The Conference Board’s Index of Leading Economic Indicators fell 0.2% MoM in December, following revised 0.5% increases in November (initially +0.4%) and October (initially +0.6%). Three-month growth in the index slowed to 3.3% (annual rate) in December from 3.6% in November. Weaker ISM new orders and building permits were the major drags in December, while the biggest boost came from a steeper yield curve.
As we can see, the LEI has historically dropped below its six-month moving average anywhere between 2 to 15 months before a recession. The latest reading of this smoothed rate-of-change suggests no near-term recession risk. (Doug Short)
But, since equity markets tend to discount 6-9 months in advance, this reliable indicator needs to stabilize pretty soon…
U.S. Existing-Home Sales Rebound in December The U.S. housing market entered 2016 after a year of strong sales, rising prices and dwindling inventories, factors supporting the economy but also likely to cap future gains for the sector.
Existing-home sales rose 14.7% in December from the prior month to a seasonally adjusted annual rate of 5.46 million, the National Association of Realtors said Friday. For all of 2015, sales reached 5.26 million, the highest annual level since 2006, underscoring the long slog back from the housing bust.
The national median home price, meanwhile, rose to $224,100, up 7.6% from a year earlier. That marks the 46th consecutive month of year-over-year price gains.
Existing-home sales had dipped in November, a development the NAR blamed largely on closing delays caused by new federal rules implemented by the Consumer Financial Protection Bureau in October. The new rules, prompted by the 2010 Dodd-Frank financial law, are meant to help consumers better understand the terms of their mortgages before they sign.
December’s strong rebound in sales, the biggest monthly gain on record, suggests that the rule postponed sales for a few days but didn’t lead to significant cancellations.
However, averaging Nov. and Dec. we get 5.11 million, down 3.9% from October.
Inventories of existing homes for sale fell 12% to 1.79 million in December. Inventory is not seasonally adjusted and it usually decreases to the seasonal lows in December and January. Nonetheless, there are now fewer homes for sale than at any time since 2000.
This CalculatedRisk chart shows the YoY trend with December inventory down 3.8% YoY. Single-Family: –5.0%.
Originations of FHA-backed mortgages, used predominately by first-time buyers, were up 54 percent in September from a year earlier, according to the most recent data from CoreLogic Inc. By December, the FHA insured 22 percent of all loan originations, up from 17 percent a year earlier, according to data compiled by Ellie Mae Inc. (…)
Long but interesting. A summary courtesy of FT Alphaville:
(…) For those who haven’t read much Pettis before… for shame… we’d recommend checking him out on accounting identities and what a good Chinese adjustment might look like before cracking on with this latest, very long, read.
For those who have, do click through when you can and read the full thing.
We’ll just leave the summary here for now:
… for those who want the 9-point summary:
- China’s economic growth is not decelerating as a natural consequence of the aging of China’s growth model. It is decelerating for three reasons. The first reason is the reversal of the growth process by which China’s imbalances have reached their systemic limits.
- The second reason is that during the phase of rapid growth, China’s balance sheets, as occurred in every similar case, evolved to become highly inverted, and just as this automatically caused growth to be higher than expected during the expansion phase, it must cause lower-than-expected growth during the contraction phase.
- Finally, the economy must shift, one way or another, from one of rising leverage to one of declining leverage, and with rising debt the only thing propping up growth levels, deleveraging cannot help but cause growth to drop.
- This means that regardless of trends in underlying productivity, growth must slow sharply, and it will, either smoothly and continuously, or in the form of higher growth early in the adjustment period and a collapse in growth later.
- The growth deceleration can be temporarily countered by rapid increases in debt, but ultimately this will only increase future deceleration, with a rising chance that the shift will be disruptive. Every growth miracle in history has been followed by an unexpectedly difficult adjustment, and it is unreasonable to have expected that China would be any different.
- The only way to minimize the costs of the adjustment is to take steps to speed up the rebalancing of demand and the repayment of debt. This must be the direction of reforms if Beijing is going to reduce the costs of adjustment and the risk of a disruption.
- Repaying debt simply means allocating debt-servicing costs, either directly or indirectly, to specific sectors within the economy. This will either occur in ways targeted by policymakers, or if postponed for too long, it will occur in unpredictable ways determined by circumstances. For example default allocates the costs to creditors, inflation allocates the costs to household savers, economic collapse and high unemployment allocates the costs to workers, etc.
- By far the most efficient ways for Beijing to minimize the adjustment costs for the economy and reduce the risk of a debt-related disruption is to allocate debt-servicing costs to local governments by forcing them to liquidate assets directly or indirectly to pay down debt, and to increase household wealth by transferring wealth directly or indirectly from local governments to the household sector. Successful reforms must be consistent with these two goals.
- Beijing has already tried to address its growth problems by implementing the productivity-enhancing reforms beloved of orthodox economists, but while these might be a good idea in normal times, they will have almost no effect on reducing the cost of China’s economic adjustment.
Point 10, btw, swings back to the right supply-side policies.
Point 10.5 involves waiting to see if they emerge.
(…) At 2.4 per cent in December, this measure of inflation has only been higher once since 2000 — in July-September 2008, when it peaked at 2.5 per cent, according to calculations by JPMorgan, as the first chart shows.
Earlier this week the Bureau of Labor Statistics said US core consumer price inflation rose to 2.1 per cent in December, its highest level since July 2012.
This is despite a 24.4 per cent jump in the dollar index, a measure of the greenback’s strength against a basket of currencies, since June 2014, a rise that would be expected to reduce the price of US imports, putting downward pressure on inflation.
Moreover, core inflation has risen even though weak oil prices have led to lower prices for some elements of the core CPI basket, such as airline fares, which fell 1.1 per cent in December, notes Harm Bandholz, chief US economist at UniCredit. (…)
In countries such as Brazil, Russia, Turkey and, to some extent, South Africa, “extreme currency pressures†are pushing inflation higher, as falling currencies raise import prices. (…)
Stripping out these countries, Mr Hensley says core inflation levels across the rest of the emerging world are “kinda averageâ€.
However, this finding may be more interesting still. “Emerging market growth rates have been slowing year by year. They are creating slack and should be seeing core inflation rates coming down and that is not happening,†says Mr Hensley, who argues that this “stubbornness†in inflation is a major issue for EM governments to tackle.
According to JPMorgan, this stickiness in inflation is particularly prevalent across Latin America, which the exception of Mexico and Asia, excepting India and Indonesia, while there are also pockets to be found in the eastern Europe, Middle East and Africa region.
Mr Hensley cites the example of Brazil where, even in periods when a plunging currency is not pushing up import prices, the country suffers from “very high wage inflation and an embedded inflation problem that is to some extent mirrored across Latamâ€.
(…) the US bank expects to see a “sharp rise†in headline consumer price inflation in the second half of 2016, “based on the simple arithmetic that, as long as oil prices do not fall another 40 per cent, this downward pressure should fade quickly,†as the impact of the earlier slide in energy prices drops out of the inflation equation.
JPMorgan expects global inflation to bottom at 1.5 per cent in June, but hit 2.6 per cent by December, as the first chart indicates. (…)
Oil, Stocks Dance the Bear-Market Tango Oil and stock markets have moved in lockstep this year, a rare coupling that highlights intensifying fears about global economic growth.
(… ) The correlation between daily moves in the price of Brent and the S&P 500 stock index over the last month-long period is 0.97, the tightest correlation for any comparable period over the last 26 years, according to data from both benchmarks examined by The Wall Street Journal. (…)
Copper prices and corporate bonds have taken similar paths to crude in recent months, driven by fears about global growth. Correlations between oil and credit indexes have moved close to 1 in recent weeks, according to strategists at Citigroup. (…)
“On average, cheaper oil should be a good thing for the economy,†said Valentijn van Nieuwenhuijzen, head of multiasset strategy at Dutch asset manager NN Investment Partners. “But in this type of market, it isn’t about the average, it is the fear of unknown.â€
More trouble in store: the oil market
When will storage tanks overflow? This question is increasingly vexing oil markets, after yesterday’s news that American petroleum stocks rose by 4m barrels last week, to an 80-year seasonal high. Over-production is the main culprit for oil prices’ tumble earlier this week to below $27 a barrel, compounded by an anticipated surge of Iranian exports now that nuclear-related sanctions have been lifted. But the storage shortage is also menacing. The International Energy Agency, a forecaster, says global stocks soared in the fourth quarter of 2015 by a record 1.8m barrels a day; they usually decline in the northern-hemisphere winter. It expects them to rise by 385m barrels in 2016. Space on land will be limited; it reckons America can cram in only another 100m barrels, and the world is adding only 230m barrels’ worth of capacity this year. Any excess will go onto seaborne tankers. After that, who knows? (The Economist)
The head of the Organization of Petroleum Exporting Countries said he wants oil producers outside the group to assist in reducing the global oversupply, signaling once again that OPEC won’t make output cuts alone.
“It is vital the market addresses the issue of the stock overhang,†Secretary-General Abdalla El-Badri said Monday at a conference in London. “It should be viewed as something OPEC and non-OPEC tackle together.†(…)
“It is crucial that all major producers sit down to come up with a solution to this,†El-Badri, 75, said at the Chatham House think-tank. There are signs supply and demand will start to come back into balance this year, he said, citing a forecast increase in global demand of about 1.3 million barrels a day, and a contraction in non-OPEC supply of about 660,000 a day. (…)
Iran’s oil minister said on Friday any emergency meeting of the Organization of Petroleum Exporting Countries would hurt the crude oil market if it made no decision to shore up falling prices. (…)
“The important thing is that there must be an intention for change, but we have not yet received such a signal,” he said. (…)
Russia’s oil industry is under threat from a number of factors–including diminished exploration and lower crude oil prices–whilst increasing production, Selina Williams and James Marson report. The decline in exploration stems from a decision by President Vladimir Putin to postpone a planned cut in oil-export duties, which executives say would divert money to Moscow that could be invested in new drilling and exploration to supplement aging oil fields.
Income from oil and natural gas makes up about half of Russia’s federal government revenue, and exports account for one-third of national economic output. Energy revenues are central to Mr. Putin’s power as he deploys military forces in Syria, but Russia faces competition in Europe, including from the U.S. The first shipments of U.S. liquefied natural gas are expected to start arriving in Europe this spring.
“We will have to limit our spending and that will lead to a fall in production,†OAO Lukoil Chief Executive Vagit Alekperov said.
Still, Western sanctions that are tied to Russia’s annexation of Crimea and the conflict in Ukraine have had little short-term impact on oil output, while China has been selling Russia the equipment it needs to boost production at existing oil fields. The Russian Energy Ministry expects oil production to stay at current levels through 2035.
Lukoil’s vice president said the company needs to work with the Organization of the Petroleum Exporting Countries to raise prices, Reuters reports. (…)
- FYI: Travel on all roads and streets changed by 4.3% (10.4 billion vehicle miles) for November 2015 as compared with November 2014.
EARNINGS WATCH
From Factset:
Overall, 15% of the companies in the S&P 500 have reported earnings to date for the fourth quarter. Of these companies, 73% have reported actual EPS above the mean EPS estimate, 8% have reported actual EPS equal to the mean EPS estimate, and 19% have reported actual EPS below the mean EPS estimate. The percentage of companies reporting EPS above the mean EPS estimate is above both the 1-year (69%) average and the 5-year (67%) average.
In aggregate, companies are reporting earnings that are 2.6% above expectations. This surprise percentage is below both the 1-year (+4.9%) average and the 5-year (+4.7%) average.
The blended (combines actual results for companies that have reported and estimated results for companies yet to report) earnings decline for Q4 2015 is now -6.0% (-5.7% one week ago). If the Energy sector is excluded, the blended earnings decline for the S&P 500 would improve to -0.6% (-0.1%) from -6.0%.
The blended revenue decline for Q4 2015 is now -3.5%. If the Energy sector is excluded, the blended revenue growth rate for the S&P 500 would jump to 0.9% from
-3.5%.
At this point in time, 11 companies in the index have issued EPS guidance for Q1 2016. Of these 11 companies, 10 have issued negative EPS guidance and 1 has issued positive EPS guidance. Thus, the percentage of companies issuing negative EPS guidance to date for the first quarter is 91% (10 out of 11). This percentage is above the 5-year average of 72%.
Note that of the 11 companies having issued guidance so far, 8 are in IT and 3 in Consumer Discretionary. The one positive guidance is in CD. At the same date last year, 14 companies had offered guidance with 2 positives. All 6 IT companies had guided lower (typical for IT) while 5 of 6 CD companies also guided lower.
Thomson Reuters’ tally now sees trailing 12-m EPS at $117.05 after Q4, up from $116.89 two days earlier. S&P also raised its Q4 estimate 0.8% from one week ago.
In all, while still early in the season, earnings are not collapsing.
At its Friday close of 1907, the Rule of 20 P/E is 18.4 using TR’s trailing EPS after Q4 and the 2.1% core CPI (that is actual P/E of 16.3 + 2.1). The chart shows how recent fears seem to have broken the 19.0 level which consistently marked the low points since October 2013.
However, the above chart uses month-end data. This next chart uses actual monthly lows since January 2014 in order to illustrate how the most recent period of fears impacted the Rule of 20 P/E:
Using actual lows reveals that, so far, investors’ angst does not measure differently than during the previous three such episodes of the last 2 years. Was last Thursday’s the bottom at 18.0 on the Rule of 20 scale, once again? Let’s review the apparent causes of the current fear episode:
-
Oil Prices
(…) For investors, the question is how long energy producers can survive amid depressed oil prices. The U.S. shale boom of the past decade helped drive economic growth. The steep drop in the price of crude threatens to wipe out that expansion. Shares of energy companies in the S&P 500 have fallen more than 8% in 2016, and are off nearly 50% from their June 2014 high.
-
U.S. Economic Recovery
(…) manufacturing activity is weak, corporate executives are cautioning that 2016 sales may again be muted and inflation is soft, calling into question the pace of the Fed’s interest-rate increases.
-
Central Bank Stimulus
Since the financial crisis, investors have grown accustomed to central bank support. In December, however, the U.S. Federal Reserve announced it was raising short-term interest rates, ending seven years of keeping them near zero. With economies around the world still sluggish, investors are questioning whether the Fed moved too soon. Other central banks, including in Japan and Europe, are still enacting stimulus measures, but traders worry about whether it will be enough.
The 72-year-old investor says it’s easy to see why global equities are off to such a bad start — falling oil, tension between Saudi Arabia and Iran, China’s equity selloff, and concern over Apple Inc.’s supply chain. The problem is predicting how they’ll turn out since most defy fundamental analysis.
“While we maintain a positive bias, we are more concerned today than at any other point since 2009 and dispute most forecasts because the issues are not limited to the economic/financial factors which the market can comprehend,†he said in a note dated Wednesday. (…)
To understand China’s economic slowdown and 44 percent stock market slide, it takes more than analyzing things like gross domestic product and earnings, according to Birinyi. Getting a handle on the situation “requires insight into that government’s political agenda which is beyond our capacity,†he wrote.
A similarly improbable set of insights is needed to assess crude oil, Birinyi says. Recession-hit Russia needs a revenue boost, while geopolitical turmoil leaves the Middle East unpredictable, and both distort forecasts.
“Thus, two of the major pressures on stock prices are beyond investors’ and the market’s usual metrics and indicators,†Birinyi wrote. “We would therefore treat market forecasts as ‘best guesses’ and only that.†(…)
Birinyi reflects the black holes currently facing investors. China is the big elephant in the room which nobody can really size up and which seems without any strong master to guide it towards a safe exit. Oil prices have come down a lot more than the Saudis supply-siders expected and OPEC has seemingly disintegrated as a result. Nobody can really forecast what will happen during the next 6-12 months in this free-for-all oil market. The collapse in oil and other commodity prices is threatening central banks’ goal for 2% inflation and investors are doubting that much can be done about it and that deflation will ensue.
Alan Blinder wrote a down-to-earth piece last week in the WSJ (Markets Are Scaring Themselves), On China:
(…) If Chinese growth slows (as is happening, though who knows by how much), many countries’ exports will shrink. That’s a big deal to some countries—especially emerging markets that rely heavily on commodity exports—but not to the U.S.
The Chinese export to us about three times as much in goods and services as we export to them. That isn’t a problem; bilateral trade is not supposed to be balanced. But it means that China is far from our leading export market—nothing like, say, Canada or Mexico.
Here’s the math: Over the first three quarters of 2015, the latest data available, exports to China made up less than 1% of U.S. GDP. Let’s imagine that Chinese purchases of U.S. products dropped by 10%, an implausibly steep decline. (For reference, the drop from 2014 to 2015 was zero.) Even such an extreme event would cut U.S. exports by less than 0.1% of GDP—an amount beneath notice.
Yes, there is a secondary effect: Weakness in China can damage nations that rely heavily on exporting to China. And if those nations sag, they will buy less from us. So let’s double the estimate. That would still cut less than 0.2% from the U.S. growth rate. More severe outcomes are possible, but unlikely. So a China-induced trade contraction should be on our worry list, but not near the top.
What about financial linkages? Haven’t drops in the Shanghai stock market been echoed strongly in U.S. markets? Yes, and that is my point. Aside from psychology, this is slightly nutty. The Chinese stock market is not where big Chinese companies go for financing. It is more like a giant casino. And as it recently experienced a huge bubble, no one should be surprised by large price drops. Besides, U.S. holdings of Chinese stocks are relatively small.
On oil:
(…) Here, it appears, the markets have even got the direction wrong. Ask yourself: When the price of something you buy goes down, does that make you better off or worse off? No, it isn’t a trick question. The obvious answer is the correct one. Other things equal, each of us is better off when the prices of things we buy, including oil, go down.
(…) the U.S. is still a net importer of oil. Over the first 11 months of 2015, net imports of oil totaled $76 billion, according to Census Bureau data. That’s way down from the same period a year ago ($174 billion). But we are not an oil-exporting country yet. So collapsing oil prices are terrible news for Saudi Arabia and Venezuela, and perhaps for Texas and North Dakota. But they are good news for most American businesses.
People fret that less drilling means lost jobs in the oil patch. True. But employment in oil and gas extraction is about one-eighth of 1% of total nonfarm employment. Yet what about the harm to investment spending? After all, drilling for oil is capital intensive. Well, capital expenditures from the energy-producing industry are about 5% of the nation’s total spending on equipment and structures. That’s down from the recent drilling boom, but not far from its historical average.
How about the falling values of energy stocks? Do they bulk especially large in the broader market? Not much. By market capitalization, U.S. energy companies account for about 6% of the S&P 500. Furthermore, the decline in energy stock prices since July has not been much steeper than that for overall stock prices—which is odd.
In sum, the traders who make stock market prices seem to have a few things wrong: China is not as big a deal to us as they think; and falling oil prices should help, not hurt, U.S. growth. Don’t misinterpret any of this as investment advice, however. The market can stay irrational longer than you can stay solvent.
China is really a problem only if you invest in commodity-sensitive companies or companies with high exposure to the domestic Chinese markets, which are not many. Oil is more problematic than Blinder says. Not only for its impact on Mexico and Canada, but because of the contagion risk from the large debt in oil-dependant countries and energy companies and the impact on large oil exporters such as Russia and many Middle-East countries. So far, the oil windfall has not offset the negative effects of the price collapse and investors are scared of oily black swans.
Myrmikan Research is expecting black swans emerging from rising bank losses:
Yesterday Deutsche Bank reported a $7 billion loss. As one analyst put it: “it would appear that either investment spend has been front-loaded or alternatively (and
far more likely in our view) that the bank has also been forced to book elevated credit losses during the quarter.†According to the Wall Street Journal, Citigroup and Wells Fargo have been forced to add to loss reserves against loans to the energy section. The CEO of PNC Financial Services Group admitted: “It’s starting to spread†as regional banks have also reported mounting losses to the commodity sector. (…)
So, it may well be (…) that the banking system is handing out loans to all and sundry. As he indicates, this also happened right before Lehman failed, as the banks extended credit lines in a desperate attempt to prevent the long-term, illiquid collateral from becoming completely impaired. But, the monetary base against which they are levering is getting smaller, meaning leverage is increasing, making the system more brittle, not less.
As banking losses mount, the Fed will be forced to unleash QE4. Gold will soar, and monetarism will lies in ashes, having been utterly refuted. Perhaps they will
become Austrians.
But this is not a repeat of the subprime crisis. One, large banks are not much exposed to oil; two, their balance sheets are much stronger than in 2008; three, there is a clear and significant offset to the collapse in oil and other commodity prices: increased purchasing power for consumers and lower costs for most companies. The winners far outnumber the losers. In fact, spreads on financials bond yields have continued to narrow in the last 6 months. They had increased continuously between 2004 and 2007 before spiking in 2008 as the crisis erupted.
The growth scare on the U.S. economy has been a recurring theme since 2009. Each scare has come and gone and this one looks similar given the status of the consumer, the energy windfall, and continued low inflation and interest rates. The Economic Surprise Index is a good reflection of the swings in economic sentiments and how unreliable economic forecasts are:
The U.S. manufacturing sector is very weak but it is not collapsing in spite of its numerous headwinds. Markit’s flash U.S. manufacturing PMI rose from 51.2 to 52.7 in January:
Survey respondents mainly commented on higher output levels in response to positive new business trends and expectations of improving domestic demand over the months ahead.
Volumes of new work strengthened in January, after coming close to stagnation at the end of 2015. The latest increase in new orders was the fastest for three months. (…) Companies that reported an overall upturn in new work mostly cited improving domestic economic conditions. The main exception to the wider trend was among manufacturers facing cutbacks in new orders from clients in the oil and gas sector.
As to the equity and high yield markets behavior, their record as recession indicators is pretty bad in terms of false signals.
Especially during downdrafts, many investors impute intelligence to the market and look to it to tell them what’s going on and what to do about it. This is one of the biggest mistakes you can make. As Ben Graham pointed out, the day-to-day market isn’t a fundamental analyst; it’s a barometer of investor sentiment. You just can’t take it too seriously. Market participants have limited insight into what’s really happening in terms of fundamentals, and any intelligence that could be behind their buys and sells is obscured by their emotional swings. It would be wrong to interpret the recent worldwide drop as meaning the market “knows†tough times lay ahead. (Howard Marks)
Investor sentiment is rarely a reliable tool except when most bulls morph into bears (charts from Ed Yardeni):
Last on the list of concerns are central banks stimulus. Evercore ISI’s Krishna Guha is not concerned:
We believe that the dovish ECB meeting today is a prelude to further dovish action from the Fed and BoJ next week. We anticipate that the Fed will signal a “time out” on further hiking and sees a higher than consensus probability — maybe now greater than 50/50 — that the BoJ will increase QE with additional equity ETF purchases.
(…) In a telling example, European Central Bank President Mario Draghi sent a strong signal Thursday he is prepared to launch additional monetary stimulus in March, a response to persistently low inflation tied to slow growth and falling commodities prices.
“We don’t give up,†Mr. Draghi said at a news conference in Frankfurt. “We are not surrendering in front of these global factors.†(…)
Mr. Draghi disappointed markets with a smaller-than-expected stimulus just seven weeks ago. On Thursday he said the central bank would “review and possibly reconsider†that package at a meeting on March 10, when the latest growth and inflation forecasts issued by ECB staff economists will be available.
The ECB’s 25-member governing council was unanimous in underlining its “power, willingness and determination to act†against persistently low inflation, Mr. Draghi said, and that “there are no limits to our action, within our mandate of course.â€
(…) he said “circumstances have changed†since December, pointing to volatility in emerging markets and a 40% drop in the price of oil since the cutoff of the bank’s last economic projections. Risks from emerging markets are worrying for policy makers because they are a key source of European export growth.
“If oil feeds into other prices, that could generate exactly what we want to avoid, namely a spiraling downward phenomenon†of wages and other prices, Mr. Draghi said.
“I think the credibility of the ECB would be harmed if we were not ready to review and possibly reconsider monetary policy stance when we would have full information,†Mr. Draghi said. (…)
- In Japan, calls are increasing for Bank of Japan Gov. Haruhiko Kuroda to launch new stimulus measures as early as next week, with Japan’s economy sputtering and inflation near zero.
“Japan’s underlying price trend isn’t deteriorating. But some indicators on inflation expectations have been somewhat weak,” Kuroda told reporters at the World Economic Forum in Davos, adding that he would carefully watch how recent global market turbulence affects Japan’s economy and prices. “We won’t hesitate adjusting policy, including easing policy, if necessary to achieve our 2 percent price target,” he said. Kuroda, however, did not comment on whether the BOJ would ease policy at next week’s rate review. (…)
- In the U.S. and U.K., central bank officials are reluctant to overreact to volatile stock markets because modest economic growth appears to be on track. Oil price declines are also seen as a sign of booming global supplies, which could help consumers, rather than of weakening domestic demand. Still, the pace of rate increases in both economies, already projected to be gradual, could slow further in the face of downward inflation pressures. (…) Earlier this week, Bank of England Governor Mark Carney said he was in no hurry to raise rates after warning last summer the central bank might be in a position to move them up by the turn of this year. Mrs. Yellen might take Draghi’s cue and also say that circumstances have changed…
(…) It is because of the long-term debt cycle dynamics that we are seeing global weakness and deflationary pressures that warrant global easing rather than tightening.
Since the dollar is the world’s most important currency, the Fed is the most important central bank for the world as well as the central bank for Americans, and as the risks are asymmetric on the downside, it is best for the world and for the US for the Fed not to tighten.
Since the long-term debt cycle issue is the biggest issue that separates my view from others, I’d like to briefly focus on its mechanics.
What I am contending is that there are limits to spending growth financed by a combination of debt and money. When these limits are reached, it marks the end of the upward phase of the long-term debt cycle. In 1935, this scenario was dubbed “pushing on a stringâ€.
This scenario reflects the reduced ability of the world’s reserve currency central banks to be effective at easing when both interest can’t be lowered and risk premia are too low to have quantitative easing be effective. (…)
That is where things now stand across the world’s reserve currencies, where the expected returns of bonds (and most asset classes) are relatively low in relation to the expected returns of cash.
As a result, it is difficult to push the prices of these assets up and it is easy to have them fall. And when they fall, there is a negative impact on economic growth.
When this configuration exists — and it is also the case that debt and debt service costs are high in relation to income, so that debt levels cannot be increased without reducing spending — stimulating demand is more difficult, and restraining demand is easier, than is normally the case.
At such times the risks are asymmetric on the downside and it behoves central banks to err on the side of waiting until they see the whites of the eyes of inflation before tightening.
That, in my opinion, is now the case.
So:
On December 18, at 2037 on the S&P 500 Index, I downgraded my equity rating from 3 stars to 2 (YIELDING TO HIGH YIELD):
I now believe that economic and financial conditions will not allow valuations to climax in the yellow zone, let alone reach the “Extreme Risk†area. In fact, investors are much more likely to seek safer grounds in coming months and downside to the 17.5 range on the Rule of 20 is quite possible as a result. At current earnings and inflation levels, this would take the S&P 500 Index down to 1825, 9% below current levels. (…)
This is clearly a risk-off financial market with declining long-term moving averages on equities. Not friendly and rather dangerous. And I fail to see any chance of a credible Fed put around the corner.
On January 14, at 1890, I increased the downside risk to 1675 or 16.3 on the Rule of 20 scale which is the lows of 2011 and 2012. Uncertainty was rising every day boosting risk aversion among investors and equity analysts. People, getting scared of a black swan event from the credit markets, began to assume for the worst, potentially leading to panic selling that could take us to 2011 low of about 16.3.
The near future is muddy enough (China, oil, credit) with little possibility to rely on strong and rational leadership (China, Saudis, Iran, Fed) to warrant more than usual caution even if a recession probability is low. Meanwhile analysts and corporate officers are also highly cautious which is driving earnings estimates lower. A strong earnings season with ok guidance might restore confidence once again. Let’s see.
Q1’16 estimates are being ratcheted down by worried analysts led by prudent corporate officers. Also, Christmas was not strong enough to help rapidly eliminate the inventory overhang, potentially slowing manufacturing production in early 2016.
At current levels (1907), the Rule of 20 P/E is 18.4, implying a 9.9% upside to fair value (2095, reduced from 2110 due to the recent increase in core inflation from 2.0% to 2.1%). Downside to 17.5 is 4.8% but it rises to 11.4% (1665) in the worst sentiment scenario (16.3 on the Rule of 20 P/E). Buying on dips is appealing but the 200-day moving average is falling and earnings and guidance need to be closely monitored in coming weeks.
(…) Lex has run the slide rule over the Footsie and Nikkei since the early 1980s, and the S&P 500 since 1950. What are the returns for those buying on the day these bear markets first breach that 20 per cent fall? The short answer is: not too bad.
The average return (excluding dividends) from nine identified entry points on the S&P was 2.9 per cent over the next quarter and 9.9 per cent in a year.
The outcome for the four putative trades in the FTSE was worse, with a 1.9 per cent quarterly rise, and a flat return on the year — partially reflecting how the FTSE missed half the 1980s bull run.
As for the Nikkei, quarterly returns were great (6 per cent) and annual returns flat — good, given the downward drift of the Nikkei for most of this time.
A 20 per cent retracement can mark a great buying opportunity, such as after the crash of 1987. As recently as 2013, a Nikkei bear drop fooled investors, sounding the alarm just before Abenomics boosted the market 16 per cent in a month. On Friday, it rose almost 6 per cent. A lesson for 2016: a monetary bazooka can always outgun numerological mumbo-jumbo.
“The short answer is: not too bad� Perhaps if you were there throughout the 52-year period considered. If we exclude the first 3 periods, the averages drop to 1.4% and 1.2% for the next quarter and next year returns respectively with only 50% odds of success.
A much better tool is the Rule of 20 P/E. Here’s where it was when each bear became official (with the actual P/E in brackets):
- Oct 21, 1957: 14.9 (12.0)
- May 28, 1962: 17.0 (17.4)
- Aug 29, 1966: 17.5 (14.0)
- Jan 29, 1970: 21.0 (14.8)
- Nov 27, 1973: 20.2 (12.0)
- Feb 22, 1982: 15.2 (7.6)
- Oct 19, 1987: 17.3 (14.1)
- Mar 19, 2001: 24.9 (21.9)
- Jul 19, 2008: 24.2 (18.6)
The actual P/E was of no help at all in. But when the official bear came with a high Rule of 20 P/E, it meant the bear was not complete and remained dangerous. When it came with a Rule of 20 P/E well into the Lower Risk area (below 18), the bear became much more sympathetic. Using the Rule of 20, waiting for the right bear ending has a 100% batting average.
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