After a volatile first quarter of 2018, in which the S&P 500 had a peak-to-trough decline of 11.8%, the equity markets stabilized and drifted higher during the second quarter. While the S&P 500 finished the first half of 2018 up 2.6%, safe-haven assets performed poorly - gold and the U.S. Treasury long bond fell by 4.3% and 3.0%, respectively.
In addition to the safe-haven assets, many other market indices and sectors performed poorly in the second quarter. While the S&P 500 increased by 3.4% in Q2 and appreciated by 2.6% year to date, the foreign markets continued to decline. The MSCI EAFE index - which is an index of 923 large and mid-cap stocks across the developed global markets, excluding the U.S. and Canada - decreased by 1.1% for the quarter and fell by 2.8% year to date. Additionally, the MSCI Emerging Markets index decreased by 7.8% in the second quarter and has declined by 6.6% through the end of June. Finally, China, the world's second-largest economy and the most significant contributor to global growth decreased by 22% from its January high and is now in a bear market.
Furthermore, the S&P 500's advance in the second quarter lacked breadth and was driven by five mega-technology stocks [Facebook (NASDAQ:FB), Apple (NASDAQ:AAPL), Amazon (NASDAQ:AMZN), Google (NASDAQ:GOOG) (NASDAQ:GOOGL), and Microsoft (NASDAQ:MSFT)]. In fact, four of the nine sectors of the S&P 500 have a negative year to date return - (i.e., financials, industrials, materials, and consumer staples).
In conclusion, we believe that the market offers a poor risk-reward, and the business cycle is decelerating. As value investors, we continue to think that we are in the final stage of a historic asset bubble, and until the asset bubble deflates, we believe that prudent investors will focus on preserving capital and providing positive absolute returns.
Investment Outlook Summary
- Equities are extremely overvalued and offer a poor risk-reward for long-term investors
- Since the "Great Recession," the major central bankers (Fed, ECB, and BOJ) bought more than $10 trillion of financial assets to push interest rates to 0% or below, and drive stock prices to an artificially high level. Now, since the Fed is selling $40 billion of bonds each month, and the ECB is winding down their QE program, equities are vulnerable as the liquidity tide reverses.
- Additionally, to fund the enormous budget deficit created by the tax cuts, the U.S. Treasury is expected to sell $90 billion of bonds each month in the third quarter, which will further reduce global liquidity and pressure risk assets.
- Despite a healthy economy, equity markets remain anemic and lack breadth. The post-election speculative blowoff ended in late January with a sharp, two-week sell-off of 11.8%. In the following six months, the bellwether S&P 500 failed to make a new high, while most global indexes declined to (or below) their February low. In fact, as of today, the S&P 500 is in its most protracted correction since 1984.
- While the foreign markets falter, the U.S. equity market remains under distribution. Four of the nine S&P 500 sectors have negative year-to-date performance and are below their 200 days moving average. In our view, five overvalued and overbought mega-cap technology stocks (Facebook, Apple, Amazon, Google, Microsoft) are driving the equity market's performance - when they falter, markets will be vulnerable to a significant decline.
- The economy is strong, though we believe that the rate of growth rate already peaked
- The massive tax cuts and deregulation are driving the economy to its most substantial growth in over a decade, while corporate profits are expected to grow more than 20% in 2018. While many pundits extrapolate today's strength into the future, we are skeptical that the current growth rate is sustainable and instead believe that the economy's rate of growth has peaked.
- The Federal Reserve is removing accommodation by increasing interest rates and selling bonds to reduce their bloated balance sheet. We believe there is a significant risk of a monetary policy error. Historically, ten of the Fed's last thirteen tightening cycles led to a recession, and the current period is arguably the most intricate. The Fed's attempt to slowly unwind their unprecedented financial repression policy - zero interest rates (ZIRP) and buying more than $3.5 trillion of bonds (QE) - was complicated by the massive tax-cut and subsequent enormous budget deficit.
- Despite the complacency in the U.S. equity markets, the trade wars with the EU and China will negatively impact the economy by slowing growth and inflating prices. We believe that the financial market's reaction to the trade war - the U.S. markets are significantly outperforming Europe, China, and the emerging markets - will embolden President Trump to be more aggressive in his trade negotiations, which will increase trade tensions and lead us toward a global recession.
In our view, the Fed's unprecedented QE program created a tide of liquidity that drove financial assets to a historic level of overvaluation. For nine years, instead of fixing the structural imbalances that led to the "Great Recession," the central bank punished savers by reducing interest rates to zero percent or below while buying $10 trillion of corporate and government debt to drive stock prices higher. These financial repression policies led to an anemic economic expansion, and by creating artificially low interest rates, our debt burden increased dramatically.
The nine years of extraordinarily loose monetary policy and tight fiscal policy (higher taxes and increased regulation) allowed "Wall Street" to thrive at the expense of "Main Street." The restrictive fiscal policy led to stagnant economic growth, which let the Fed continue their financial repression policies for much too long. In this period, the Fed's QE policy created a tide of liquidity that drove financial assets to a level of record overvaluation. Additionally, the artificially low-interest rates incentivized corporations to buy instead of build (i.e., borrow to buy back stock or make acquisitions, instead of investing in capital equipment).
Now, after the current administration's tax cuts and significant deregulation, the economy has accelerated, which is good for "Main Street" (more jobs and higher wages), but, in our view, will be bad for "Wall Street" as the Fed aggressively moves to normalize interest rates and their balance sheet.
The Fed began selling their bond holdings late last year, and the subsequent reduction in liquidity led to a dollar shortage and weakness in the emerging markets. As of July 1st, the Fed increased its bond sales to $40 billion per month. While the Fed is reducing its bloated balance sheet, the U.S. Treasury is scrambling to sell bonds to fund the enormous budget deficit created by the tax cuts. The Treasury is expected to sell $273 billion of bonds in the third quarter, which is an additional $91 billion per month reduction in dollar liquidity. In our view, risk assets were driven artificially higher by the central banker's tide of liquidity. Now, due to the unusual circumstance of a massive budget deficit concurrent with a Fed tightening cycle, the liquidity tide has reversed, and risk assets are vulnerable.
Chart 1: Equities are Expensive - Market Capitalization to GDP has Never Been Higher
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 145% of GDP; this is an all-time high. Based on this valuation measure, stocks would need to decline by more than 50% to be considered fairly valued.
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 504% of GDP, which is 2.8 standard deviations above the 65-year mean.
Chart 3: The Corporate Debt Burden is Excessive
Artificially low-interest rates incentivized corporations to borrow and buy, instead of investing and building. The lack of capital investment will continue to hurt economic growth. Currently, the corporate debt burden has never been higher and is at a level synonymous with past recessions.
While the S&P 500 is up modestly year to date, most global markets are performing poorly in this environment of decreased liquidity. In fact, nearly all MSCI global indexes and MSCI country funds are below their 200-day moving average, and most are negative year to date. Additionally, within the S&P 500, four of the nine sectors are negative for the year and are below their 200-day moving average. In our view, the lack of market breadth despite the strong economy and robust 20% earnings growth is surprising and is best explained by the significant reduction in global liquidity.
Interestingly, while the major averages are mostly flat this year, corporations will repurchase a record amount of stocks. According to the Wall Street Journal, S&P 500 companies are poised to repurchase a record $800 billion of stock in 2018. We believe that ebullient CEO will regret repurchasing so much stock, especially at a record valuation and near the peak of the second longest economic expansion.
Chart 4: The Global Markets are in a Correction
The MSCI EAFE index - which is an index of 923 large and mid-cap stocks across the Global Developed Markets, excluding the U.S. and Canada, declined by 12% from its January peak and is currently down 2.5% year to date. While the trade war is responsible for some the decline, the market acted poorly before the advent of the trade war, and we believe the diminished liquidity led to lower asset prices.
Chart 5: Emerging Markets are on the Verge of a Bear Market
The MSCI Emerging Market Index has declined by 19% since its January peak. The index is currently down 5% year to date. The reduction in dollar liquidity led to turmoil in the emerging markets.
Chart 6: China is in a Bear Market
China - the world's second-largest economy and its largest growth engine - is in a bear market. The Shanghai Stock Exchange Composite has declined by 24.7% since its January peak. The index is currently down 14.5% year to date.
While we believe that the reduction of liquidity has negatively impacted risk assets, we are also concerned that there is a significant risk of monetary policy error. Historically, ten of the Fed's last thirteen tightening cycles led to a recession, and the current period is arguably the most intricate. The Fed's attempt to slowly unwind their unprecedented financial repression was complicated by the massive tax cut, subsequent massive budget deficit and strong economic growth.
While the self-confident Fed is forecasting four hikes this year and three hikes next year - the yield curve is flashing a different signal. Historically, when the yield curve inverts (i.e., a two-year note yields more than a ten-year bond), a recession follows. In fact, yield curve inversions correctly signaled all nine recessions since 1955, with a lag of six to 24 months. There was only one false signal in the mid-1960s, which only led to the economic slowdown. Currently, the yield curve (shown below) is the lowest since August of 2007 and only 0.25% away from inverting.
Chart 7: The Yield Curve is Forecasting a Dramatic Economic Slowdown
The yield curve (2-year to 10-year) has flattened by near 73bps in the past twelve months and is the lowest since the last recession. The yield curve is close to forecasting a recession.
Recently, the Fed released the minutes from their June 13th meeting. Interestingly, in the minutes, the Fed suggested that technical factors "might temper the reliability of the slope of the yield curve as an indicator of future economic activity." In other words, they are not sure that the yield curve still works and is signaling a slowdown. In our view, the yield curve and the Fed both have perfect forecasting records. The yield curve has never missed a recession, and unfortunately, the Fed has never correctly predicted one.
While deregulation and the tax cuts led to our strong profit growth, the bond investors - who determine the shape of the yield curve - are probably focused on the health of the consumer. The savings rate was near a 60-year low, which indicated that the consumer sector, which accounts for 70% of GDP, is extended and vulnerable. Last week, the government dubiously revised and nearly doubled the savings rate to 6.7%. This revision seems suspect, especially since the Federal Reserve said that in 2016, 44 percent of American households said they would not be able to easily handle a hypothetical emergency expense of $400.
Chart 8: Personal Savings Rate (before government revision) Indicates That the Consumer Sector of the Economy Is Vulnerable
In the last twelve months, the personal savings rate declined by 0.60% to 3.2%. The low savings rate - which is two standard deviations below its 60-year average of 8.2% - indicates that the consumer is struggling to maintain living standards.
Low or negative real wages (wages adjusted for inflation) force the consumer to increase borrowing and decrease savings to maintain their living standards. Prospectively, low or negative real wages will create a significant headwind for the economy.
Chart 9: Low Real Wages Pressure the Consumer
The recent surge in inflation to 2.9% year over year (a six-year high) caused real wages to go negative. Consumers must borrow and reduced their savings to maintain their living standards.
The other significant economic concern is the trade war between the U.S., the EU, and China. We believe that President Trump monitors the market's reaction to the trade war, and its response must embolden him. Since our financial markets and economy are significantly outperforming China and Europe, we expect that the President senses that he is winning and he will continue to amplify the trade war until the other sides back down, or the U.S. markets sell-off. In our view, as the trade war accelerates, global economies will slow, and financial markets will be vulnerable to a significant decline.
- We continue to believe that equity markets are extremely overvalued and offer a very poor long-term risk-reward. The central banks bought $10 trillion of financial assets to drive interest to zero (or below) and artificially inflate risk assets to a historical level of overvaluation. We believe that stocks are poised to regress to the mean as the Fed raises interest rates and removes liquidity. We continue to believe 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 1,450, which is 48% below the current value.
- Tax cuts and deregulation fueled the strong economy, though we believe that the rate of growth has peaked. The massive tax cuts and deregulation drove the economy and corporate profits to their most substantial increase in over a decade. We believe that the growth rate peaked due to the significant economic headwinds - the Fed increasing interest rates, the Fed and the U.S. Treasury draining global liquidity by selling approximately $130 billion of bonds each month and the accelerating trade wars between the U.S., EU, and China. Additionally, the consumer, which is 70% of GDP is extended and vulnerable because wage increases cannot outpace the inflation rate.
- We believe that the odds of a policy error are very high as the Fed attempts to unwind ten years of profligate monetary policies. Additionally, this tightening cycle is complicated by the massive late cycle tax cuts and large budget deficit which will reduce global liquidity. Historically, the last 10 of 13 tightening cycles led to a recession.
- We believe that prudent investors should maintain a defensive asset allocation, since 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.
If there are any questions or comments, please don't hesitate to contact me directly.
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.
Subscribe to our weekly market review: The Value Investor's Market Review
The material in this report is for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. The information contained herein has been obtained from sources believed to be reliable, but not guaranteed. All investments contain risk.
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.