The good news is that over the last month, the bulls have had their wish list fulfilled.
- The ECB (European Central Bank) announces more QE (Quantitative Easing) and reduces capital constraints on foreign banks.
- The Fed reduces capital requirements on banks and initiates $60 billion in monthly treasury purchases.
- The Fed is also in the process of cutting rates as concerns over economic growth remain.
- Trump, as expected, caves into China and sets up an exit from the “trade deal” nightmare he got himself into.
- Economic data is improving, on a comparative basis, in the short-term.
- Stock buybacks are running on pace to be another record year. (As previously noted, stock buybacks have accounted for almost 100% of all net purchases over the last few years.)
Here Is A Short List Of US Economic Concerns
Currently, the market is continuing to wrestle with a rising number of risks:
- The Fed Is Pushing On A String: A mature, decade old economic recovery will not likely be revived by more rate cuts or by lower interest rates. The cost and availability of credit is not what is ailing the US economy. Market participants are likely to lose confidence in the Fed’s ability to offset economic weakness in the year ahead.
- Untenable Debt Loads In The Private And Public Sectors: “Katy, bar the door!” should rates rise and debt service increase. (As I noted all week, the corporate credit markets are already laboring and, in some cases, are freezing up).
- An Unresolved Trade War With China: This will produce a violent drop in world trade, a freeze in capital spending, and a quick deterioration in business and consumer sentiment.
- The Global Manufacturing Recession Is Seeping Into The Services Sector: After years of artificially low rates, the consumer is no longer pent up and is vulnerable to more manufacturing weakness.
- The Market Structure Is Frightening: The proliferation of popularity of ETFs (Exchange-Traded Funds) when combined with quantitative strategies (e.g., risk parity) have everyone on the same side of the boat and in the same trade (read: long). The potential for a series of “Flash Crashes” hasn’t been so high as since October 1987.
- We Are At An All Time Low In Global Cooperation And Coordination: In our flat and interconnected world, what happens to global economic growth when the wheels fall off?
- We Are Already In An “Earnings Recession:” I expect a disappointing Q3 reporting period ahead. What happens when the rate of domestic and global economic growth slows more dramatically and a full blown global recession emerges?
- Front Runner Status Of Senator Warren: Most view a Warren administration as business, economy, and market unfriendly.
- Valuations On Traditional Metrics (e.g., Stock Capitalizations To GDP) Are Sky High: This is particular true when non-GAAP earnings are adjusted back to GAAP earnings!
- Few Expect The Market Can Undergo A Meaningful Drawdown: There is near universal belief that there is too much central bank and corporate liquidity(and other factors) that preclude a large market decline. It usually pays to expect the unexpected.
- The Private Equity Market (For Unicorns) Crashes And Burns: Softbank is this cycle’s Black Swan.
- WeWork’s Problems Are Contagious: The company causes a massive disruption in the US commercial real estate market.
The Fed News
In less than 12 months, we have seen the Fed raise rates, cut rates, shrink its balance sheet, expand its balance sheet, inject liquidity, withdraw liquidity, and do who knows what else behind the scenes. Either Fed officials are confused or we are at some kind of economic turning point. Or, possibly both; there is no playbook. At a minimum, I think we are at a turning point and the Fed is having to improvise policy as events dictate.
Last week, the Fed quietly did an about-face. It swiveled from shrinking its balance sheet by $50 billion per month—effectively draining money out of the economy—to now expanding it by $60 billion per month. The money spigot is, once again, open.
The last time the Fed resumed expanding its balance sheet was in September 2012.
At the time, it was dubbed quantitative easing, often shortened to QE.
QE is when a central bank buys government securities—usually treasuries in order to raise the money supply, encourage lending and investment, and juice the economy.
QE is seen as unconventional monetary policy and has been used three times in the US:
The goal of quantitative easing is to push people out of conservative investments, like money market funds and bonds, and into riskier assets like stocks.
Remember when you could earn 5% on a savings account? Those days are long gone thanks to QE.
Ray Dalio On The Fed
Hedge fund owner Ray Dalio said the global business cycle is in a “great sag,” and the world’s economy holds at least two parallels to the 1930s.
Speaking on a CNBC-moderated panel at the IMF and World Bank annual meetins in Washinton, DC on Thursday, Dalio said it was now too late for central banks to make much difference as economies enter a natural downturn.
“This cycle is fading. We are now in the world in what I would call a ‘great sag,” said Dalio, adding that monetary policy, and especially interest rate reductions, were unlikely to offer much stimulus.
“Europe is at the limitation of that. Japan is (too), and the US doesn’t have much to go on for that,” he told CNBCs Geoff Cutmore.
Dalio said the world was also experiencing the biggest wealth gap since the 1930s, and that was creating political stress.
“In the United States, the top one-tenth of 1% of the population has a net worth that is approximately equal to the bottom 90%,” he said.
Dalio told the CNBC panel that China’s new swagger was further evidence the world now echoes the depression era of the last century.
“Also like the 1930s, we have a rising power challenging an existing world power in the form of US-China challenges.”
The hedge fund titan claimed there were four types of wars to watch for: trade, technology, currency, and geopolitical.
Latest Economic Information
Since the end of 2015, US GDP growth has steadily climbed. In the first quarter of 2016, it stood at 1.1%. It has averaged 1.9% year-over-year growth since then, reaching a peak of 4.2% in the second quarter of 2018. In the second quarter of this year, the growth rate was 2%.
Meanwhile, the economic strength around the rest of the world is slowing.
In the first quarter of 2016, China’s rate of growth was 6.7%. It peaked in the first half of 2017 at 6.9%. By the second quarter of this year, growth had slowed to 6.2%. Now, the Chinese government hopes to simply hit the low end of its target range for the year (6% to 6.5%).
Europe hasn’t fared much better. In the first quarter of 2016, growth in that region stood at 1.7%. It peaked in the fourth quarter of 2017 at 2.7%. It has since dropped to 1.2% during the second quarter of this year.
In both cases, the growth rate has steadily declined since peaking in 2017. If this recent trouble around the rest of the globe carries over to the US, it could create a ripple effect.
A number of data points over the past few weeks have shown that US economic growth could be slowing down:
It started with the Conference Board’s latest Consumer Confidence Survey on September 24.
The Conference Board is a private research group that releases a monthly report on the attitudes and spending intentions of US consumers. It helps us see how consumers are feeling. When they’re optimistic, they spend. When they’re pessimistic, they save.
In September, the numbers were much weaker than expected.
The index dropped for the second straight month, falling from 134.2 in August to 125.1 in September.
On October 1, the Institute for Supply Management (ISM) released its latest Purchasing Managers’ Index (PMI) data. It’s a broad survey of US manufacturing activity. A reading of more than 50 indicates expansion, while less than 50 signifies contraction.
This information is important for Wall Street. The data are viewed as a “leading indicator” because they generally predict the economy’s future growth or contraction. When factories produce more, it’s because demand for their goods is rising. When they produce less, it’s because demand is declining. Overall US economic activity tends to follow this.
The PMI number for September was much weaker than expected. It came in at 47.8, down from 49.1 in August. It was the second straight month showing contraction, and it was the lowest reading on this indicator since June 2009 – the last month of the Great Recession.
That tells us the US manufacturing slowdown is getting worse. New orders, new export orders, production, and employment numbers were all weak, implying near-term growth will remain low.
The October 2 data release indicated that US businesses in the private sector added 135,000 jobs in September, lower than the expected 140,000. Even more important, at that time, ADP significantly reduced its estimate for August. The company now believes 157,000 jobs were created in the month, down from the original estimate of 195,000.
Over the past six years, ADPs data have indicated an average monthly gain of 198,700 new jobs. This year, the average monthly gain is only 173,200 jobs – a drop of about 13%.
On October 3, the latest release of ISMs Non-Manufacturing Index (NMI) signaled that the global weakness is starting to affect the domestic economy.
Most experts typically view the NMI as ancillary. Its subsectors include retail, utilities, agriculture and forestry, transportation and warehousing, mining, and public administration – services that all see increased demand when US manufacturing is growing. They’re much more domestically focused than the ISMs PMI subsectors. Many of these businesses support the manufacturing industry, so they wouldn’t see the same type of demand without it.
The NMI registered 52.6 in September, down from 56.4 in August. (Again, anything more than 50 indicates expansion.) While the latest data showed the non-manufacturing sector grew for the 116th straight month, more cracks appeared below the surface. You see, the NMI fell to its lowest level in three years. It was 51.8 in August 2016.
Year Over Year Industrial Production Comps
The furthest we can go back in order to have data for at least 3 of the 4 countries is 1979. The chart below shows the maximum year-over-year industrial production figure for them. If the indicator is below 0, it means that every country is seeing a decline in industrial production.
The last time this happened was 2008.
Looking at forward returns for the S&P 500 after all of them first fell below 0, there were some heavy declines over the next few months.
More Signs Of Contraction In The US Economy
We flagged disturbing weakness in the Cass Freight Index for you back in June. Now, it’s even worse, as their shipments index has shown year-over-year declines for 10 consecutive months.
Key Points:
- Weak volume and pricing in important air, rail, and truck markets points to economic contraction.
- Low spot transportation prices are consistent with disappointing housing starts and lackluster auto sales.
- Asian airfreight patterns suggest the region is on the verge of recession, if not already in one.
- Inbound air volumes to Shanghai have plummeted. This suggests lower demand for the components Chinese factories assemble into high-value tech devices.
- In the US, dry van volume is in line with capacity, suggesting the consumer economy is still relatively healthy. But, seasonally, we should be seeing higher volume right now, and its absence is troubling.
- Whether we blame normal cycles or trade disputes, growing evidence from freight flows says the economy is beginning to contract.
- Cass believes its data points to 3Q US GDP growth being negative or close to negative.
Bottom Line: Cass data is starting to show that growth is capped not by limited capacity, but slowing demand. This conflicts with other reports that suggest tight labor is constraining producers. Meanwhile, the Federal Reserve has been cutting rates and now intends to restart QE. Growth fear is spreading, but the response may be too late.
It is hard to miss the huge divergence between corporate after-tax profits and the lift-off of the S&P 500 index.
Some People Just Know When To Sell
Take mega private-equity firm Blackstone, for example. It has demonstrated an uncanny knack for enticing investors to buy its shares just when those same investors are about to take it on the chin.
“Blackstone Knows When to Sell” happened for the first time back in July 1998.
At the time, Blackstone was still a privately held partnership. The company sold a 7% stake for $150 million to insurance provider American International (AIG). As part of the deal, AIG also agreed to provide an additional $1.2 billion of investment capital to Blackstone.
As the Wall Street Journal reported, the Blackstone-AIG deal came at a time when institutional investors – apparently more interested in failing conventionally than succeeding unconventionally – were pouring “unprecedented amounts of capital into leading buyout firms.”
Blackstone didn’t say how it would use the additional $1.2 billion at the time. But, you know how it goes: borrow $1.2 million, you have a problem. Borrow $1.2 billion, and the bank has a problem.
The risk landed on AIG’s balance sheet. All signs point to Blackstone cashing up in the face of what the company – and in hindsight, embarrassingly few others – viewed as a potentially imminent downturn. As we now know, Blackstone was spot-on.
A month after Blackstone sold the 7% stake to AIG, the Russian government defaulted on its debt, crushing the Russian ruble and many hedge funds trading the country’s bonds.
Long-Term Capital Management (LTCM) became the most notable victim. LTCM was headed by a motley crew of pedigreed academic geniuses and Salomon Brothers alumni who didn’t survive that firm’s famous treasury bond scandal in the 1990s, as well as two Nobel laureates.
Apparently, they were all uniquely talented in the fine, complex art of borrowing $100 billion, levering up 100-to-1, buying a boatload of bonds, and blowing it all sky high.
LTCM threatened the integrity of the entire global financial system, requiring a $3.6 billion bailout from a consortium of 14 banks (which were run by even more financial weapons researchers, as we learned a decade later in the 2008 financial crisis).
In the fallout from the Long-Term Capital Management debacle, US stocks fell nearly 20% in a span of roughly 6 weeks from July 17, 1998 through August 31, 1998. The dot-com frenzy topped out less than two years later, kicking off a two-year bear market.
Blackstone: 1, Market: 0. Coincidence? Maybe, maybe not.
“Blackstone Knows When to Sell, Part Deux” was written and performed in July 2007.
The firm went public just 3 months before the housing bubble peaked and led into a 17-month bear market that took the S&P 500 down 58%. Pure coincidence, right? These guys can’t possibly be a band of living, breathing, bonus-mongering sell signals can they?!
Blackstone, Chapter 3, happened just a few months ago.
I’m talking about Blackstone’s conversion from a publicly traded partnership to a regular C corporation (C-corp). Why would the company decide to do that?
It’s simple. Blackstone wanted to sell into the biggest frenzy of our time: index funds.
When announcing the decision in April, Blackstone CEO, Steven Schwartzman, said other companies that transitioned from partnership to C-Corp had “experienced strong stock price performance, a meaningful pickup in trading volume, and a significant increase in mutual- and index-fund ownership.”
For everyday investors, those three considerations mean jack-diddly squat. But, to people running portfolios full of levered-up, illiquid assets that can’t sell at the drop of a hat, they mean absolutely everything.
In other words, mutual funds and other institutional portfolios have rules against buying partnerships. They’re too messy at tax time. The change to a C-Corp means anybody and everybody on Wall Street can now load up on Blackstone’s shares. Large institutions dominate trading activity today, so you have to sell what they’re allowed to buy.
Blackstone’s switch from partnership to C-Corp became official on July 1. On July 26, less than a month later, the S&P 500 hit a new all-time high, then promptly fell nearly 7% in less than 3 weeks.
For now, it’s easy for most investors and talking heads to write it off as a minor correction, but what if it’s not?
What if it’s a repeat of the 1998 Blackstone-AIG deal, with the market selling off in the near term and eventually giving way to a serious bear market less than two years later?
Are we, once again, looking at a massive “melt up” over the next year and a half, followed by an equally massive bear market rout for another year and a half after that?
It might be too much to expect history will rhyme that closely, but you have to admit, Blackstone is building a nice track record of facilitating the sale of its own stock into the frothy markets that prevail just before minor hiccups, major hiccups, and the near total suffocation of major bear markets.
Remeber, private-equity firms need some way to sell. They’re in the business of owning giant, stinking, levered-up piles of garbage they can’t sell because they’d have to write it down to reality and admit it’s garbage, endangering their sacrosanct bonuses.
US-China Interim Trade Deal
With limited substance behind the recent US-China trade truce, Morgan Stanley strategists remain deeply bearish on the S&P 500.
What does the “interim” mean for the GDP growth?
Hedge Funds
The Commodity Futures Trading Commission (CFTC) publishes a weekly report that shows how different types of traders in the US futures markets are currently positioned. It is a good way to estimate market sentiment. Speculative traders are one type of futures buyer, which are mostly hedge funds—a category the CFTC report labels as “non-commercial” traders. Right now, hedge funds are not betting the stock market is headed higher.
Market Data
- Stocks have held up well lately, more or less, but high-yield (junk) bonds are under-performing relative to other parts of the corporate bond market.
- The S&P 500 is up during the past 8 months, with a slow and choppy rise. Participation among its stocks seems to be waning, with fewer and fewer stocks managing to hold above their 50-day averages.
- Hedge fund managers appear to have ever-lower exposure to stocks, which has been a theme this year. It’s now on par with the ends of crises in 2002, 2008, and 2011. They also have near-record low exposure to most of the S&P’s major sectors.
- Soft sales: One economic prop that has buoyed sentiment in recent weeks has been the consumer. While other economic data has been poor (some even recession-era bad), most of them focused on the consumer have been good. Retail sales is a big one, and it just showed the first decline in six months.
- The S&P 500 has climbed, yet fewer than half of stocks on the NYSE have managed to rise above their 200-day moving averages.
