Ominously quiet as the S&P 500 breaks 3,000
As the S&P 500 crosses the 3,000 level again today, there appears to be a growing sense of trepidation ahead of the July 30-31 Federal Open Market Committee meeting to decide on the next Fed Funds rate move.
In just the first half of 2019, the S&P 500 has already returned better than 68% of all annual returns since 1927. As the graph below shows, the annualized 2019 return of the S&P 500 of approximately +38% is on pace for the highest return since 1958. Many analysts and investors have a growing feeling that this record stock market pace may be at risk with a weakening economy that may require as much as a 50 bps point rate cut in the coming weeks.
While this has been a fantastic year to date with gains across the major indexes and related index funds, the SPDR S&P 500 ETF (SPY) +19.48%, the ProShares UltraPro Dow30 (UDOW) +48.41%, the ProShares UltraPro QQQ (TQQQ) +82.34%, the Invesco QQQ Trust (QQQ) +24.83%, the iShares Russell 1000 ETF (IWB) +19.70%, the Federal Reserve and many analysts remain concerned about the divergence we are seeing between the economy and record high market indexes. Investors are increasingly counting on a 50-bps rate cut and the first rate reduction in a decade and economic factors are increasingly weighing on markets. Timing the end of the longest expansion in history may be an impossible task, but signs are increasingly showing a strong divergence between returns and fundamentals as conditions begin to slow.
Where is the fundamental growth picture?
The Federal Reserve is very focused on the contributing factors to the rising probabilities of a recession into 2020 as illustrated on the chart below. Wage growth is one of these key factors and despite the low levels of unemployment, Chairman Powell said yesterday:
We don't have any basis or any evidence for calling this a hot labor market. We have wages and benefits moving up at 3%, which is good because it was 2% a year ago, but 3% barely covers productivity increases and inflation... 3% is a low unemployment rate, but to call something hot, you need to see some heat... we haven't seen wages moving up as sharply as they have in the past."
While the Fed is focused on economic factors and risks that contribute to economic recessions, my focus here on the markets and how those similar risks may be adding up for the stock market investments. In the chart below, we see an excellent comparison of how S&P 500 gains are diverging from actual earnings growth since late 2018.
(Real Investment Advice)
If strong earnings fundamentals are the heat, these record gains in the S&P 500 index are not looking very hot.
... To call something hot, you need to see some heat" - Fed Chairman Powell (July 10, 2019)
Where is the volatility?
While this fundamental divergence continues, we have only seen FOUR moves of the S&P 500 up or down of more than 2% so far this year. The 2019 S&P 500 volatility is strangely 50% below the average of the last ten years. Usually such low volatility behavior is tied to very strong market liquidity treatments, programs, or effects designed to produce stabilizing effects. The relationship between the S&P 500 volatility and the changes in the Federal Reserve's monetary policy are well documented in my prior article:
Volatility changed dramatically into 2018. As the Fed began draining liquidity through the new balance sheet normalization policy, the CBOE VIX volatility index began to spike to record levels in February this year. This also immediately ended the longest stretch of consecutive low volatility the S&P 500 has experienced in 25 years. The start of this dramatic shift is detailed in my first volatility report: What Is the VIX Telling Us From 3 Prior Events?
The chart above shows the progress of the three Quantitative Easing (QE) programs from 2009 through the start of the Quantitative Tightening (QT) program in earnest in 2018. What is most noteworthy is that the market volatility decreased to a record low as the Fed added liquidity through 2017 in the QE policy. However, as the Fed's "asset normalization policy" began in 2018 to unwind the asset holdings we saw a large spike in 2018 to 20 daily events where the S&P 500 moved (up/down) by over 2%.
The chart below shows the number of positive and negative moves greater than 2% on a daily basis as counted for each year back to 2008.
Currently, 2019 has been an extremely quiet year with few large moves on the S&P 500. So where has the volatility gone and when will it come back? My simplified working thesis is that two very strong opposing monetary forces are at work and they are very closely related. When one of these forces becomes stronger and overtakes the positive force of the other, we will see another liquidity based correction in the market. What do I mean? Let me explain this possibility further.
Two Powerful and well-known forces of market liquidity are at work
One powerful force is the Federal Reserve quantitative tightening program that is having an adverse impact on market liquidity. This current unwind of the stabilizing Quantitative Easing (QE) program has already removed over $648 billion from the Fed's balance sheet since it began in earnest in 2018
At the same time, the Fed is talking about cutting the fed funds rate, the Fed is very aggressively reducing the System Open Market Account Holdings every week. We don't know whether the market will react in a linear fashion to the roll-off of assets capped at $50 billion per month or whether there is some threshold level of liquidity say at $3.50 Trillion in Fed assets where the market cannot further absorb the tightening. Ultimately that effect remains to be seen if it ever emerges at all.
The second powerful force is the astounding record of corporate buybacks and dividends that are in large part driven by low interest rates and a debt-fueled market price inflation program. This surge in repurchases is benefiting in part from the Fed's interest rate policies that have kept interest rates very low since the financial crisis in 2008.
One analyst found that,
since the beginning of 2011, the S&P 500 would have been 19% lower than it is today if no buybacks were performed at all.
In his evaluation of a scenario measured from the start of 2011, there have been over $3.5 trillion in S&P 500 aggregate net repurchases. Nothing sustains price like repurchases fueled by investment and record-high levels of debt at record low rates of interest.
(Ned Davis Research)
Looking at how the buybacks compare to the actual operating earnings of the S&P 500 companies so aggressively engaged in this activity shows another story.
The increasing rate of buybacks (red) in Q1 2019 reached 99.8% of the company operating earnings and may have crossed 100% into Q2 as earnings growth for the S&P 500 continues to decline. What the lower half of the chart below shows is that for only the 3rd time in 20 years, these buybacks + dividends are larger than the total operating earnings of these companies.
As I begin to analyze this in more detail and research further, it seems harder to call the market hot, if fundamental growth and earnings are the heat. I analyzed this divergence in 2018 and highlighted the extreme difficulty hedge funds and managers are having at producing alpha:
Many factors certainly contribute to the liquidity and fund flows into and out of the market. In my early estimation of these factors, it appears that the record corporate repurchases are sustaining the record market gains and further attracting additional investment into the market. Should these very strong repurchasing levels subside without the Fed curtailing the aggressive QT policies, we could see liquidity constraints overtake the markets again much like the end of 2018 when QT reached the $50 billion monthly Fed cap in October.
According to MarketBeat.com, the most recent and largest buybacks are in the following stocks.
|Date||Company||% of Shares||Buyback Amount|
|7/9/2019||Alliance Data Systems (ADS)||14.2||$1.1 billion|
|6/27/2019||Regions Financial (RF)||9.0||$1.37 billion|
|6/27/2019||Hanover Insurance Group (THG)||3.0||$150 million|
|6/27/2019||Bank of America (BAC)||11.6||$30.9 billion|
|6/27/2019||Bank of New York Mellon (BK)||9.5||$3.94 billion|
|6/27/2019||Wells Fargo & Co. (WFC)||11.1||$23.1 billion|
|6/27/2019||U.S. Bancorp (USB)||3.6||$3 billion|
|6/20/2019||Central Pacific Financial (CPF)||3.6||$30 million|
|6/18/2019||Fifth Third Bancorp (FITB)||N/A||100 million shs|
|6/4/2019||Cracker Barrel Old Country Store (CBRL)||1.2||$50 million|
These individual selections representing a high number of financial sector stocks can be viewed as part of the larger sector trends. The latest buyback trends by sector of S&P 500 companies are shown below up to Q1 of 2019.
Related to these corporate buybacks are the strong gains of the CFO Insider Trading anomaly I am testing in my research for members of my service. My most recent article on this subject shows that these CFOs have a significant statistical advantage and some of that could very easily be related to the timing of corporate buybacks. The 31.4% annualized returns of the top CFO insider purchases suggest this is a very meaningful factor to consider in your stock selections as well.
How do we know when the liquidity patterns change?
One strong indicator that may give us early insight will be a change in the number of greater than 2% moves in the S&P 500 volatility in the second half of the year. As charted above on the daily moves of the S&P 500 from 2008 through today in 2019, we can watch for daily events to possibly catch up to the 10-year average in the second half of this year. Another strong indicator will be a shift to negative momentum in my Momentum Gauge charts that have correctly forecasted all the major market runs and downturns since the gauge was developed in 2017.
On the weekly momentum chart above, we are seeing the S&P 500 move to record highs while negative momentum has increased this week and positive momentum conditions have declined. The best confirmation is a crossover on the daily momentum gauge charts plotted live throughout the day for my subscribers.
My growing concern is that the Federal Reserve's Quantitative Tightening program may overtake its more favorable market counterpart of massive corporate repurchases. How this relationship impacts the market liquidity is a subject for further investigation in my ongoing study of these forces. The effects may become more evident if interest rates don't remain at favorable levels that continue to fuel the record corporate borrowing. How sustainable the market will be through 2019 from the movements of these massive market flows remains to be seen.
All the very best to you in your investment decisions!
JD Henning, PhD, MBA, CFE, CAMS
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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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.