Tag Archives: Fed Chairman Powell

Crazy Days

I have been somewhat out of the loop on the market over the past 2 months, partly due to work and partly due to a general apathy towards trying to understand the current market reasoning. I am very much in a risk off mode on a personal basis having moved mainly into cash since April to protect YTD gains (and take the hit on YTD losses!). At the end of April, I posted my thoughts about the equity market (with the S&P500 being my proxy for the “equity market”). Since then, the equity market has sea sawed 7% down in May and 7% up June to date, now in sight of new all-time highs. The volatility has primarily centred around the China trade talks and the economic outlook.

With the 10-year US treasury yield now just above 2% compared to around 2.5% at the end of April, clearly market expectations have changed. At its meeting last week, the Fed highlighted an increase in uncertainties to the global economy and stated that “in light of these uncertainties and muted inflation pressures, the Committee will closely monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion”. The market is loving the new Powell put rhetoric (he does seem to be overcompensating for the year end 2018 “error”) and some are taking language such aswe will act as needed, including promptly if that’s appropriate” to mean multiple cuts this year, as many as three this year have even been advocated. Equity markets seem to be missing the point that multiple rate cuts will mean the economy has deteriorated rapidly, with a recession a real possibility. Hardly a reason for all time high equity markets!

There’s also the issue of the Fed’s current benchmark rate of 2.25% to 2.5% which is not exactly at normal economic boom levels given it historically has taken cuts of 3-4% to reverse recessionary slowdowns. Powell may be counting on the shock therapy of an early and relatively large cut (50 bps?) as an antidote to any rapid worsening of the trade war with China (or the outbreak of a real war with Iran!). In such an outcome, it is inevitable that talk of QE will re-emerge, providing yet more distortion to this millennium’s crazy brand of monetary policy.

A whole host of other things are bothering me – I highlighted high valuations on the hot business software stocks (here), Slack’s valuation (now over $18 billion. It had $135 million of revenues last quarter!!), a bitcoin rally, the fantasy-land UK conservative party leadership contest (the UK used to lead the world in the quality of its political debate, how did it get to this?), and, last but not least, the Orange One and Iran and well everything else to do with Trump. Sorry, that turned into a bit of a rant.

And so, we come to the G20 meeting of the world’s greatest leaders this week. Maybe it’s my mood but I found myself agreeing with the analysis (here) of Dr Doom himself, known as Nouriel Roubini to his friends. Roubini highlights three possible scenarios on the US China talks – an agreed truce with a negotiated settlement by the end of the year, a full-scale trade & tech & cold war within 6 to 12 months, or no trade deal agreed but a truce whereby tariffs agreed to be capped at 10% to avoid escalation. The third option is in effect a slow-burn trade war or a managed trade escalation.

I would agree with Roubini that either the first (but without the settlement this year) or third options are the most likely as both sides have reasons to avoid a rapid escalation. China needs time to prepare its economy for a prolonged conflict and to see how Trump fairs politically. Trump can portray himself as the John Wayne figure his man-child self longs to be in standing up to China and can pressure the Fed to stimulate the economy from any short-term impacts. Unfortunately, a managed escalation of a trade war is exactly like a managed Brexit. Impossible. You are either in or out. Have a deal or don’t have a deal. Could a grand deal be struck with this G20 meeting proving the turning point? Its possible but unlikely in my view (I’m referring to a real deal, not a fantasy/pretend deal). I hope I’m wrong.

Against this backdrop, forgive my lack of insight into the current collective wisdom of the market but an all-time high equity market makes little sense to me. And that’s me being polite.

Enervating Market

Wow, what a December this has been in the equity markets! Not a buyer in sight as we (effectively given the Christmas break) end the year at the S&P500 close today of 2,417. This really is a market to stay well away from. I suspect Q1 2019 will again be volatile until we get into earnings season and get a taste of the sector 2019 EPS projections (a minor relief rally from institutional funds allocating capital followed by more programme selling is my guess).

This recent post postulated that with small single digit EPS growth for 2019 and 2020, a slowing but non-recession scenario, a range of 2,500 to 2,300 on the S&P500. Well, we’re bang in that range now!! And the consensus is for more downside with the probability of a recession beginning next year raising by the day. Not even dovish statements today from John Williams of the New York Fed could tempt the buyers out of hibernation. The prospect of the demise of the Fed put has freaked the market out this week. My crude calculations estimate that a slow drop in operating EPS over 2019 of 6%, likely in a mild recession scenario, could result in the S&P500 testing 2,000.

I have been bearish on this market for several years (here, here and here are just recent examples) and although the majority of my assets have been in cash throughout 2018, the graph below from BoA Merrill Lynch, sends a shiver down my spine. As with most people, my equity positions have been hammered. According to BoA ML, the last time there was positive cash and negative equity, credit, and government returns in the same year was 1969. To plagiarize the old investing adage, it would take some monkey to call a bottom on this equity market any time soon.

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The outlook for 2019 is highly uncertain at the current point in time, nobody really knows how it will pan out and I’ll leave the musing over that topic to future posts. As this post in January highlighted, I do think quantitative tightening and the great unwinding of Central Bank easing experimentation is having some nasty unintended consequences.

At this time, I do find it insightful to look at recent movements in a historical context. If you look at the number of months with moves greater than or equal to +/-1% in the S&P500, the comparison between the decades is as below. The number of such moves are surprisingly consistent across the decades.

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If we assume that the 1970s and the 2000’s were extraordinary decades with the oil and financial crises respectively, then there could be more up months than down months due in the remainder of this decade for it to look more like the 1980s or the 1990s. A pretty flimsy analysis admittedly!

Continuing the theme of trying to end the year on a positive note, if we look at the historical months with moves of +/-5%, as below, it could be argued that the recent volatility is healthy as extended periods of reduced volatility prior to the dotcom bubble and the financial crisis didn’t end well!!

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That’s a happier note to end on (albeit rather pangloss).

A very happy and healthy Christmas to all who have spent any time reading my musings this year.

Bye-bye buy the dip

As my previous post illustrated, I got caught up with the notion that the fall in the equity market of late was an opportunity to buy into some names in the expectation that we’d go higher into year end. It’s clear that the classic “buy the dip” strategy that has worked so well in recent years, well, doesn’t work anymore. The graph below, from a report by equity strategist Michael Wilson of Morgan Stanley, has been widely cited to illustrate the failure of the strategy in 2018.

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Wilson commented that “such market behaviour is rare and in the past has coincided with official bear markets (20 percent declines), recessions, or both.” There is much discussion amongst commentators about whether we are entering, or indeed have entered, a bear market. I like the simplicity of the argument by Peter Oppenheimer, another equity strategist this time at Goldman Sachs. Oppenheimer argues that a decline in corporate profits in 2019 implies a recession in the US and as a recession is unlikely in 2019, he expects corporate profits to continue to grow, albeit at a much-reduced pace.

As pointed out by Wilson, we will not know the answer about where corporate profits are going until firms report Q4 and guide for 2019. He did also say that equity analysts are always slow off the mark as they wait for firms to reluctantly report on bad news. The after the fact downgrades on NVDA are testament to that! With some commentators calling the bottom around 2,550 to 2,600 on the S&P500, it looks unlikely that there will be any major upside in the market until there is more clarity on Fed policy and the trade issues with China.

If the market moving up depends upon Fed Chairman Powell indicating a policy change to “one and wait” or for a breakthrough at the G20 on trade, then I think we’ll go down further or, at best, sideways. If there is some modest indicator that the pace of interest rate rises in 2019 will be data dependent from Powell and the G20 meeting results in a short-term cease-fire between the US and China, then markets could find a bottom and stabilize. Whatever about the likelihood of the Fed rescuing the market (unlikely in my opinion), I fear that any meaningful relaxation in US-China tensions is against the play-book of the Orange One in the White House. The rhetoric from side-kick Pence at the weekend with language indicating China was leading other Asian countries into debt bondage does not bode well for next week’s G20 summit.

On China, I really like Ray Dalio’s explanation of the fundamental difference between the Chinese and US system (here is just one example of his latest thoughts), being a top down versus a bottom up approach. As Dalio explained it, the Chinese place an importance on family and paternal direction as opposed to the US adoration of the individual above all else. Unfortunately, I doubt that the current US leadership has the intellect to nuance a workable resolution between these two philosophies.

Following on from the analysis in this post on peak quarterly earnings, the current market narrative is that the EPS estimates for 2019 and 2020 will come down over the coming months. Currently S&P is showing a 11% projected increase for 2019 operating EPS for the S&P500 (13% on a reported EPS basis). The current market jitters indicate the market view those figures as unrealistic. Oppenheimer indicated that Goldman Sachs is currently thinking about a 6% and a 4% growth in EPS for 2019 and 2020 respectively is more realistic. Wilson indicted Morgan Stanley are projecting EPS growth for 2019 in the low single digits.

Given that estimates usually increase over time in the good years and decease in the bad years, I am going to assume a 3% and 1% increase in operating EPS for 2019 and 2020 respectively in this no recession but slowing growth scenario. Given that forward multiples would also decline in such a slowing environment (I have assumed to a modest 14), I estimate year-end targets for the S&P500 for 2019 and 2020 of 2,500 and 2,300 respectively, a decline of 6% and 13% respectively over the S&P500 today! The graph below shows the scenario as described.

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Economies generally don’t have slow gentle soft landings, it’s nearly always turbulent. Just look at the chart above to see how improbable the gentle scenario is compared to history. We need a major boast, such as a comprehensive resolution of the US-China trade issue, to maintain the bull market. Otherwise, I suspect the great EPS growth party is over.

Interestingly, Morgan Stanley also highlighted the headwind of quantitative tightening, as per the graph below, on the current market fall. I last discussed this issue in this post in January.

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No more buy the dip for a while yet I fear…….