As US Stocks Set New Highs, How do Corporate Bonds Look?

February 13, 2017

The S&P500 rose another 0.8% last week in what looked like a resumption of the “Trump trade” that is betting on lower corporate income taxes to boost corporate profits and overall economic growth in the near future. Whether any of Trump’s market-boosting proposals actually get implemented is far from certain, but the US stock market doesn’t care; it is starting to price all this in as a certainty. In the meantime, since sales and overall profits are not yet rising, valuations are getting even more stretched. For the S&P500, price-to-sales and price-to-10 year earnings (Shiller PE) are at levels seen only once or twice over the past 100 years!

In US economic news last week, the results were mostly week. One exception was initial jobless claims, which hit another multi-decade low. The problem with reading too much more positive news into this reading is that history suggests that once claims fall to current levels, they don’t fall much further; in fact, from these super-low levels, they usually begin to climb. The other reports were weak. Gallop’s measure of US consumer spending plunged. Job openings, as measured by t he JOLTS employment survey, fell. Consumer credit missed expectations by a lot. Import prices jumped; this hurts corporate profits. Meanwhile export prices barely budged. Consumer credit also missed.

Since almost all broad and well-established measures of US stock market valuation clearly show that prices are on the high side of average, an investor looking for value could naturally ask about the other major corporate security available to buy—corporate bonds. Specifically, how do the prices of investment grade and high yield bonds look?

One important measure to assess is the yield spread between corporate bonds and comparable (in terms of maturity) US Treasuries. When the spread is large (ie. the corporate bonds pay a lot more than the comparable Treasuries) then the corporate bonds are priced lower….in other words, more attractively. When the spread is small, then the corporate bonds are priced high.

Today, the spread between Treasuries and high yield corporate bonds is as low as it’s been since before the Great Recession began. In other words, high yield bonds are not cheap; arguably, they are expensive and offer little value.

For investment grade corporate bonds (say BBB rated paper), the same is true—spreads are lower than they’ve been since late 2014 and the period before the Great Recession began (2004-2007). So investment grade corporate bonds are also not cheap; arguably, they’re expensive.

Once again, this makes life difficult for anyone trying to build a value-oriented portfolio. Not only are most US stocks very expensive, but so are most US corporate bonds. And given that stocks and bonds make up the bulk of any large investment portfolio—at least they ought to—this means that when the next market correction hits, even a well diversified portfolio will get hurt more than it might otherwise, since both corporate bonds and equities will most likely retreat in valuation.


Gold and Silver Poised to Jump?

February 6, 2017

The S&P500 ended last week essentially unchanged…..actually rising but by an ever so tiny 0.1%. Volume was light, which is unsurprising in a market that showed no net direction during this period. And volatility also didn’t move much, but more so because it was already hugging multi-year lows; investors remain super complacent.

In US macro news, the week got off to a poor start. Personal income missed expectations; personal spending only met expectations. The Case-Shiller home price index (20 city, not seasonally adjusted) missed expectations—while home prices rose, they rose far less than expected. The Chicago PMI result was a disaster, coming in far below the consensus estimate. Consumer confidence also missed. Construction spending missed, and so did ISM services. On the positive side of the ledger, ISM manufacturing beat expectations. Initial jobless claims were better than expected. And factory orders also exceeded expectations. The big number of the week, payrolls, was a mixed bag. On the one hand, the headline jobs number was stronger than expected, but on the other hand, headline unemployment ticked higher and average hourly earnings missed badly.

Given that the S&P500 barely budged last week, the technical picture also didn’t change much—the S&P remains extremely stretched to the upside and looks very vulnerable to at least some sort of sell-off….at the very least, a retreat back down to the 50 day moving average would be a simple target. Instead, it continues to hug the upper Bollinger Band, suggesting it’s somewhat above fair value.

Technical analysis, meanwhile, is painting a bullish picture for precious metals. Both gold and silver have traced out a long-term (weekly) inverted head-and-shoulders formation on their respective charts. One key part in this formation was the failure of both gold and silver to make a new low in late 2016; the prior major low at the end of 2015 was deeper. The second and remaining part of this formation involves the neckline and whether or not it will be broken to the upside. For gold, this is around $1,400 which was last seen in mid-2016. If gold rises, and stays, above this level, then there could be a lot more upside ahead for it. So precious metals will be interesting to watch over the upcoming weeks and months.

Challenging Times for Investors

January 30, 2017

Last week the S&P500 made another modest jump higher. With most of the advance occurring on one day, the S&P closed up 1% by the end of the trading week. Volume was light, and volatility—as measured by the VIX index—dipped down to levels not seen since 2014. This is an amazing situation:  as investors push stock prices in the US reach to all-time highs, these same investors are buying very little insurance against potential losses from these all-time highs. Most investors are throwing caution to the wind and believe that stock prices simply can not fall, at least not by much.

So in terms of technical analysis, prices are even more stretched than they were last week…..on both the daily and the weekly chart resolutions. And in terms of broad, long-term valuation measures (measures that are more stable that the simple P/E ratios because E, or earnings, is so volatile), prices are near multi-decade highs.  The price-to-sales ratio, the price-to-GDP ratio, and the more stable Shiller PE ratio are all clearly screaming that the bull market that started in 2009 has pushed valuations to levels that have been attained only a tiny percentage of the time (in terms of weekly closes) in the last hundred years. And every time this has happened in the past, future (or prospective) returns from those stretched valuations have not only been dismally low, but they’ve usually translated into losses over the shorter (one to five year) horizons.

One of the unfortunate consequences of this run-up in prices, is that anyone—professional or not—who’s been the least bit concerned about normal pull-backs in equity prices (or even more serious drops such as an emergence of another bear market) has been brutally punished in terms of performance results. Historically, it almost always paid off, in terms of investment performance, to protect against downside movements in equity prices, typically with hedges in the same asset class (equities) or by owning assets that are negatively correlated with equities (such as US Treasuries).  But in this latest bull market move, the most successful strategy has been to be 100% long US stocks, with no hedging. Even better–you could beat the stock market if you levered up by borrowing money to buy even more stocks; very risky, but this has worked for the relatively small percentage of money managers who’ve done it.

What has this meant for those who have not done this—simple: poor performance. For example, in the world of US hedge funds, where some of the smartest and most experienced money managers do their work, about 90% of them have under-performed the S&P500 since 2009. Yet another example is Harvard University, which boasts of having the largest university endowment in the country—Harvard’s endowment recently reported a 2% loss for the fiscal year 2016. What’s worse, the size of Harvard’s endowment at the end of fiscal 2016 ($37.7 billion) was essentially unchanged from where it stood at the end of fiscal 2007 ($37.4 billion). That’s nine years of no net growth, despite employing an army of the best and the brightest money managers in the world!

Of course, this situation will change at some point, but until it does, the challenging times for investors may continue for a bit longer.

As Stock Market Prices Cling to All-Time Highs, Internals Deteriorate

January 23, 2017

The S&P500 dipped a very insignificant 0.15% last week, ending the week essentially unchanged from the prior week. S&P volatility inched up a bit higher, but the VIX index still closed near the very low end of its long-term range. And equity trading volumes were light—but a big part of that had to do with the MLK holiday which reduced the number of trading days last week.

In macro news, the reporting was light and mixed in terms of results. On the positive side, industrial production beat expectations. Initial jobless claims dropped to a multi-decade low. And the Philly Fed survey beat consensus estimates. On the negative side, the Empire State Manufacturing Survey missed. The housing market index also missed. And consumer prices—both headline and core—came in just as expected.

The technical picture for the S&P500 has not changed much. After reaching the present price levels early in December—on the heels of the Trump presidential election—the S&P500 has not moved much. And since the upward price movement has stalled, momentum indicators have turned bearish. The loss of upward momentum doesn’t suggest that any big fall is imminent; it does suggest that a minor pullback would be normal to see.

On the other hand, several longer-term breadth indicators are sending bigger warning signals, signals that do suggest that a larger drop should be unsurprising. While prices hover near all-time highs, the number of issues advancing minus the number declining is now negative…..not something you normally see in a healthy, rising stock market.  Also, the McClellan Oscillator has now turned negative….something that usually precedes larger drops in stock prices. Finally, the percent of stocks above the 50 and 150 day moving averages has turned down; also not good for the near-term prices.

Finally, the Fed had now openly communicated that it’s near-term policy will be to raise rates. This is therefore a tightening policy, a policy that stock markets rarely celebrate (as interest rates go up, corporate profits get reduced by higher financing costs, and consumer purchasing power also gets reduced by higher financing costs).

So while stock market prices cling to super high levels, market internals are deteriorating and interest rates are rising. This has never—-in the past—-boded well for future stock market prices.

Buy the Election….Sell the Inauguration?

January 17, 2017

The S&P500 went pretty much nowhere last week. To be precise, it slipped a minuscule 0.1%. Volume rose but this happened mainly because, by comparison, the prior week’s volume was shaved down by a holiday. S&P volatility remained super low—the VIX index hovered near the extreme lows last reached in the summer (of 2016) months.

As has been the case for the last several weeks, the S&P500 remains extremely overbought. On both the weekly and the daily charts, the S&P continues to hug the upper Bollinger band and is well above the 50 day moving average. From these levels, even a small pullback to this 50 day average would seem very reasonable over the next week or so.

Last week’s macro reports came in mostly on the weak side. While initial jobless claims were better (lower) than estimated, both wholesale trade and business inventories beat consensus estimates, everything else missed expectations. The labor market conditions index fell. Retail sales—both headline and core—missed consensus estimates. Consumer sentiment was lower than expected and core producer prices were hotter.

So as usual, there are no conclusive signs that the US economy is about enjoy any strong growth spurt. Instead, it continues to stumble along, the same way is has since it first came out of the Great Recession.

Finally, there’s been a lot of post-election analysis of the US stock markets—analysis that’s focused on the massive bounce that occurred after Trump got elected President. Most experts missed this trade; in fact, most of these same experts predicted the opposite—if Trump were to get elected, they claimed, then markets would tank. So over the these past 60+ days, many of these same experts have been jumping—even if a bit late—-onto this stock buying spree. Meanwhile, US Treasuries have been sold off hard; the US 10 year note yield has risen, just since the election, by almost 100 basis points.

But over the last couple of weeks, the US 10 year note yield has started backing off those highs. And as of Friday, this yield has now fallen by about 30 basis points. The reason this is important is because the yields in the US Treasury market are somewhat correlated to the US stock market prices: when stocks rise, US Treasury prices tend to fall….and vice versa.

So this recent decline in yields is important because it suggests that as more money flows into the safety of the Treasury market, that there’s a chance the buyers of Treasuries will be sellers of US stocks.

And given that there’s been such a huge run-up in stock prices since the election, even a modest selloff—after the inauguration—would make sense.

US Stock Markets Continue to Levitate

January 9, 2017

After dipping the prior week, the S&P500 resumed its recent bounce and rose a strong 1.7% last week. Volume was very light, but once again this was due more than anything else to the holiday season and reduced number of trading days At the same time, stock market volatility dropped even further, this time roughly matching the lows reached in the normally super complacent summer months.

In US macro news, the results were mixed to weak. While PMI manufacturing rose a bit from last month, and ISM manufacturing beat expectations, most other reports were disappointing. Mortgage applications—for both refinancings and purchases—dropped again.  The ADP employment report missed, fairly badly. PMI services also fell. International trade was worse than expected. Factory orders missed. And the big report of the week—payrolls—was disappointing.  Fewer jobs were created than economists had predicted. While average hourly earnings rose, the average workweek fell. Also disappointing was the labor force participation rate which showed no signs of improvement; instead, it’s still hovering near multi-decade lows.

Technical analysis continues to show an extremely over-stretched stock market.  Prices are literally moving up an off the charts…..on both the daily and weekly resolutions.

But that would be OK if valuations were not so obscenely….when viewed by historical comparisons….high.  For example, in the S&P500 the enterprise value of all businesses divided by their total earnings before interest and taxes (EV/EBIT) is now as high—or higher—than it was during the tech bubble!

Yet investors continue to buy, buy, buy….clearly with the implied expectation that regardless of today’s obscenely high values future valuations will climb even higher. In short, most stock market investors have now succumbed to the greater fool theory—-primarily based on the fact that this theory has seemed to work over the last couple of years and also because everyone can point to the still very accommodating monetary policies of the Federal Reserve.

Clearly, these investors have forgotten the fact that the greater fool theory never works forever. Also, these investors are ignoring the fact that not only has the Fed already raised rates twice in this cycle, but it has signaled that it will be raising them three more times later this year.

Surely, most of these investors know fully well what they’re doing—they’re picking up free nickels in front of a deadly steamroller. And they’ll all be able to get out of the stock markets just before any serious selling begins…if it ever even begins.


US Stocks End the Year with a Whimper

January 3, 2017

The Santa Claus Rally somehow failed to arrive in the last week of 2016. Instead of rising slightly—like they do more often than not during this holiday season—the S&P500 slipped 1.1%.  Volume of course was light, again due to the holiday period. And volatility jumped, more that the slight drop in prices would have predicted. The VIX index rose from roughly 11 almost 15, or about 30%…..not an insignificant increase.

Things were quiet in US macro news. The Case Shiller home price index showed another very modest rise in prices. What’s more notable is that now—fully five years after the US housing market bottomed in late 2011 and early 2012, the US housing market has fully regained all those losses and returned to all-time high prices across most major metropolitan markets. Consumer confidence beat expectations, most likely on the back of near record high prices in the US stock markets. Pending home prices however, missed expectations, most likely due to the two-month run up in mortgage rates. International trade also disappointed. Initial jobless claims increased more than estimated and finally, the Chicago PMI missed, quite substantially.

An interesting divergence has now developed in the US equity charts. While the weekly resolution still shows that an uptrend in prices is still fully in effect, the daily charts show a completely different story. They point to a recent breakdown in momentum, and with last week’s losses in the books, they suggest that the uptrend in prices has begun to break down. So this upcoming week will be enough to resolve this divergence. It should only take about five days to determine if the longer-term weekly charts will be correct (and the uptrend will resume) or if the shorter-term daily charts will be correct and continue to push US stocks lower.