6 reasons why an equity bear market has begun

Market leadership

Out of 35 country stock markets, just four are up this year, led by the Norway and the U.S.  Thirteen are down by double digits.  China and India, which account for 18% of the world’s GDP, are -15.4% and -20.7% respectively.  Even within the U.S., fewer and fewer stocks are participating.  According to Delta Investment Management, just 50.8% of 3,600 stocks are in uptrends, even though the S&P 500 is up 13.1% over the past 12 months and just 1.5% below its all-time high.

 

Investor sentiment

Sentiment has rebounded from the whiff of pessimism created by the February-March selloff to levels of extreme bullishness.  Sampling our 10 favorite sentiment indicators, the median reading is in the 90th percentile of bullishness.

 

Bullishness Percentiles

Indicator 10-YearBearish

Extreme

10-YearBullish

Extreme

Recent

Value

Bullishness

Percentile

Date ofRecent

Value

S&P 500 2901.61 10/4/18
VIX 59.93 9.14 12.12 85th 9/28/18
3-Month VIX 48.90 13.00 15.75 87th 9/28/18
Investors IntelligenceBulls – Bears -26.4% +54.0% +42.3% 92nd 9/21/18
Consensus, Inc.Bulls 18% 78% 69% 68th 9/21/18
AAII Cash Allocation 44.8% 13.0% 16.0% 84th 9/30/18
NAAIM Equity Exposure Index (Median) 0% +100.0% +82.5% 59th 10/3/18
MMF / Mutual Fund + ETF Assets 41.0% 12.2% 12.4% 99th 8/31/18
Mutual FundCash Levels 4.1% 2.9% 3.0% 94th 8/31/18
Rydex Bear Fund Assets / Total Assets 59.2% 3.4% 4.8% 96th 10/3/18
Rydex MMF / Bull +Sector Fund Assets 98.6% 6.8% 7.1% 93rd 10/3/18

Sources: Investors Intelligence, Consensus, Inc., American Association of Individual Investors, National Association of Active Investment Managers, Investment Company Institute, Guggenheim Investments, Bearing Asset Management

 

Interest rates

Interest costs on the $21 trillion federal debt have doubled since the 2016 election as we move closer to trillion dollar budget deficits.  The 30-year Treasury bond yields 3.38%, a 4-year high.  The 10-year yields 3.23%, its highest level since 2011.  Cash (using 2-year T-bills as a proxy) is the most competitive with stocks since late 2007.

 

Liquidity

The world’s central banks have been cutting back on quantitative easing.  The Federal Reserve has contracted its balance sheet 5.0% the past 12 months.  Combined, the Fed, Bank of Japan and ECB will no longer be adding liquidity by the end of the year.

 

Positioning

Stocks are priced for perfection and investors are positioned as if the record 10-year bull market will go on indefinitely.  Retail investors cash levels, from TD Ameritrade to Schwab, are at all-time lows.

 

Economy

Since 2009 total worldwide debt increased by over 40%.  Within the U.S., since the end of 2008 student loan debt is up 127%, auto loan debt 57%, corporate debt 76%, and public debt 98%.  Margin debt has more than tripled.  There is currently $8 trillion in dollar-denominated debt outside the U.S. and currencies in 20 countries have declined by double digits against the U.S. dollar.  In other words, their interest costs are rising.  We’re already seeing cracks appear in countries like Argentina, Turkey and South Africa.  To this fragile situation, President Trump is risking a trade war.  Never a good idea, but the timing couldn’t be worse…

 

7th Reason

It’s October…

Bearing rules for selling short

1. Never fight human progress. I want to ride secular waves, not fight them. Tech and health care are mostly off limits from the short side. There are always exceptions, like Valeant Pharmaceuticals and Tesla, but if the stocks are simply overvalued, we’ll be a spectator. If anything, I’d rather be long clear winners, even if I have to pay up a little. This is a natural hedge against our short position.
2. Short companies highly vulnerable to the cyclical event. These are typically dependent on cheap credit in one way or another. They also tend to drink the Kool Aid during the boom and take on too much leverage.
3. Short consumer fads… when the stocks are priced as if growth will continue indefinitely. Canada Goose might be an example today, but it’s only on my radar for now.
4. Only short a stock if you see a path to a potential 75-100% decline. Otherwise, the risk/reward isn’t worth it. (There is a lower bar for bonds, but the same risk/reward formula applies.) That means the business will be impaired, which usually involves intensifying competition and indefensible moats. The ETF business is a good example.
5. Compartmentalize risk. Evaluate every position on risk/reward. Don’t assume your hedges will work (they often break at the most inopportune times). Don’t allow one losing position to swamp the rest of the boat.
6. Big trees will underperform. $1 trillion market caps of AMZN and AAPL are a good example. This doesn’t necessarily mean they qualify as impaired businesses or stocks that can go down 75-100%, but knowing they are highly likely to underperform over the next decade (after all, trees don’t grow to the sky) is valuable information. E.g., this could be the pin that pops the passive investing bubble.

Predictions for 2018

When reviewing our predictions for 2017, the biggest surprise was that we actually got a few right:

  1. Inflation begins to become a concern.
  2. U.S dollar peaks.
  3. Official U.S. deficit for fiscal year ended 6/30/17 exceeds $600 billion.

Yet the stock market ignored all of this bad news and rallied, with the S&P 500’s total return over 21%.  Large cap tech stocks did even better, reflected in the Nasdaq 100’s 38% rise.

Our picks for best performers on average outperformed the S&P 500 while the worst performers underperformed:

Best:

  • Wal-Mart (WMT): +46.56%
  • Dollar Tree (DLTR): +39.04%
  • Illumina (ILMN): +70.64%
  • Bristol Myers (BMY): +7.71%
  • Fertilizer stocks (POT, PHOR.ME)

Worst:

  • Global banks (DB, CM, WBK): +16.06%
  • Investment banks (GS, JPM): +17.84%
  • Auto finance (AN, KMX): +6.41%
  • Municipal bond insurers (AGO, MBI): -21.88%
  • Office REITs (BXP, SLG, VNO): -6.41%
  • Retail REITs (GGP, O, PEI, SPG): -6.76%
  • Technology (XLK): +34.25%
  • Industrials (XLI): +23.99%
  • Chinese financials (CHIX): +53.60%

Our predictions for 2018:

1) The bubbles in blockchain, cryptocurrencies, and cannabis all burst.  Bitcoin ends the year under $5,000 (and possibly under $1,000).

2) Global bond markets continue the bear market that began July 2016.  The yield on the U.S. 10-year note, 2.40% to start the year, ends over 3.00%.  Government and corporate bonds sporting negative yields ($10 trillion currently) drop below $5 trillion.

3) Global stock prices peak in the first quarter.  The S&P 500, which hasn’t had a 5% draw down in a record 400 trading days, ends the year down at least 15%.

– best performers: genomic sequencing (Regeneron Pharmaceuticals), discount retailers (Target, Wal-Mart), retail roadkill (Bed Bath & Beyond), offshore drillers (Transocean, Ensco), natural gas E&P (Range Resources)

– worst performers: Tesla, global banks (Deutsche Bank, Westpak Banking, Canadian Imperial Bank), Chinese financials (CHIX), auto finance (CarMax, AutoNation), municipal bond insurers (Assured Guarantee, MBIA), passive investing (BLK, MSCI), office REITs (Boston Properties, Vornado), retail REITs (Simon Property Group, Realty Income), technology (XLK), industrials (XLI), infrastructure (Caterpillar, United Rentals).

4) The U.S. budget deficit goes from roughly $700 bil to over $850 by the end of 2018, despite an influx of repatriation taxes.  Higher debt service costs begin to become a concern.

5) Nascent global price inflation proves to be unshakable.  Gold and other precious metals benefit, helped also by less competition from digital currencies.  Gold mining stocks gain from the added tailwind of reduced costs relative to gold – especially fuel and equipment – and lower regulatory costs courtesy of the Trump administration.

6) Commodities will be a mixed bag with food commodities generally higher and economically-sensitive commodities lower:

– strong: coffee, wheat, natural gas

– weak: lumber, copper, crude oil

War complacency

With investor complacency already high (65% of the sub-10 VIX readings since 1993 took place in the past 3 months), it should be no surprise that the escalation of tensions with North Korea would be met with a yawn.

At 2:21 PM E.T. yesterday (with the S&P 500 down 0.87% on its way to a 1.45% loss), MarketWatch columnist Mark Hulbert published an article advising investors to remain calm:

If war breaks out with North Korea, we’ll have bigger things to worry about than our portfolios.  But that’s OK, because doing nothing is almost always the best investment strategy during a geopolitical crisis.

That is the clear conclusion to emerge from an analysis conducted by Ned Davis Research of the most momentous geopolitical crises of the last century. The firm found that far more often than not, the stock market, as measured by the Dow Jones Industrial Average strongly rebounds from its post-crisis panic low — so much so that within six months it is actually higher than where it stood before that crisis erupted.

The research report covered 51 events from 1900 to 2014, including the bombing of Pearl Harbor and JFK assassination.  Of note: the average stock market drop during each crisis was 17.5%, so the positive returns came after a fair amount of pain.  With stock valuations broadly at record high valuations, it is not difficult to envision a much larger correction if war breaks out with North Korea.

One problem with these sorts of back tests is that economic and market events can’t be replicated in a lab.  History doesn’t repeat, though it often rhymes.  To unravel this complicated puzzle, let’s look at three variables: valuations, sentiment and economics.  From a valuation standpoint, there is no way to compare past crisis lows to today’s twin asset bubbles in both stocks and bonds (at the lowest yields in 5,000 years of recorded history).

As for sentiment, a bit of history:

  • After WWI there was a sharp but brief depression in 1921.
  • After WWII, economists predicted another depression.  Instead we got a two-decades-long boom.
  • Initially, in the early-1960s there was complacency about the Vietnam conflict.  That eventually ushered in the intractable inflation of the ‘70s, which helped trigger (along with Watergate) the worst bear market in stocks since 1929-32, in real terms, from 1972-74.
  • The Gulf War brought back memories of the quagmire in Vietnam and was widely anticipated.  Stocks sold off in late 1990 as a result.  Operation Desert Storm began mid-January of 1991 and was over in a month.  There was no quagmire.
  • In 2003, the Iraq War was widely predicted to be brief, but it turned into quagmire.  Fortunately for stocks, they were 3 years into a burst tech bubble and prepared for bad news.  An aggressive Fed fomented the housing/credit bubble of the mid-2000s.

The lesson of #4 and #5 was that war – brief or quagmire – leads to bull markets.  Investors constantly fight the last war.  The complacency regarding North Korea is a direct reflection of recent past war experience plus an 8-year bull market where buy-the-dip behavior has been constantly reinforced by central bank asset purchases.

Lastly, let’s take a look at economics.  With the onset of war, we can expect the following to occur:

  1. The war economy is engorged while the real economy (or consumer economy) is drained.  GDP growth is highly misleading during wartime.  The consumer is worse off as resources are siphoned off to be destroyed (see chapter 3 of Henry Hazlitt’s Economics in One Lesson, “The Blessings of Destruction“).
  2. The immense costs of war are paid for through government borrowing and inflation.
  3. Government, aka the public sector parasite, is ratcheted up during war, but doesn’t relinquish all of those gains after the war (see Crisis and Leviathan by Robert Higgs).

Imagine these maladies foisted on an economy struggling to grow (the most anemic recovery post-WWII) and wheezing under record debt levels including $20 trillion of government debt (having doubled the past 8 years), $1.2 trillion in auto loan debt, $539 billion in margin debt, etc.  That debt has remained manageable thanks to miniscule interest rates, but a wartime economy would threaten this state of nirvana.

Moral of the story: act before the crisis.  With stocks and bonds priced for perfection, ignore impending danger at your peril.

Is new ETF to track ETF industry another sign of an ETF bubble?

Burton Malkiel, early influence (along with Eugene Fama) on Vanguard founder and indexing pioneer John Bogle, has been hired to join the investment committee of the Tosoro ETF Industry Index.  This index guides the ETF Industry Exposure & Financial Services ETF (TETF) recently unveiled on June 26th.

Adding irony to the launch, there appear to be flaws with index construction, not uncommon for ETFs.  The companies in Tier A, which make up 50% of the index and have “direct financial impact” from the ETF industry, are equal-weighted.  That means BlackRock (BLK), with a $71 bil market cap, has the same weight (6.25%) as Wisdom Tree Investments (WETF) with a $1.43 bil market cap.

One dirty little secret of the ETF industry is that there is no such thing as a “passive” index.  Otherwise, why the need to hire an investment committee to decide components and weightings?  The timing of a new ETF is another matter, and almost always a backward look on performance and forward look on what will entice investors.  These are not impartial decisions made by machines, but value judgements made by humans.  Value, as any Austrian economist knows, is always subjective.

Canaries in the coal mine

  1. Several debt-fueled roll-ups have unraveled
  2. U.S. middle class consumer under stress
    1. Trump populism a symptom
  3. Creative destruction adding to woes of retailers
  4. State government finances under pressure
    1. Connecticut, Illinois, Kansas
  5. 35-year bond bull market ended a year ago

 

Is Mario Draghi pulling away the punch bowl?

“Draghi hints ECB may start winding down QE,” read the MarketWatch headline this morning:

European Central Bank President Mario Draghi hinted on Tuesday that the ECB might start winding down its large monetary stimulus as the eurozone economy picks up speed, even as he warned against an abrupt end to years of easy money.

The comments, at the ECB’s annual economic-policy conference in Portugal, come as investors watch closely for a sign that the world’s second most powerful central bank is preparing to withdraw controversial policies such as its EUR60 billion ($67.52 billion) a month bond-buying program.

Mr. Draghi said the ECB’s stimulus policies are working and will be gradually withdrawn as the economy accelerates. However, he warned that “any adjustments to our stance have to be made gradually, and only when the improving dynamics that justify them appear sufficiently secure.”

With the Fed now talking about contracting its balance sheet and the BOJ and ECB doing the heavy lifting, this seems like a big deal, yet equity markets have barely noticed.  The Euro Stoxx index was -0.13% while S&P 500 futures are currently -0.07%.  3-month VIX futures (Oct contract) stand at just 14.25. The eurozone sovereign debt markets are a different matter:

Germany 10-year = -0.56% (0.32% yield-to-maturity)

France 10-year = -0.59% (0.69% ytm)

Italy 10-year = -0.80% (1.98% ytm)

“Today Draghi moved his first step towards indicating that ECB monetary policy will become less [stimulative] in 2018,” said Marco Valli, an economist with UniCredit in Milan.

Mr. Valli said the ECB might reduce its monthly bond purchases to EUR40 billion in the first half of next year, followed by a further reduction to EUR20 billion per month in the second half of the year. That would be a slower pace of stimulus reduction than many analysts had been expecting.

Keep in mind, the ECB and Bank of Japan have been doing the heavy lifting as year-over-year growth in total assets shows:

Fed = 0%

ECB = +36.7%

BOJ = +20.0%

The bond markets are starting to pay attention (though still wildly delusional). Perhaps the equity markets should as well.

Traders buy the dip as Trumphoria begins to fade

There were two headlines about bearish sentiment on CNBC and Yahoo Finance this week that were classic.  CNBC claimed the fear gauge was “breaking out.”  Yet the VIX still shows plenty of bullishness (62nd percentile 10-year reading).  I pay little attention to the VIX: it’s mostly noise.  Far more important are the VIX futures 3 months and out.  The 3-month VIX closed the week at a 95th bullishness percentile.

 

Earlier in the week, this Yahoo Finance headline read: “By one measure, investors have almost never been this nervous about stocks.”  Reading the fine print, their methodology is flawed, even admitting that the cost of downside protection is cheap.  Delusional!

 

Buy-the-dip is so ingrained by 8 years of bull market behavior, hardly anyone sees any downside.  The crowd is rationalizing their behavior with talk of “fear” and “cash on the sidelines.”  All nonsense, of course.  This week assets in Rydex MMF dropped 13% to an all-time low $457 mil.

 

This all took place while the averages were breaking down with financials leading the way (XLF -2.63%).  On Fast Money at Thursday’s close, the fast monkeys were all foaming at the mouth to buy bank stocks!

Market timers remain all-in.  The NAAIM Exposure Index jumped 19% to 86.7%.  Among assets in Rydex bull and bear funds, just 7.6% are positioned for the downside, weighted for leverage.

 

I realize we shouldn’t get overly infatuated with market timing, but this “what, me worry?” behavior struck me as noteworthy.  So far, at least, this is very different from the breaks in August 2015 and January 2016 in which Rydex MMF balances and 3-month VIX futures spiked.

The bear crying wolf

A perennially bearish hedge fund manager with an Austrian economics bent recently appeared as a guest on the Tom Woods Show.  Tom Woods opened the discussion with:

What do you say to somebody who says, “The trouble with you Austrian-influenced financial guys is that you’re always bearish, so of course you’re going to be right when things go wrong.  Why should I listen to you now?”

Great question.  Are we Austrians eventually right, but always early?  Is this one “big, fat, ugly bubble” that, when it bursts, will vindicate all of us?  Are we just flat wrong?  Is Austrian Business Cycle Theory (ABCT) out of touch with reality?  Or are we stopped clocks, right twice a day, but miss out on a lot of opportunities the rest of the time?

For the full article by Kevin Duffy, see here.

Predictions for 2017

Those who have knowledge don’t predict. Those who predict don’t have knowledge.” ~ Lao Tzu, 6th century BC poet and father of Taoism

It appears Lao Tzu anticipated the accuracy of our 2016 predictions twenty seven centuries ago.  While we got a few right (rebound in gold mining and Brazilian stocks, the demise of Valeant Pharmaceuticals, and 50/50 chance Trump would be the next president), we got plenty wrong, most notably a 25% bear market in stocks.

Bloodied, but unbowed, here is our short list for 2017:

1) The Trump honeymoon is short-lived, doomed by absurdly high expectations, faulty economics and political expediency.

– positives: Sanctions against Russia end as the Cold War thaws.  Regulations are cut, especially in the energy sector.  U.S. corporate tax rate is cut to 25%, bringing it more in line globally.

– negatives: Obamacare is not repealed, but instead replaced with a watered down version, dubbed “Trump Care.”  The debt ceiling is raised in March and federal spending continues to grow unchecked, even adjusted for inflation and population growth.  Trade tensions increase.  Common Core is not repealed.

2) Global economy officially enters recession.  China, the Euro Zone and U.S. all join the fray.

3) Global backlash against the political establishment continues.  Populist parties do especially well in Europe.  French, German and Italian bonds suffer.  Heading into 2018, a breakup of the EU looks like a serious possibility.

4) Most global equity markets enter bear market territory.  The S&P 500 ends the year down over 20% (below 1800).

– worst performers: financials (global banks, investment banks, auto finance, bond insurers), REITs (retail and office), technology, industrials, Chinese financials

– best performers: discount retailing (Wal-Mart, Dollar Tree), food-related, fertilizer, genomic sequencing (Illumina), cancer drugs (Bristol Myers)

5) Inflation begins to become a concern.  Gold and gold mining stocks do very well.

6) U.S. dollar peaks, losing ground to the Swiss franc, euro, British pound and Japanese yen.

7) China cracks widen.  Bonds extend losses.  Equities fall over 20%.  Yuan experiences at least one official devaluation, even though the Chinese sell over $200 billion in U.S. Treasuries to shore up their currency.  Trump cries fowl, labeling China a “currency manipulator.”

8) Official U.S. deficit for fiscal year ended 6/30/17 exceeds $600 billion.  Talk of future trillion dollar deficits becomes more commonplace.

9) Active investing makes a comeback.  BlackRock is a notable underperformer.

10) Global free market reforms are a mixed bag.  Brazil makes progress, India regresses.

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