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On Friday one of my buddies sent me an email outlining his quick thoughts about why the stock market was vulnerable to a big correction. I was about to email him back when I came up with the idea of combining my response as a post. So without further ado, here is his email:

The BOJ just said there’s a limit to central bank insanity. That’s very negative for all financial assets.

I agree that sentiment makes you want to be long, but sentiment is not ALWAYS wrong, just most of the time. Plus in reality sentiment has been a ‘mixed bag’ for some time now as Lizanne Saunders says, and we have had two 20 percent corrections in the past eight months.

I think Brexit is a non-event but Trump could really scare the market

The VXX is starting to show signs of life. I’m thinking May could be really ugly


The MacroTourist’s response

I find myself in the strange and uncomfortable position of defending the bull side of the argument. As you know, this is a position I have rarely taken. It is even more unusual because I am doing so with the stock market ticking near all time highs. I was bullish in late 2008 (too early I might add), but that was in the midst of an ugly sell off. Fighting the tape during that sort of panic is much more in my nature than arguing a stock market that has risen over 200% in the last six years might go even higher.

There is not much point arguing about the sad state of the economy. I acknowledge and accept this has been a pathetic economic recovery fueled mostly by massive monetary stimulus. These financial shenanigans goosed corporate profits to unrealistic heights. Earnings as a percentage of GDP hit levels that will certainly be difficult to eclipse.

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We will be lucky if this ratio doesn’t collapse in the coming years. At the very least, I expect it to slowly drip back towards more rational levels. For too long Wall Street has taken more than their share of the pie, and Main Street will increasingly pressure companies’ profitability. I am by no means a bull on corporate earnings.


Earnings, earnings, earnings…

I think earnings as a percentage of GDP are headed lower, but that doesn’t necessarily mean stocks will collapse. Even with that ratio falling, earnings can hold their own. Have a look at a log chart of corporate profits over the past 60 years:

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There has basically only been one big decline in earnings - 2008. Most of the other poor performance periods were sideways affairs.

I know it is fashionable to expect another credit crisis that wreaks havoc on corporate profitability, but I don’t think 2008 will happen again until it is long forgotten. Banks have been forced to de-lever, consumers have been busy paying back debt, there simply aren’t the same sorts of excesses in the system. All the scary risks now sit on Central Bank’s balance sheets.

But as you rightly point out, the recent Bank of Japan “nothing done” is worrying.

“The BOJ just said there’s a limit to central bank insanity. That’s very negative for all financial assets.”

I agree the recent BoJ move was uniformly bad for financial assets. The Yen carry trade has long been a massive tailwind. I even bought some short term puts on the S&P 500 because of the BoJ pass. But I disagree with the notion this BoJ pass means we have reached peak Central Bank insanity.

I have full confidence in Central Banks insanity. I don’t buy the argument Central Banks will somehow come to their senses and reverse course. I don’t even think they can slow down. The Federal Reserve tried to tighten and they nearly brought the global economy to a halt. The truth of the matter is that Central Banks are “all in” with their financial monetization plan. They will keep doing more and more until they get the inflation they so desperately desire. Anything else will cause a slowdown and de-levering that will cause catastrophic losses to their balance sheets, not to mention economic pain for the general population.

Ask yourself how many economies have been destroyed by allowing deflation to overwhelm an over indebted financial system? Then ask yourself how many have been destroyed by governments trying to print their way out of their mess?

There is always a first time, but I don’t think history is on the side of those forecasting a self induced Central Bank led credit reset. The Bank of Japan has not suddenly gotten religion about the madness of their policies. They are scared because the numbers have become so large. But when the rubber hits the road, they will not stop their monetization.

It would be one thing if the markets were forcing the Central Banks to buy their currencies to defend abrupt moves. But this is the complete opposite. Central Banks are being forced to sell their currencies to stop unwanted appreciation. The Central Bank supply of ammo to achieve this result is infinite. They can make as much as needed.

Although I acknowledge the short term consequence of the Bank of Japan’s recent move is bearish, I do not think this is a start of some sort of Central Bank change of heart. The reality is that the Bank of Japan and the ECB are still expanding their balance sheets at astonishing rates. A little bit of waiting to see how it plays out is not unreasonable.

Which brings me back to my earnings argument. Right now the P/E on the S&P 500 is 19. That is the highest it has been since 2004 and it can hardly be described as cheap.

But what were bond yields in 2004? The US 10 year was over 4%. Right now it is 1.80%.

I don’t know what the right P/E should be. I have a feeling risk free rates are more mispriced than stocks, but my best bet is that both stocks and yields are headed higher in the coming quarters. A P/E of 19 might seem stupid, but Central Banks monetizing their balance sheets by buying risk assets is infinitely more stupid.

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Why can’t the P/E go to 20? 25? Or even 30? It’s all dumb. Central Banks are desperate to reboot the global economy, and in the process will unleash a wall of liquidity that threatens to disrupt all reasonable estimates of fair value.

I do not discount the possibility Central Banks miscalculate and push back down on the brake too quickly, but even if they do, they will be back with the gas pedal before you know it. The Federal Reserve’s recent action is a perfect example of this behaviour.

I am not advocating a big long position in US stocks. I agree they are probably the most stretched with the least amount of artificial monetary boost. But I think a long position in European and Japanese stocks is an interesting speculation. You can buy out of the money long dated calls at levels that provide for a great risk reward (more to come in a future post).


Sentiment

As for your comment about sentiment;

I agree that sentiment makes you want to be long, but sentiment is not ALWAYS wrong, just most of the time. Plus in reality sentiment has been a ‘mixed bag’ for some time now as Lizanne Saunders says, and we have had two 20 percent corrections in the past eight months.

There is no doubt fading consensus for the sake of being in the minority is a dumb strategy (and one I fall for way too often). But I don’t buy that sentiment is a ‘mixed bag.’ There is no one willing to stick their necks out and say you should buy stocks.

But contrast this to late 2014 when everyone was super bullish and convinced Central Banks would send stocks up 20% in perpetuity.

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Tell me the last time someone got up there and said they were aggressively buying the stock market? It ain’t happening. Even the regular bulls are straddling the fence and hedging their bets.

It is truly amazing that stocks are pushing towards new highs, yet the level of apathy is off the charts.

The pain trade is higher, there is no doubt in my mind. Whether the market squeezes the bearish participants or not is still up in the air, but a scream higher hurts more investors than an ugly decline. This is in direct opposition to the Central Banks. For them, the pain trade is lower. Now you might want to fade the Central Banks, but I am not as willing. They are insane and won’t stop until this thing explodes in a fiery melt up. It seems foolish to fight the participant with the unlimited ammo weapon…


Trump and the market

I think Brexit is a non-event but Trump could really scare the market.

I am not as convinced a Trump win would scare the market. Don’t forget all the fear mongering from Rush and the boys with Obama. And I don’t buy that Hillary will be a friend to Wall Street. The reality is that Wall Street’s days of dominance at the expense of Main Street is over. The market has probably already figured this out.

In the mean time, the Presidential Cycle firmly points to higher stocks:

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My best guess is the Presidential Cycle overwhelms any individual candidate worries.


How it plays out

Most everyone I know is either sitting on the sidelines, or actively fighting this stock market rise. I completely understand the reasoning behind their negativity. Stocks are priced at levels that make no sense.

But Central Banks long ago made complete farces out of equity markets. They will continue printing until they get the inflation they so desperately desire. Shorting stocks in this environment seems like a poor risk reward. I would much rather focus on shorting long dated risk free bonds. These instruments are priced at levels that make even less sense than stocks. When France is issuing 50 year bonds at under 2% yield, you have to ask yourself where the real bubble is.

I wrote about financial markets following the 1987 play book, and I see no reason to change that thesis. The possibility of a mad scramble out of bonds into stocks this summer is way higher than most market participants realize. Stocks will only go down once the bond market takes away the keys from the Central Bankers. I would rather bet on shorting bonds than stocks. I know this opinion is in stark contrast to the Gundlach’s of the world who believe we will collapse in a deflationary mess. These pundits think Central Banks are creating a disaster of epic proportions. I too believe Central Banks will mess things up, I just think they will overdo it on the upside, not the other way round…

Thanks for reading,
Kevin Muir
the MacroTourist