Diary of a Financier

Bull v. Bear

In Capital Markets, Dissertation, Economics on Wed 25 Sep 2013 at 11:16

I’ve spent considerable time this week synthesizing all of the information I’ve consumed over the past month(s) and rendering a timely, cogent market opinion.  The following, hard data attempt to substantiate an objective narrative that can guide me through the equity market over the coming days, weeks, months, and quarters…


  1. NYSE margin debt- A look at y/y real growth in margin debt vs the S&P 500 (SPX) shows a positive long term trend in credit extension against a negative trend in equity performance.Margin debt vs SPX performance- real growth y/y Margin debt gets deployed straight into the equity market, so there’s only one way to slice these decreasing marginal returns, as Deutsche Bank observed 9/13: “5-year rolling nominal global growth (GDP) is the lowest since the 1930s, so the performance of financial assets is almost entirely due to liquidity and not growth… food for thought as tapering starts before growth has proven self-sustaining.” Further, the post-summer MFI/volume spike I had awaited has arrived this month, as expected.  But, even though the kick ushered SPX to new alltime highs, the gains are in the process of being retraced, so I have to ask [disappointedly]: ‘That’s all we get!?’
  2. Debt ceiling debate- Fears of a US government shutdown or Treasury default are now manifestUS Treasury bonds sovereign CDS spread in credit markets after Treasury CDS spiked this week.
    • Counterpoint: This grey swan is a good thing—pointless panic that offers a buying opportunity.  Further, a long shutdown should force the Fed to prolong QE, as a taper wouldn’t be justified were output lost or a swath of aggregate demand deferred into 1q14.
  3. Energy renaissance & tech revelation- Now, hardly one month after I extolled these virtuous American cycles, I have to issue a near term warning: Wall Street has really latched-onto these themes and a lot of probable future growth has been fully discounted.  I know I’m pivoting awfully quick here.  Why here, why now?  Look at the silly momo charts of $AMZN $TSLA $IBB $IWM or any of the names on The Fly’s “very best tech stocks of the future” list.  We still stand to realize massive economic benefits from productivity gains in these industries, but it’s a long term story fraught with many short term hiccups—especially for capital markets, as separate and distinct from the economy.
  4. Housing recovery pause- Housing has made a massive contribution to GDP this year, and the Fed’s depending on it to keep clocking in 2014.  Recent data have affirmed that housing is taking a pause now, having been handicapped by rising rates.  Anecdotally, my wife and I have been looking for a home in the Boston suburbs, where there’s little inventory and most sales (in our wheelhouse) are settling above asking price, within a week of listing.  Agents won’t Housing recovery- 1992 analogue (JP Morgan)even work with you unless you’re preapproved for a mortgage.  I get the sense that demand is being pulled-forward as buyers fear missing-out on the generational low in mortgage rates.  That said, real estate is a local market with lots of geographic variance, so to be objective about this, I look at Homebuilders ($XHB)¹ like $DHI $HOV $KBH $PHM $TOL, which have all corrected 30-40% from their 2013 highs—at which point there were clear signs of froth.  This recovery is analogous to 1990-94’s, which took a breather with a correction in 1992.
    • Counterpoint: These transactions that I’m guessing are being anxiously pulled-forward should pad housing-related data into YE13.  Also, shadow inventory is no longer a problem, as it’s either been liquidated or recovered by ZIRP, which allowed delinquent mortgagees to adjust/refinance at lower rates.
  5. Leverage- Corporate high grade leverage ratios are at an alltime high; bond issuance proceeds are still going toward capital structure initiatives (i.e. buybacks & dividends) instead of investment in future growth; and private equity’s heavy-hitters see little value in the US.  As ever, anxious buyers from fringe PE shops are undertaking nonsensical LBOs with exotic financing structures–a clear sign that value is so thin that it need be leveraged to bear significance.  One leveraged loan manager described underwriting as “loosey goosey” to me on 9/23. Credit risk premia have remained thin. Plus, QE tapering stands to pressure any fragilities that exist within the High Yield ($HYG) space.
  6. Fundamentals- SPX FY14 earnings consensus sits at $122.94 EPS, which translates to a 1844 price target (+9% from today’s close) at a 15x PE multiple, 1721 (+1.7%) at 14x, or 1598 (-5.6%) at 13x.  That looks like it leaves a pretty fatAnalysts Street consensus EPS- over-optimistic group think margin of safety were EPS to miss or multiples contract; we should expect as much in preparing for a worst case scenario… after all, the market has had to fade incessant downward consensus/guidance revisions over not only the past 2 years, but also 22 of the last 25 years.  That’s a huge part of why we experience multiple expansion in the first place (i.e. price rising faster than earnings).  Historically, the average forward EPS growth consensus estimate (FY1) is double the actual number, which means we can expect the currentFY14 growth forecast of 13.7% to actually come-in around 6.87% (~$115.5 EPS).  That means a 15x PE multiple would putSPX at 1732 (+2.3%), 14x at 1617 (-4.5%), and 13x at 1501 (-11.3%)–all leaving no margin of safety.
    • Counterpoint: SPX earnings yields of 6.5% still tower over Baa corporate bond yields at 5.42% in a rare, bullish inversion of the spread between the two.  This condition has persisted since 2010, but it has already quickly compressed—down to this 1.1pp premium from 1.8 at the end of Q2.  So while the static condition is bullish, the headwinds are overwhelming.  Namely, I still expect actual SPX multiple contraction in 2014, because a QE taper (and eventually a 2015 end to ZIRP) raises bonds yields, SPX sectors minus 200DMAsand therefore equity earnings yields should correlate.  The likely headwind of multiple contraction (rising earnings yields) is why I don’t care to consider SPX price targets using 16x or 17x PEs.
  7. Sector technicals- A number of SPX sectors are stretched far above their 200DMAs: $XLV $XLI $XLY $XLB all show unprecedented variances by historical standards, which begs for a correction to mean revert these large deviations.


  1. European recovery- A lot of Euroskeptics remain, so an EMU recovery hasn’t been fully discounted yet.  As European data start to realize a turnaround, the resonance could be powerful, considering that Europe accounted for 13.5% of 2010SPX revenues, before dropping to 9.7% in 2012.  US capital markets were resilient during the 2011/12Eurocrisis; imagine whatSPX can do with that wind at its back.
    • Counterpoint: Fed stimulus (QE & ZIRP) was extended to provide continuing support to the US economy/markets amidst the Eurocrisis, thus a Eurorecovery & QE taper is a much more modest net benefit than it may appear.
  2. SPY technicals- There are two concerns in the daily chart, including the primary, long term rising wedge pattern, whose SPY daily/30min/1mintrendline resistance held again this week, and the 2x bear divergence in MACD, which is akin to momentum being busted.  Other than that we have classic support at $168 (also the 50DMA) with a bull reversal underway in the stochastic and MFI.  Intraday fractals best emphasize that ongoing bull reversal, with the 15-minute in particular exhibiting a nice falling wedge that’s part of a larger bull flag with near 2x bull reversal.  Such a setup suggests that $SPY should breakout higher tomorrow—lest it get put in the penalty box to contend with $168 for another week.  Tomorrow, I’m looking for a SPY breakout >$168.5 first trendline resistance before testing second at $170.  A sustainably bullish breakout requires the maintenance of 15min bull divergence and resistance-cum-support.
  3. Inventories, Durable Goods & Railtraffic– These are 3 indicators I’ve watched religiously, and all 3 have ample room to run higher.  Inventories continue to slide on a y/y basis, but Inventory/Sales ratios remain near historic Inventories & Capital Goods- y/y growth & inventory/sales ratioslows.  Strong US (and global) PMIs suggest that new orders and manufacturing are both surging, which followthrough will be reflected shortly.  Further, railtraffic volumes have rallied impressively, which confirms this narrative.
    • Counterpoint: I’m concerned about subprime buyers’ share of durable goods purchases, particularly in the auto space.  Bank lending shows the same signs of consumer stress, with potential froth in subprime loans.
  4. M&A activity- Some prominent financiers like Steve Schwarzman ($BX) and Jimmy Lee ($JPM) have suggested that mergers & acquisitions will pickup before YE13.  They cite the same properties as discussed in the housing recovery node above: cash-flush corporations are under pressure to increase net income, so with a QE taper neigh, they’re going to make some deals while capital is still cheap and before it’s too late.
  5. Sentiment- Howard Marks’ (Oaktree) comments from August still ring true: everyone’s still conscious of the equity risks out there, and not everyone trusts the stock market yet, with memories of the crisis still so fresh.  You rarely have a bear market as a result of a grey swan, and you can’t have a bear market until everyone’s crowded onto the same side of the ship.


As is not always the case, this particular entry finds data conclusive enough to make a long term prognosis.  After weighing both sides of the balance against one-another, I’m coming-around to the idea of a 2014 bear market without an economic recession.  It takes data of high significance to persuade me toward such long term bearishness, because 90% of the time, the best strategy is keeping optimism as a default setting

This doesn’t mean the market will full-out crash or reach another generational low. It does prepare me for a bear market though. I’m particularly watching the credit cycle, which I’ve tracked studiously within these pages. Given the leverage within the system today and all the investors sent scurrying up the risk curve, I can envision a sudden washout in the junk debt space.  Not to keep repeating myself, but ZIRP sent investors chasing yield up the risk spectrum in fixed income (and even into equity for some)–a trend hastened by demographics. For its part, QE has created an artificial supply squeeze in risk-free paper too, since the Fed has cornered the market in Treasuries. That’s a dangerous combination: investors holding imperfect substitutes for their suitable assets without anywhere to run for safety (except cash).

So much can change over such a long time horizon too, and I must admit that I expect to witness some patent irrational exuberance as we surpass Thrill and summit Euphoria atop Investor Cycle of Psychologythe Investors Cycle of Psychology–which means that this cyclical bull market’s highest momentum rally likely lay ahead of us.  Accordingly, I don’t think we’ve reached the “point of maximum risk” yet, but that may arrive in the coming months/quarters. That would be preceded by multiple expansion, as greater investor participation in the stock market can revert those uncharacteristically high SPX earnings yields relative to bond yields.  This is the sole, identifiable catalyst with the potential to substantiate my null hypothesis (i.e. long term bullishness).

Thus, we will await the specter of Euphoria before battening down the hatches.  At that point–call it YE13–SPX may close the year between 1750-75, which leaves it at an even richer FwPE multiple with even thinner margin of safety.

The “Bearish” tag on this entry pertains exclusively to that long term horizon. In the short term, I’ll react to a sustainable breakout by SPY tomorrow, which should set the tone for year end–one way or another.  The do-or-die technical setup in SPY is no coincidence: given our proximity to quarter-end window-dressing, managers’ behavior in the Q3 close and Q4 open should reveal a lot about their gut feelings for year-end.

We ourselves just had a massive quarter.  We’ve crushed our index in Q3, regaining more than all of the ytd alpha we lost in a shaky Q2.  Regardless, our plan is to focus on reallocating our portfolio away from overbought sectors into a couple laggards, and out of the US into Europe. In doing so, we’re keeping our emotions in check, managing the psychology of crowds, and pursing the real value wherever it takes us. Those are the things we can control.


¹XHB itself is a bad example, having managed to weather the storm since its index contains a lot of renovation/restoration/hardware companies like $USG $MAS $WHR in its top 10 holdings.

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