETS

0.0%

NET SAFE ASSETS

30.0%

Market Outlook:

Despite the February correction, the market's valuation has not improved, and risk assets continue to offer a poor long-term risk-reward. For nine years, the Fed's unprecedented QE program drove financial assets to a historic level of overvaluation. In our view, while QE did not stimulate the economy, it did lead to substantive economic imbalances (overvalued financial assets, wealth inequality, too much debt, and malinvestment). Currently, the Fed is tightening monetary conditions by raising interest rates and gradually selling their bond portfolio. We believe that just as the Fed overestimated the economic impact of QE, they will underestimate the effect of tightening financial conditions in our highly leveraged economy - in fact, 10 of the last 13 tightening cycles ended in recession.

The markets recent speculative blow-off and sharp correction lead us to believe that the bull market is over. We are concerned that the global central bank's policy of printing money to buy financial assets fueled an asset bubble. The recent price action is similar to the end of previous asset bubbles. We expect that a close below the February low will lead to another precipitous decline and a bear market.

Chart 1: Market Capitalization to GDP - Stocks Remain Very Expensive

In a 2001 Fortune Magazine article, Warren Buffett stated that market capitalization relative to GDP "is probably the best single measure of where valuations stand at any given moment." Currently, stock market capitalization is 139% of GDP; this is significantly above the 50-year average of 65%. Based on this valuation measure, stocks would need to decline by more than 50% to be considered fairly valued.

Source: FRED

Chart 2: Private Sector Net Worth Relative to GDP Has Never Been Higher

The central bank's easy money policies drove most asset classes to a historic level of overvaluation. Since 1950, private sector net worth (real estate and financial assets) has averaged 377% of GDP. Currently, private sector net worth is 500% of GDP, which is 2.8 standard deviations above the mean.

Source: FRED

In simple terms, the "Great Recession" was caused by too much debt and the bursting of the housing bubble. Instead of addressing the structural imbalances in the economy after the recession, the Fed reduced interest rates to zero and printed money to buy financial assets. For nine years, the global central banks purchased financial assets to stimulate the economy and now hold more than $15 trillion of financial assets. While this aggressive monetary policy led to the weakest post-WWII economic recovery, it also created more substantive economic imbalances. In addition to inflating financial assets far from their intrinsic value, central bank policies created wealth inequality and incentivized corporations to grow earnings through financial engineering (borrow to buy), instead of capital investment (build). In our view, the overleveraged corporate sector is vulnerable as the Fed raises interest rates and their profit margins regress to a normal level.

Chart 3: The Corporate Debt Burden is Excessive

Artificially low-interest rates incentivized corporations to borrow and buy, instead of investing and building. The corporate debt burden has never been higher, which will negatively impact profits as the Fed raises interest rates.

Source: FRED

Chart 4: Corporate Profitability Continues to Decline from an Elevated Level

Profitability has peaked for this cycle. Currently, corporate profits are 8.5% of GDP, which is one standard deviation above the historical mean of 6.6%. We expect that earnings growth will disappoint as profitability returns to an average level. Also, as interest rates normalize, the interest burden for many corporations will increase dramatically.

Source: FRED

In addition to the overleveraged corporate sector, the Federal debt has also expanded significantly since the last recession. We are concerned that the excessive debt burden, coupled with the CBO's estimated $1 trillion budget deficit, has the potential to turn an economic slowdown or policy mistake - i.e. Fed tightens financial conditions too much, or a trade war with China - into a severe recession.

Chart 5: Federal Debt to GDP

Currently, the Federal Debt to GDP is greater than 100%. "This Time is Different: Eight Centuries of Financial Folly" by Carmen Reinhardt and Kenneth Rogoff, is the seminal study of debt-driven economic booms and busts. They concluded that when government debt exceeds 90% of GDP, median growth rates decline.

Source: FRED

Despite the significant tax cut and deregulation, the nine-year economic expansion continues to slow. The yield curve, which has a superior record forecasting economic slowdowns, has flattened by 1.0% in the last twelve months and is at its lowest level since the 2008 recession. This significant flattening does not bode well for economic growth.

Chart 6: The Yield Curve is Forecasting a Slowdown

The yield curve (2-year to 10-year) has flattened by near 100bps in the past twelve months and is below 50bps for the first time since the last recession. The yield curve is forecasting anemic economic growth.

Source: FRED

Consumer spending is approximately 70% of the economy, and a healthy consumer sector is critical for economic growth. Real wages, which are an important leading indicator of consumer spending, have been flat for the past year and have led to increased consumer borrowing and a significant drop in the savings rate. Stagnant real wages and a low savings rate will lead to disappointing economic growth.

Chart 7: Real Wages are not Growing

Real wages - an important leading indicator of consumption - have been flat for the past year and forecast disappointing economic growth.

Source: FRED

Chart 8: Employment Growth Peaked Three Years Ago

Employment growth, which is a lagging indicator, peaked in February of 2015 at 2.3% and is currently growing at an anemic 1.55%. Slowing employment growth is not consistent with a strong economy.

Source: FRED

Chart 9: A Low Savings Rate Leads to Reduced Consumption

The savings rate has dropped significantly over the past two years and is currently 1.6 standard deviations below its historical average of 8.3%. Stagnant real wages led to a reduction in the savings rate, which will reduce future growth.

Source: FRED

Finally, in addition to fueling asset and credit bubbles, Quantitative Easing also changed the underlying market structure by reducing volatility and mitigating market corrections. In this environment, passive and rules-based quantitative investment strategies, which are primarily driven by market factors (momentum and volatility) thrived at the expense of active, fundamental investors. In our view, the significant investment flow from fundamental investment funds, into these quant strategies created a self-reinforcing feedback cycle that drove stocks up and volatility down, regardless of valuation or the fundamentals.

We are concerned that the self-reinforcing cycle that propelled stocks higher is poised to reverse into a negatively reinforcing cycle that drives volatility higher and equities lower. This negative self-reinforcing feedback cycle could be similar to the "Portfolio Insurance," which lead to the 1987 crash.

Chart 10: Equity ETFs Prospered at the Expense of Mutual Funds

Since the last recession, nearly $2 trillion flowed from equity mutual funds into passive equity ETFs. We are concerned that since many ETFs are more liquid than their underlying holdings, normal corrections will become excessively volatile

Source: Financial Times

Chart 11: Quantitative Investment Strategies Increase Systematic Risk

Quantitative investment strategies, which are driven by market factors, not valuations or fundamentals prospered during the Fed-induced financial repression. We are concerned that the self-reinforcing cycle that propelled the market higher could reverse and lead to accelerating selling.

Source: Financial Times

Summary:

We continue to believe that equities are extremely overvalued and offer a very poor long-term risk-reward. The profligate Fed is raising interest rates and selling bonds from their portfolio, which will have a negative impact on overvalued risk assets. We believe the recent market correction is the beginning of a bear market, which may be amplified by the proliferation of quantitative and passive funds. We estimate that equities are poised to return less than 2% per year over the next ten years, and we estimate that fair value for the S&P 500 is 1450, which is 45% below the current value.

The overleveraged economy is vulnerable, and an economic slowdown could turn into a severe recession. Instead of addressing the economic imbalances that led to the "Great Recession," the Fed's QE program increased them by inflating assets, creating wealth inequality, and encouraging excessive debt accumulation. Unfortunately, the current economic expansion, which is nine-years-old, is slowing despite a massive tax cut, deregulation and a massive budget deficit. We are concerned that a policy error - i.e., the Fed tightens too much, or a trade war with China - or an external shock will turn a slowdown into a severe recession.

Our asset allocation remains defensive and consistent with our view that risk assets are overvalued, the market offers a poor risk-reward, and the business cycle is decelerating. As long-term value investors, we continue to believe that we are in the final stage of a historic asset bubble, and until the asset bubble deflates, we will focus on preserving capital and providing positive absolute returns.

All information disclosed in this statement is accurate and complete to the best of our knowledge. Past performance is no guarantee of future results, and there is no assurance that the firm or client's investment objectives will be achieved.

Disclosure: I am/we are long SPY, QUAL, TWM, SDS, QID, OUNZ, DBC, TLT, VOO. 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.

Additional disclosure: All information disclosed in this statement is accurate and complete to the best of our knowledge. Past
performance is no guarantee of future results, and there is no assurance that the firm or client’s
investment objectives will be achieved