It’s time for another rendition of Bull v. Bear. This isn’t an exhaustive list, but it’s a good appraisal of the major factors at the forefront of my mind. The Bear case is overwhelming; I’m left confident that a bear lay just around the bend, although catalysts for longer-term prospects are percolating…
- US Dollar Index (DXY)- USD has traded alongside its 1996 analogue: it found resistance at the right shoulder of a false Head & Shoulders top two weeks ago, and it’s now working toward neckline support. 1996 suggests that neckline will hold (hence the “false” H&S), from where DXY will rally 42% over the long term. DXY’s reaction upon reaching its neckline between 78.00-79.00 (-2.5%) will tell all, particularly since this short term pattern is trading into the vertex of a longer term symmetrical wedge, which means a significant breakout will occur in one direction or the other.¹
- NASDAQ (COMPQ)- QQQ is barreling toward right shoulder resistance of a classic H&S top, complete with bear divergence on daily indicators. I won’t delve into an analysis in this entry, but I wanted to mention it as something that reinforces my confidence in the bearish SPX read.
- Credit Cycle- There are signs everywhere that the credit cycle will to spin out of control. Historically normal corporate bond technicals (e.g. credit spreads) are masking frothy fundamentals. At the same time, it’s hard to reconcile analysts who cite record corporate cash balance with the reality of resurgent net debt levels. While corporate leverage may look like its only starting to ramp, it’s hovering high above a healthy range: currently at 1.7x vs. 1.2-1.5x normal range. Leverage peaked at 2.1x & 2.3x highs in 2002 & 2009 respectively. You’ll notice that these ratios spiked to their ultimate highs in the middle of crises (not at the beginning), because asset values in the denominator crashed. The aggregate of cash flow statements show companies locking-in cheap financing and using the cash to refinance/roll outstanding liabilities or [more commonly] pay dividends in lieu of immediate investment opportunities. Of course CFOs have reasonable cause to obtain long-term debt at ZIRP spreads, but the interest expense will burden margins in a slow growth environment until Discounted Cash Flow (DCF) models start projecting better investment/project opportunities. Further, the resurgence of Paid In Kind (PIK) bonds and Collateralized Loan Obligations (CLOs) are both early signs of exuberance–“early” because credit investors have only just begun to bid in the space.
- Bifurcated economy- I’ve realized that it’s time for SPX to recouple with the slow-growth economy. Why now? Well, corporate profit margins are at 70-year highs, while wages’ share of GDP has reached an alltime low. SPX margin growth has stalled at its outer bound after companies have cut through flesh to the bone. Corporations now need revenue growth for earnings expansion, which means they need a boost from households. That can’t happen with labor operating off belittled wages. Stubbornly high household savings* (part & parcel with consumer deleveraging) is a symptom of the pressure on consumers. Household incomes have to recover–hopefully the easy way–and that recovery will occur at the expense of corporate margins.
- Inventories- Business inventories have returned to their cyclical ceiling, a boundary that has served as a reliable bearish indicator throughout history. Were inventories to wane, I expect to see early signs crop up in railroad traffic data.
- *US household savings & deleveraging- The private sector has continued to deleverage, with savings making an impressive comeback since 2007’s lows. The government has filled the spending void with its own deficit accumulation. If you were to view the interchange between public and private sectors like osmosis (as most modern economists do), the $1.128T federal deficit is not that much compared to $7.61T consumer deposits. (Those deposits are only a portion of private sector savings, excluding corporate cash, for example.) A modest increase in private investment (decrease in savings) could alleviate some/all of the pressure on the federal deficit. That dynamic was seen empirically from 2009-present: In 2008, private investment fell -22% (worst drop in postwar era), and the government took the reins to displace this lost production. As private investment recovered between 2009-12, the deficit shrank from 10.1% to 7.0% of GDP (the fastest reduction in postwar era). The fiscal cliff, however, threatens to unnaturally pull forward secular, public sector deleveraging.
- Housing recovery- Increased housing investment can wholly repair what remains broken with the economy and fiscal imbalances. In addition to savings data, homeowners en masse have deferred residential investment (along with a lot of other durable goods) for 5 years now, which turnaround would be part & parcel with the aforementioned pickup in private investment.
- QE3 transmission- Mr. Bernanke’s latest round of easing hasn’t had sufficient time to work its way through the system. The growth in bank reserves (and as an extension, the monetary base) has begun to rise since the program initiated, but the effect is still modest in context. Weekly POMOs (~$27B) have hardly offset MBS paydowns (~$20B) from rolloffs/prepays. With only $50B in short term notes left to sell, the Fed will succeed Operation Twist with unsterilized monetization in 1q13.
- Technical Breakdown- For the aforementioned technicals to fail, bear divergence in daily & weekly technical indicators would need to be broken. Due to the SPX charts’ construction (and the raw math), this would happen simultaneously on each fractal. Such reversal out of damning divergence is conceivable. Further, it would go a long way toward aiding the monthly fractal’s test of the secular bear market—something that’s proven very stubborn, as I mentioned back in August.
- Bonds’ Duration Risk- Agnostic to economic forecasts, this is a warning for bonds buyers, particularly those of constant maturity bond funds (NAVs). In a long term chart of 10y Treasury yields, you’ll notice the round-trip interest rates have made—back to zero after the 1980s peak. As a homeowner gets excited to lock in a 3.5% mortgage rate for 30 years, bondholders should be growing equivalently anxious given their interest rate risk. Per the properties of bond duration, a 1% rise in interest rates would translate to -7% in losses in municipal bonds and -20% in Treasuries. Particularly if your fixed costs are already rising, interest rate risk is something to think about for the long term. This flight into risk assets is the effect the Fed hoped to coax with ZIRP/QE, and it votes for equity outperformance.
¹I have to acknowledge the different macro backdrops between the mid-90s and today though. What’s unique about 1996 is that both equities and USD strengthened through the end of the decade—an unconventional, positive correlation for a pair that usually move inverse of one another. I’ve compared SPX in 1996 to today’s market, and they look much different. In ’96, SPX had rallied unabated for years; it was full tilt, having bumped & run into steeper and steeper pitches with every passing year without correction. While today’s SPX is near multiyear highs, it’s not been without kinks in the road. SPX technicals are bearish, as I’ve covered ad nauseum in this Diary, so I don’t think we’ll get a resurgence in the strong Dollar/strong stocks relationship quite yet.