Have you seen the stockmarket

 By Nick Anderson

152 years of S&P500 returns

 From Visual Capitalist

Observe how the returns are skewed to the right, i.e., are greater than zero.   And how big falls are not always immediately followed by big rallies--for example, 1931's -50% was followed in 1932 with -10%.  1933, however, was between plus 40 and plus 50%.   There were a couple of bear traps (false rallies) between 1929 and 1933.  And the level of the S&P500 didn't pass the 1929 peak until 1954.

US shares at 125 year valuations

 From BarChart

US share market at record concentration

 From IsabelNet

The US share market is more concentrated than it's ever been.  And that makes it risky, because most of the top ten stocks are from a single industry: AI/tech.  

AI is proving very costly, and is not yet generating anywhere near its cost in revenue.  The last time this kind of euphoria overtook markets was during the dot com boom at the turn of the century.  And that ended badly, with the S&P500 falling 50% over the next two years.  Some of the hot favourites (Amazon, for example) eventually went on to become billion-dollar companies; most vanished without trace.

Bubbles almost always pop.  They rarely deflate softly.

US stock valuations reach an all-time high

 From Jesse Felder

‘A combined measure of valuations for US stocks has just hit a new record high, pointing to poor long-term market returns.’ blinks.bloomberg.com/news/stories...

 

Wall Street is very overvalued

 From Kalani o Māui

Glossary:

P/E = Price to earnings ratio, where "earnings" equals profit per share (or, in this case, for the index as a whole.)

Trailing P/E = price relative to current earnings

Forward P/E = current price relative to forecast earnings

CAPE = cyclically adjusted P/E

P/B = price to book, i.e., price relative to the book value per share

EV/EBITDA = enterprise value relative to earnings before interest and depreciation

Q ratio = the share price relative to the replacement value of the company's assets
Mkt cap/GDP = total market capitalisation relative to nominal (i.e., not inflation-adjusted) GDP

In all cases, the higher the indicator, the more expensive/overvalued the market is.

Note that the vertical scale is shown as a percentile.  In other words, at the moment, on average, these indicators are in the top 95% of the last 125 years, which implies that Wall Street is very expensive.

Just how deep will the US recession be?

Readers of this blog will know that I have worried about this issue for many months now.  

Here are two more charts which strongly suggest that a deep recession is possible.   They show data back to 1970.

The first chart shows the 12-month change (absolute, not percentage) in the Fed Funds rate.   The Fed Funds rate is the rate the Federal Reserve Bank charges for overnight borrowings by banks from the Federal Reserve system.  It is the bellwether which sets the level of interest rates in the market.   In the chart, I have plotted it upside down, because when interest rates rise, the economy slows, and when they fall, the economy accelerates.  I have also moved it forward, that is, I have plotted it with an 18-month lag, because it takes a long time for the change in rates to take effect.  

The QCI is a monthly coinciding index (i.e., it coincides with the business cycle), which closely tracks real GDP.

Notice how close the relationship between the change in rates and economic activity is, except for the GFC (2008/2009), where the downturn was materially worsened by the half-witted orgy of ill-advised mortgage lending by the banks in the years prior to the Fed raising rates.  The inevitable hangover took down the banking system and everything else with it.

The other apparent break in the relationship was caused by the Covid Crash of early 2020.  This also caused the spike in the QCI in early 2021 via the year-on-year calculation.

The rise in rates (shown in the chart as a fall, because, remember, it's inverted) is consistent with the deep recessions of 1973-1975 and 1980-1982.  The only good news is that this indicator (the inverted change in Fed Funds) is bottoming---provided the Fed doesn't raise the Fed Funds rate from now on.

Click on chart to see clearer image

The second chart shows the rate of change in real (i.e., after allowing for inflation) money supply.  The data for both M1 and M2 appear to have been distorted in early 2020 by a definitional/regulatory change by the Fed affecting the classification of chequing and savings accounts.   It's partly this change which may have caused the spike in the year-on-year rate in 2020/21.  But the spike was prolly also caused by the Fed flooding the system with liquidity.  However, this distortion is now passed.

Real money supply is falling faster than it has done at any time in the last 63 years (1960-1970 not shown in the chart).   It's falling faster than it did before the 1973–1975 and 1980–1982 recessions, and they were, before the GFC, the deepest recessions the USA has experienced since the Great Depression.  The implication is that the US is likely to experience a recession as deep as those two.  In other words, not a "soft landing".    See this interesting analysis from Reuters.

Click on chart to see clearer image.
Note: money supply charts not plotted with a lag.

So I remain sure that the US will experience a recession this year, with a peak-to-trough fall in real GDP of 3-5%, and a rise in the unemployment rate of 5-6%.

What could prevent these outcomes?   Well, Covid has distorted many indicators, and many economic relationships.  So time-honoured linkages and drivers may no longer work.  I think that, though possible, this is very doubtful.  

Of the Big 8, the US, Europe, the UK, Brazil and Russia are themselves likely to go into recession or are already in one this year.  China is rebounding, and India is still growing strongly.  On balance, the rest of the world won't save the US.  In the past, it usually went the other way---US recessions transmitted themselves to the rest of the world.   (The China rebound will likely reduce the depth of Australia's recession, though our Reserve Bank has also raised rates by too much.) 

During the 1973-1975 recession, the S&P500 fell by 44% peak to trough.  During the 1980-1982 recession, it rose at first before falling by 20%.   During the GFC, it fell by 57%.  However, the banks are much better capitalised now than they were when the GFC began, and the kind of financial crisis we experienced then is less likely (but by no means impossible) today.  So far this cycle, the S&P500 is down just 14%.  The risks, surely, are on the downside.

Boomtime

 As ever, this chart shows the extreme-adjusted versions of  IHS Markit's PMI (manufacturing) and the Institute For Supply Management's ISM manufacturing index.  Extreme-adjustment removes or attenuates extremes in the data (duh!) to give a clearer picture of underlying trends.  In addition, if we take the average of two independent (statistically) time series, this also gives us a smoother picture―that's the green line in the chart below, and it's the one to concentrate on.

This is the strongest cycle over the last decade.  A rebound from the covid crash, a fiscal sugar hit, and the record low Fed bank rate have all produced a massive stimulus.  Which makes it inevitable that the Fed will start tightening policy, moving the Fed Funds rate back to pre-crisis levels―2-ish per cent.  It's currently zero.   

Their moves are likely to be cautious and measured, but all the same, equities are vulnerable.

Massive underperformance of value stocks

 From The Economist

The age-old strategy of buying cheap shares is faltering

Shares of value firms have underperformed the market since 2010

In the US,  the 'growth' stocks which dominate the indices are the tech stocks, including Tesla, Apple, Twitter, Facebook.  The 'value' stocks tend to be older  industries. And oil has traditionally been classified as 'value' but has underperformed direly as the cost of new oil fields has risen while the price of oil has fallen.   

Increasing financial instability

This chart shows the 12 month moving total of percentage moves in the S&P500 index without regard to sign.  For example, if the market moves 3% down in one day then 3% up the next, that would add up to 6%.  Moves of less than 3 or 5% in either direction are left out. 

The real significance of this chart is that the volatility is increasing.  Each cycle produces wilder movements.  And that's very interesting, because it suggests financial markets have become more and more unstable.  Unstable financial markets matter because the instability spills over into the real economy, as happened in 2008/2009 with the GFC.   Perhaps after all neo-liberalism is not an unmitigated good for the rich.

A covid-19 vaccine?

The Moderna vaccine will have to pass through several more rounds of studies in order to be proven safe and effective for the general public. CREDIT:AP

From The Age:

The first coronavirus vaccine tested on humans appears to be safe and able to stimulate an immune response against the virus, the American biotechnology company Moderna has announced.

The results sent the US stock market soaring despite the small and early nature of the study.

The findings were based on results from eight people who each received two doses of the experimental vaccine starting in March.  The participants - all healthy volunteers aged 18 to 55 - produced antibodies that were later shown to stop the virus from replicating in infected cells in a laboratory, the key requirement for an effective vaccine.

The levels of "neutralising antibodies" were similar to the levels found in patients who had recovered after contracting the virus in the community.

The Food and Drug Administration has awarded Moderna a "fast track" designation for the experimental vaccine, a move that speeds up the regulatory review process.

The Dow Jones Industrial Average and S&P 500 both enjoyed their biggest one-day gains since early April, thanks largely to optimism about the hope of developing a vaccine.  The Dow Jones rose by 3.9 per cent on Monday (Tuesday AEST) while the S&P 500 gained 3.2 per cent.

It's a long and uncertain road from preliminary trials with just a few participants to regulatory acceptance and mass production.  The next step will be to test the virus on a couple of hundred volunteers.  That will take a couple of months.  Them if it's still effective, the test will be extended to 10,000 participants, and again, this will take a few months.  With a larger test base, side-effects will show up better.  We will be able to see if it's really safe.  For example, some vaccines have serious effects on just 1% of the sample.  That might be enough to make the regulators refuse permission, or give it with restrictions.    Many vaccines pass early testing but fail larger tests.  We also don't know how long the antibodies will last.   And even if the vaccine does work, it's prolly not going to be approved before the end of the year, and may not go into mass production a few months into the new year.

Meanwhile, although China has recovered from the downturn caused by their lockdowns, most other countries are still slowing.  Removing lockdowns in countries where the virus has spread widely into the population may not expand economic activity much.  In Sweden, which enforced no lockdown, economic activity has nevertheless plunged, because there has been an "unofficial lockdown".  If tens of thousands keep on dying, people are not going to enthusiastically embrace flying again, for example.  Locked into a sealed cylinder with re-cycled air, queuing cheek-by-jowl with hundreds of others?  And until a vaccine, most countries are going to maintain quarantine for international travellers.  Ending compulsory lockdowns won't  end cautious behaviour by most people.

It's too early to rejoice about a successful vaccine.  If it passes the next stage of tests, the likelihood that it will be effective and accepted by regulators rises sharply.  Even if it still has some risks, it could be given to at-risk sections of the population, such as people with diabetes (a disproportionate share of those who have died from the coronavirus have had diabetes), or the elderly, , allowing a more relaxed approach to the virus in the rest of the population.

The S&P500 since 1871

I've been working on long times series history for the USA.  We have several key series back to the first world war, and some even  further back.  But first, I had to rewrite some of my own programs, which took a while.  My programs are mostly written in APL with some VBA, and read and write to Excel files.  However, Excel doesn't handle dates before 1900.  So I had to do some coding in APL to allow for this.  Anyway, one of the first of my long term series is the S&P500, which I have got a monthly average for back to 1871.  And here's its chart (as usual, click to enlarge).  By the way, the software which produces this is written in APL.

Note that because this is plotted on a log scale, the same percentage move takes up the same space on the chart.  So even though in the Great Depression, the market only fell 17 or 18 points, it was by far the largest percentage fall.  Also, see how from 1871 to the early 1940s, the trend growth rate of the market (which would be a straight line because it's a log scale) was appreciably lower than the trend growth rate since then.  Notice also how the 1987 crash, which seemed so huge at the time is just a blip on this chart.

Fascinating.

Over 1500 posts. Thank y'all.

 A thank you wizard, by Nicholas Jackson
I'm an erratic wizard. Often the foresight is true.  Sometimes it isn't.

Over 1500 posts since I started this blog, way back in February 2009.  1560 to be precise.

My first blog post suggested that the share market had bottomed.  I was a month early—it actually reached its trough in March 2009.   I had sold most of our portfolios in early January 2008, after the the first negative payrolls report for the cycle.  Looking back on it now, taking the sell and the buy a year later together, I didn't do too badly.  Of course, I got other calls wrong.  The Goddess of Markets sees to that.  For example, I thought, as had happened with preceding recessions, that resources (mining) would turn down with the rest of the world economy, and invested too little in those sectors.  In fact, thanks to China pulling out all the stops, resources did better than the rest of the share market.  Ah well!

Anyway, thanks to all for following my blog, and finding what I say interesting and worth dropping by for.

Chicago PMI slides. Recession?

An indicator which shows the state of the great US industrial heartland, the mid-west, is the last regional indicator to be released.  Unlike the others, it isn't calculated by a regional Federal Reserve Bank, but by the same people who calculate the national ISM (Institute of Supply Management) survey, except just for the mid-west, and is released a couple of days earlier than the national index.  It gives a good indication of what the national ISM figure will be.  The regional Fed surveys for June point towards a continued slowdown in the US economy, as does the prelim estimate of IHS Markit's manufacturing PMI for June.  It's all consistent with the picture of a US slowdown, but not recession.  Not yet.

Will the Fed use all these falling indicators to justify easing monetary policy?  GDP is still strong.  Employment is still growing.  The unemployment rate is flattish.   Personal incomes and consumption expenditure were both up in May, not down.   There's not an overwhelming consensus of data (yet!) which points towards the need for a rate cut, even though it is clear that the economy has slowed.  What will tip the Fed towards easing will be an actual fall in payrolls, and that may have happened in June (data out in a week's time).  But it might not, too—a jump in payrolls for June will  take a Fed Funds rate cut right off the table, while a fall will bring it on.  Either outcome will not be liked by equity markets, because right now they're factoring in a mild recession tempered by a dovish Fed.  A fall in payrolls implies recession, now, and with powerful downward momentum.  A jump implies no rate cuts.   The only "good" outcome will be a small rise in payrolls.  See you same time, same place next weekend.

Trump and markets could be set for a brutal reckoning

Two "long-cycle" leading indicators are pointing towards a US recession.  They are auto sales and housing starts.  For most people these are the largest big-ticket items they'll ever buy, and if they start to have doubts about the economic future, or are themselves starting to feel the economic pinch, they  pull in their horns.  They're also important to the economic cycle because although even together, they're not a huge chunk of the economy, their swings are large.  If they go on falling, we're in for a recession, for sure.  I think they will go on falling.

Car sales lead the peak of the cycle by many months, but the lead is shorter at the trough

In this last chart I have combined housing starts and auto sales into a single composite index.
The decline so far is indicative of a recession, which is consistent with several other longer-leading indicators

My concerns are now being shared by mainstream analysts:

America's manufacturing industry suffered the sharpest slowdown last month since the depths of the global financial crisis, prompting calls for emergency rate cuts to avert a spiral into recession.

IHS Markit's momentum gauge [the PMI] fell to the lowest level since September 2009 as America's fortress economy succumbed to fading fiscal stimulus and mounting damage from trade wars with China, Europe, and Mexico.

Chris Williamson, the group's chief economist, said US profit margins are being squeezed. Manufacturers are cutting output and laying off staff. "Surging order book growth just a few months ago has now turned into contraction, the first such decline seen in the series' 10-year history," he said.

Michael Darda from MKM Partners said: "There is still time for the US Federal Reserve to right the ship, but time is running out."

Mr Darda said the yield curve for US Treasuries is inverting across every relevant maturity, flashing a red warning sign. "Long-cycle" indicators such as housing and car sales are already slipping into a deepening downturn. "It's time for the Fed to take out an insurance policy with a 75 to 100 basis point rate cut," he said. "If the Fed sits on its hands and a full blown recession gets under way, taking rates all the way back to zero may not be enough to revive growth. An ounce of prevention beats a pound of cure."

The M1 money supply has stalled over the last eight months yet the Fed is still engaged in quantitative tightening (reverse QE). This is draining dollar liquidity at home and across the world.

"The US is now on recession watch," said Edward Harrison from Credit Writedowns. "I don't think the Fed will pivot aggressively. It will end up over-tightening and creating a credit event. Trump's policy moves are potentially the thing that tips this into recession."

The Powell Fed gave no indication in its minutes in late May that it would soon come to the rescue. The hawkish text suggested that the US economy is in rude good health despite "transient factors" and that some voting members are even itching to raise rates.

[Read more here]

S&P has prolly peaked

Back in December at the low point for the S&P500 (2351) I said that the market was extremely oversold and therefore would rebound, but that, in my judgement, it wasn't the beginning of a new bull market.  It's been an amazing run, though.

The market is now extremely overbought.  All the good news is now in share prices, so it's vulnerable to any unexpected bad news -- which always comes.  Those who bought back into the market close to of after the lows will now be wondering whether they should crystallise cash profits, i.e., sell.  If the market does retreat from the recent high, it will form a "head and shoulders" top, which tends to be quite bearish.

If, however, the market just goes sideways from here, and momentum falls back to neutral levels, then the market will likely, in 6 or 8 weeks, head higher.  We shall see.

Bear markets

They don't last a long time.  On the other hand, it can take a decade or more to get back to the previous high.

Source: Visual Capitalist

Oil goes ex-growth

Shares with high earning per share growth tend to be highly valued.  Their dividend yield is low or non-existent.  It doesn't matter to the market because investors are confident that future profits will grow dramatically, so they are prepared to bid up the share price.  A good example of this today is Tesla, while in the past, companies like Microsoft, Apple and Amazon were also high growth low yield companies.  

On the other hand, low-growth companies have high dividend yields.  These high yields are needed to compensate for the lack of growth.  And when a company's profit growth starts to slow, its share price tends to retreat, or at any rate grow more slowly than the the rest of the share market.  Over time, the market demands a higher yield, because prospective earnings growth is falling. In the market, this is called "going ex-growth".  If profits or earnings per share are growing, this rise in yield can be achieved without the share price falling.  But usually, share prices decline, and market capitalisations fall, until the market thinks that the high yield adequately compensates  for low growth.

This is not to say that high yielding shares are necessarily bad investments.  Once the readjustment process is over, a high yield means a high income, without the volatility that can affect high growth stocks.  But during the process of adjustment to the new reality can be painful.  This is what is happening now to oil companies.  There is no reason why oil companies won't go on being profitable--for now.  But the traditional model has been expensive research and development to find new oil fields as replacements for old, emptying, ones.  And that's no longer a viable model, because 15 or 20 years out oil demand will have collapsed.  New oil fields will be worthless.  The money spent finding them and developing them will be wasted.  In short, oil companies which accept the new reality may still be worth investing in; those which do not are likely to be  big losers in this shift.

And it seems the market accepts these conclusions:

For generations of investors, Exxon Mobil Corp. has been a cornerstone of fund managers’ portfolios alongside the biggest names in corporate America. Not so much any more.

From leading the S&P 500 Index a decade ago, the company has dropped to the ninth-largest in a top 10 now dominated by technology giants. Its rivals Royal Dutch Shell Plc and Chevron Corp. aren’t faring much better, with investors demanding unusually high dividend yields to hold the stocks.

Source: Bloomberg
Note: The "energy" sector includes coal and some renewables companies as well as oil and gas.

At fault, a toxic troika that combines gushing supply with fears that long-term demand will flat-line as electric vehicles and renewable energies grow, and climate change policies proliferate. And while cash flow for oil’s majors in 2018 is likely to be the highest in 12 years, investors are largely unmoved.

“Earnings have started to come through but no one believes it’s sustainable,” said Kevin Holt, who helps manage $934 billion at Invesco Ltd. in Houston. “That’s why the stocks haven’t worked even though the commodity has gone up. Everyone’s saying they don’t believe it.”

Years of elevated spending on mega projects worldwide caused costs to soar. That kept drillers from taking full advantage when oil prices were averaging about $95 a barrel in 2011-2014, and it left them exposed when a stubborn two-plus year rout took hold. In February, the weighting of energy stocks in the S&P 500 dropped to 5.5 percent, the lowest in 14 years.

Beyond the S&P, Big Oil’s weighting in global equity indices is now at a 50-year low, Goldman Sachs Group Inc. said in a March report. Of the MSCI World Index’s 100 biggest stocks, only six are oil producers.

The tepid interest in oil “is reflective of a significant paradigm shift in the global energy landscape,” Paul Cheng, an oil equities analyst at Barclays Plc in New York, said in a note to clients. “Investors, particularly generalists, seem to be growing increasingly skeptical of the long-term value of oil and gas assets given the supply and demand risks posed by shale oil and EVs.”

[Read more here]

When good is bad

US employment data for February continued the strengthening trend of the last year, despite incredibly cold weather over much of the eastern US and incredibly warm weather/drought over the rest of the country.  The highest increase in a decade, if you ignore the short-lived spike when the US Federal Government hired a couple of hundred thousand temporary workers to take the ten-year census in 2010.

The US share market fell. But hang on, surely if times are good and getting better, surely the market should have gone up?  Well, no.  Because the stockmarket is a resultant (thinking of vector algebra here) of earnings, confidence and interest rates.  And this strength in employment suggests that interest rates in the US will start to rise soon.  For 6 years, the central bank discount rate (the "Fed Funds" rate) has been near zero, as the Fed tried to get economic growth going again after the GFC.  And a rule of thumb is that a "neutral" discount rate/cash rate should be roughly equal to nominal GDP growth,  which in the US over the last year has been around 4% per annum.  A stimulatory rate would be below nominal GDP growth, a contractionary rate above it.  After strong stimulus, it is now necessary to raise interest rates to prevent future asset price bubbles and rising inflation. What these strong data suggested was that the probability of that happening has risen.

Now, it may happen that interest rates can rise (slowly!) but earnings may rise too, in which case the stockmarket will go sideways or even up.  This often happens in the middle of an economic recovery.  But later on in the recovery, earnings growth becomes harder to achieve, and the annual increases in profits slip.   If interest rates start rising then, PE compression ( a falling price-earnings ratio) overwhelms the rise in earnings, and the market falls. In addition, in the case of the US share market, a big chunk (25%, 30%?) of profits are generated abroad (think of all the multinationals which dominate the Dow and the S&P)   And since the US is so out of phase with the rest of the world, where interest rates won't be rising any time soon, the US$ is soaring, reducing foreign profits when they are converted to US$.  The market isn't going to be rescued by a rise in earnings.

So this may mark the peak in the current bull market run in the US.   I don't think the fall will be substantial, but I do believe it will qualify as a "bear market", traditionally 20% or more.

A blip?

Click chart to get it at full size

US markets fell a couple of percent last week.  In the context of the last 25 years, the fall is barely visible on the long-term chart (which is, as it should be, plotted on a log scale).  Yes, the market's had a good run, yes, it's much pricier than it was, and yes, there are question marks about emerging market growth.  On the other hand, DM (developed market) growth is accelerating, and DM central banks are very unlikely to raise interest rates for many many months.

If the blue line (the 150 day moving average) turns down, I shall be very concerned, because that would be one (strong) signal that a new bear market is emerging.