By Joseph Y. Calhoun
Global stock markets, especially in the US, have made a furious comeback from the lousy start of the year. At its worst level the S&P 500 was down 11% year to date and 15% from its peak late last spring. At that nadir the market was trading at roughly the same level as November of 2013, over two years of gains wiped out by what appeared to be a nascent bear market. Since bottoming on the 11th of February, the S&P has traded up 13% and is now positive on the year, albeit a small gain. Has the bear been vanquished? Or is he just hibernating?
Despite that rally the market still trades at about the same level as November of 2014, a year salvaged from the lows. You could have collected 10 year Treasury coupons and made about the same as collecting the S&P dividend during that time, avoided the stock market volatility and be sitting on a capital gain to boot. Over the last two years the returns from the 10 Year Treasury and the S&P 500 are not that dissimilar. The 10 year Treasury has produced a total return of about 11.25% versus the S&P 500’s 12.4%. When one considers the volatility of the stock market versus the bond market, the clear risk adjusted winner is the bond market. So, while the rally has been nice, it hasn’t been enough – yet – to change the math of a decision to remain bearish and underweight stocks.
So, despite the title of the post, it should have been pretty easy being a bear – if you made the decision to own longer duration bonds as an alternative. Of course, not many people have done that as, paradoxically, investors have been almost more afraid of bonds than stocks. I’ve been reading articles about a bond bubble for several years now and that talk pushed investors to the short end of the curve, scared to death that rates were about to spurt higher. This fear of higher rates also pushed investors into floating rate funds, junk and corporate bond funds. And wouldn’t you know it, short term Treasuries have been the worst performing part of the Treasury curve, floating rate funds are barely floating, junk took a big hit although it has made a decent comeback and corporate bonds have offered nothing over the coupon. Beware the consensus trade.
I’ve felt pretty good about how our portfolios have been allocated. We have had more duration in our bond portfolios than most and that has certainly helped and we took profits on the longest duration positions right near the top (see here). We did have a significant portion in TIPS though which only recently started to perform as inflation expectations finally picked up. We also had gold in our portfolios and that helped although you never have enough of the things that go up and always too much of the things that go down. On the stock side we’ve been underweight which has been good but overweight EAFE versus the US which has been bad. But with the dollar weak, I still think that’s the right call.
But now we find ourselves at another crossroad. As I said, stocks are rallying and being underweight gets harder to maintain every day. The bulls are out there yapping about how this was just another correction, another dip to buy and that we better get back in, yada, yada, yada. What makes being bearish so hard is the noise of the perpetually bullish street, the lure of easy money in a market you know is overvalued but keeps going higher. And stocks move so much more quickly than boring old bonds; making the same return in stocks and bonds doesn’t feel the same.
And the economic data has been getting better recently, right? Well, maybe. As I said in last week’s economic review we have seen improvement in the regional Fed surveys and that continued this week with the big jump in the Richmond Fed survey. Unfortunately, as so often happens, the positive of that report was offset by the negative of the Chicago Fed National Activity Index which fell back into negative territory indicating growth below trend. And the CFNAI is one of those broad measures intended to give a quick overview of the entire economy rather than just one region like the Richmond or Philly Fed reports. And it is actual data rather than surveys with small sample sizes like the regional Fed surveys.
We’ve also seen some slippage in the two areas of the economy that have been unambiguously good the last couple of years, autos and housing. As I noted last week, autos are not adding anything to the growth in retail sales and the inventory to sales ratio for the industry is elevated, near the high end of its historical range, close to 3 to 1. Indeed, inventories would seem to still present a headwind for an economy already growing below trend. An economy I might add that has performed poorly enough to produce the Trump phenomenon which is, more than anything, based on the economic angst of the not 1%. Housing also seems to be struggling some with existing home sales falling back, year over year sales gains down to just 2.2% from double digits last month. Housing starts have been okay but permits have flattened out and new home sales are down over 6% from last year.
There are some other bright spots. Personal income has been growing although savings seems the more preferred disposition at the moment. The employment picture is still okay although the quality and quantity of jobs does still leave a lot to be desired; it could be better but at least it’s a positive. Unemployment claims are still near cycle lows and despite the Phillips curve rhetoric from the Fed, inflation continues to be a non-factor – for now.
Overall, as I said last week, it doesn’t seem the economic picture has changed all that much. What has changed is the value of the dollar and the expected path of monetary policy. The weaker dollar has pushed up commodity prices and the stock prices of companies in associated industries. Specifically, the rise of the market over the last five weeks has been led by energy stocks which makes sense given they were a big part of the problem on the way down. Credit spreads have narrowed along with the rising price of oil as investors get optimistic – possibly too optimistic – about the fate of the shale oil industry.
Is a rally based on a weakening dollar sustainable? If you think about what drove the market lower, one is tempted to answer yes. How many earnings reports have we seen the last year that were negatively impacted by the strong dollar? Multinational companies with a lot of non-dollar revenue have been a big part of the earnings decline, which will likely total 4 consecutive quarters when Q1 numbers are released. If the dollar pulls back, theoretically some of that should be relieved. Of course, that assumes those companies didn’t do something to mitigate the damage of a strong dollar. How many of them hedged their exposure and will now be reporting losses on those hedges? I can’t answer that but it does show how difficult it is to operate globally in a floating exchange rate world.
With US valuations still on the expensive side and earnings estimates still falling, it is hard to see the S&P 500 making new highs. The weaker dollar does take some pressure off the oil industry but it doesn’t change the fundamental picture of way too much supply and not enough growth to offset the glut. Even if the dollar weakens more I think oil prices may well have another leg lower before finding a durable bottom. If that happens, credit spreads will widen again and we’ll do this whole correction/bear market dance again. Would wider spreads and more defaults in the oil patch be enough to push us into recession? As I’ve said many times, I don’t know. I don’t think so but frankly it may be a close call.
If the dollar does stay weak and the US manages to avoid recession then the more attractive investments are probably found outside the US. A falling dollar – or put another way, a rising Euro or Yen or Real Or $A – will certainly put the wind at the back of investors in non-dollar assets. A weak dollar could also be a positive for commodities other than oil that have worked off their fundamental excesses. And gold will be likely be in demand as well if the greenback continues south.
Short and intermediate term momentum has shifted to a buy for Asia ex-Japan, Latin America and emerging markets generally. Long term indicators still favor the US market but if the dollar falls through support that may well change. Europe continues to lag but we’ve seen hints of economic improvement there recently. Certainly any improvement is merely cyclical and not secular but a cyclical upturn in Europe should allow investors to make some money.
I will continue to follow our indicators, a majority of which are still negative. Credit spreads have narrowed but not enough to reverse our defensive posture. The yield curve has steepened a bit lately which is positive but it is ever so slight and we still don’t know how to interpret the 10/2 curve in a ZIRP world. Valuations, as I said, are still rich versus historical norms. And long term momentum still favors bonds and gold over stocks, a trend that I suspect has further to go (particularly the gold trend). Unless credit spreads continue to narrow, I doubt I’ll be upping our risk allocations any time soon. What seems more likely is a continued move toward investments that benefit from a weak dollar.
It is always hard to buck the crowd, to be a bear when the market is up this much, this fast. That’s why you need to have indicators you can turn to, ones that have stood the test of time, that are not influenced by the Wall Street bullish cacophony. Like JM Keynes I change my mind when the facts change. Despite the rally, the facts – at least for now – still favor the bears.