LONGWave - June 2020

Can a Stock Market Disconnected from the Economy be Maintained?

There is little dispute among long term market professional that equity markets have disconnected from the economy. Last Thursday, yet another investment legend Jeremy Grantham went on record that in his estimation we are in the midst of the fourth major bubble in his lifetime. Knowing Bubbles never last, we asked the question in this month’s LONGWave whether this time was different? The short answer is: Yes!

• FREE MARKETS cannot disconnect from markets on a permanent basis. They can on a short-term basis normally referred to as a “Bubble”.
• CONTROLLED (‘Nationalized’) MARKETS can disconnect from the economy on a permanent basis. They in fact are no longer freely trading markets but rather pre-determined and price-controlled trading of financial instruments.

This bubble (often referred to as the “Everything” Bubble) was with us prior to the Covid-19’s crushing market drop but has shown itself with the degree of bounce from its March lows as being different! The reason is that it is being driven by US Federal Reserve (with assistance from other major global central banks) as a monumentally excess liquidity driven market. I won’t debate here whether this is in fact required after the greatest Global Demand / Supply shock in history, but rather point out the fact that it is what has and is currently causing the market to rise and become disconnected from the economy. 

So, the question remains will it be sustained?  The answer lies in the changing rate of the Global Liquidity Proxy!

We layout in the video and show below how the equity markets have reconnected with the Global Liquidity Proxy. The sole question is whether this rate will be be maintained, increased or decreased, when changes will occur and by how much?  We address this in this month’s 47 chart LONGWave video. [Spoiler Alert: The answer is NO]

Video is 23 Minutes with 47 Supporting slides.

SITUATIONAL ANALYSIS

• MARKETS ARE DISCONNECTED FROM THE ECONOMY
  • Markets closed last week at a red flag screaming 151% market cap to GDP for the S&P 500 while the Whileshire 5000 was at 163%.  There is no history, none, that shows valuations above 150% market cap to GDP are sustainable. None.
  • Small Business has been crushed and a recent report from Azio, a major small business bank survey indicated that 47% of the small business owners surveyed said they anticipate shutting down, and 41% said they are looking for full-time work elsewhere. 
  • Forecasts are roughly $142 for the S&P 500 at the moment for 2020. Even if profits jump to just north of $160 which would be near 2019 profits, we have forward P/E multiples now already well 20x – valuations leave little to chance of being even close to historically reasonable.
    • I’ll this assumes corporate tax rates do not move higher – something that would happen should Biden defeat Trump and the Dems sweep Congress. 
    • Then there are the expectations of Covid-19 containment plus vaccines that are ready to go and inoculate tens of millions of people rapidly; which seems difficult given how poorly testing has gone.
  • An engineered “V” Shaped recovery in stocks does not mean a “V” shaped recovery in the Economy.  Demand destruction is enormous. The CBO Estimates it will Take 10 Years Just to Get Back to Even.
  • B of A’s latest Fund Manager Survey, which polled 223 participants with $651 billion in AUM, showed the vast majority of financial professionals remain incredibly bearish on the global economy. Respondents do not expect global manufacturing PMI to rise back above the contraction level of 50 until 4Q20.
  • The supply-side story in Asia has yet to be revived because the demand story in Europe and North America is offline. Without Western demand, reviving Asian factories will not be possible; thus, world trade won’t rebound. It could take several years or more for global GDP to recover back to even 2019 levels.
  • The gap between current prices and discounted present value of likely future cash flows is the highest ever.

MARKETS HAVE ‘RECONNECTED’ TO THE GLOBAL LIQUIDITY PROXY

SINCE THE MID MARCH 2020 LOWS, THE GLOBAL LIQUIDITY PROXY HAS RECONNECTED WITH GLOBAL STOCKS

MAINTAINING THE RATE OF LIQUIDITY INJECTIONS WILL BE A CHALLENGE!

The recent rate of increase illustrated in the chart to the right. In the past 8 weeks, central banks have been buying $2.4 billion per hour of financial assets.  This rate of increase is obviously difficult to sustain and likely not to be!

The amount of QE purchases implemented, and new credit facilities announced has accounted for around 55% of all measures across the G20 and 60% of the $4.5T increase in G10 central bank balance sheets. This share will likely gradually ease over time as the Fed's aggressive pace of QE is easing while intervention in other countries, such as the newly discounted TLTRO3 in the euro area, are yet to come online. 

Relative to the size of the economy, the Fed and BoC have seen the largest increase in their balance sheets since the Covid-19 shock - with a 12-13pp of GDP increases since the end of February, compared to rises of 6-7pp across the euro area, Japan and the UK.

Courtesy of Zero Hedge

Earnings dropped in the first quarter by 16%, the biggest decline since 2008, and are poised to fall again in the second quarter because of business disruptions tied to the coronavirus. Yet the S&P 500 has recovered most of its 34% plunge after setting a record in February.

Courtesy of Zero Hedge

WE HAVE ACHIEVED THE INITIAL MATASII TARGET BOUNCE OF 3140 ON THE S&P 500

The S&P 500 is presently trading in the range of our initial expected market bounce target of 3140 based on our "Bi-Sector" Analysis. 

We strongly recommend those with a more technical orientation to carefully consider Nomura's Charlie McElligott's work on current GAMMA levels within the CTA's and other Managed Futures Funds (see examples: here, here, and here). 

THE STEEPENING YIELD CURVE (EXPECT 'YIELD CURVE CONTROL' BY SEPTEMBER ) IS IMPORTANT

I have showed our proprietary MATASII Yield Curve Analysis (below) before, saying to wait for the second Yield Curve steepening. It is then that markets begin to react in a sustained fashion. Prior to that even it is the world of traders, speculators and manipulation. After that it is the reality of the economy and the world where investors live.

The US treasury yield curve, as represented by the spread between the 10- and two-year yields, expanded or steepened to around 72 basis points on Friday to hit the highest level since February 2018.

The curve steepened by 25 basis points last week and over 10 basis points on Friday alone and is indicative of growing optimism in the economic recovery among bond traders.

The latest US Non-farm Payrolls report showed the economy added 2.5 million jobs in May, pushing the unemployment rate lower to 13.3%. Wall Street economists were looking for job losses of around 8 million. The data has revived the talk of a V-shaped economic recovery in the US.

While high growth expectations are lifting long-term yields, the short-term yields are lagging due to Federal Reserve's pledge to keep interest rates near zero for a prolonged time.

The Fed is highly likely to be forced to ease pressure on long-term yields via yield curve control where it essentially pegs long-term yields via forward guidance and by buying long-term bonds to maintain the peg. This is now being discussed and might happen later this year.

The Bank of Japan has been doing this for years. To dodge this, Japanese banks, pension funds, and other entities have chased yield overseas. This has turned Japanese banks into the most fervent buyers of Collateralized Loan Obligations (CLOs), backed by junk-rated leveraged loans issued by over-leveraged US companies that are now toppling. Yield curve control has insidious side effects.

And in an inflationary scenario, yield curve control would make Treasuries as unappealing for long-term bondholders as a toxic-waste dump.

The Dollar's recent weakness may be the market smelling this and consumer inflation.

Finally, we will decidedly end our notes with our reaffirmation of the growing need for alternative strategies.  We would like to think that our alternative view on markets is consistent with our preference for alternative risk and alpha driven strategies.  Alternatives offer the investor a unique opportunity at non correlated returns and overall risk diversification.  We believe combining traditional strategies with an alternative solution gives an investor a well-rounded approach to managing their long term portfolio.  With the growing concentration of risk involved in passive index funds, with newly created artificial intelligence led investing and overall market illiquidity in times of market stress, alternatives can offset some of these risks.