Monday, January 15, 2018

The Great Market Melt-Up of 2018?

Michael P. Regan and Lu Wang of Bloomberg report, Are You Missing Out on the Great Market Melt-Up?:
Make no mistake, fear is running amok on Wall Street these days—fear of missing out.

As the S&P 500 got off to its best start to a year since 1999 and the Dow Jones industrial average topped 25,000, it’s clear that fear of missing out—FOMO—has jumped to the top of the fear charts with a bullet. It’s risen above worries about North Korea’s “Rocket Man” and the unpredictable U.S. president who revels in provoking him. It’s blown past lingering concerns about the European Union coming apart at the seams. It’s even eclipsing the most popular talking point of fear merchants everywhere: marketwide valuations that in many cases are approaching the highest they’ve ever been.

Is this such a bad thing? Maybe yes, probably no. Unlike other FOMO-driven rallies of the distant and not-so-distant past—from Dutch tulip bulbs in the 1600s to dot-com stocks at the turn of the century to the Great Bitcoin Craze of 2017—there’s little debate that there will be something legitimate to miss out on in the stock market in the near term, rather than the hazy distant future.

Forget about the economy. The massive tax cuts President Trump signed into law on Dec. 22 will probably boost gross domestic product growth by a few tenths of a percentage point, but that’s not what investors are excited about. As economists gently inch up GDP estimates, equities strategists may find themselves stepping over one another to jack up their forecasts of different parameters: the benefits to corporate profits, the subsequent cash returns to shareholders, a return of confidence and greed to the collective investor psyche—and good ol’ FOMO. The wholesale dismantling of Obama-era regulations adds a hard-to-quantify, but real, fuel to the fire.

The average estimate of strategists surveyed by Bloomberg on Jan. 8 is for the S&P to end just below 2,900 by next New Year’s Eve. If the rally continues at anywhere near the breakneck pace with which it started the year—up almost 3 percent in the first four sessions of 2018—it will hit that yearend forecast before Groundhog Day. Some measures of upward momentum in the market are at the highest in half a century or more, and often the strong momentum generates more strong momentum.

When price gains get downright ridiculous, it’s referred to on Wall Street as a “melt-up,” perhaps because these self-perpetuating rallies tend to be followed by meltdowns. This is the uncomfortable prospect that many investors are contemplating. For those of us old enough to remember the dot-com boom and bust, it’s tempting to assume the market will never become that irrationally exuberant again. Of course, many current market participants were in grammar school then. Old-timers need to consider that the market’s collective memory may be shorter than their own.

Jeremy Grantham, co-founder and chief investment strategist of asset manager GMO LLC in Boston, who’s been following markets for five decades, is an old-fashioned value investor who finds himself in the “interesting position” of looking beyond valuation metrics, instead studying previous melt-ups to try to figure out how long the current party will last. The takeaway, by his analysis, is that the S&P 500 would need to surge as high as 3,700, or 34 percent, in 18 months to qualify as even the tamest “classic bubble event” in history.

Grantham defines a bubble as having “excellent fundamentals, euphorically extrapolated.” His description is sounding more familiar every day. Earnings growth for S&P 500 companies is forecast to accelerate to almost 15 percent in 2018, according to estimates compiled by Bloomberg. Economic indicators are strong and beating estimates; the average GDP forecast for 2018 has risen to 2.6 percent, from 2.1 percent on Election Day 2016. Credit markets are healthy. Business, consumer, and investor confidence is off the charts.

Yet most of the measures investors use to evaluate stocks are dizzying. The S&P 500 trades at 2.3 times its companies’ sales, a hair below its dot-com peak. Price-earnings ratios are also sky-high: Goldman Sachs Group Inc. estimates the median stock in the index has been more richly valued for only about 1 percent of the benchmark gauge’s history. What’s known as the cyclically adjusted p-e (CAPE) ratio, at more than 33, is above its level before the crash of 1929—indeed, it’s higher than at any moment in history, excluding the dot-com debacle.

Some of these valuations can be explained away, for those willing to try. The CAPE ratio, often called the Shiller p-e after Yale economist Robert Shiller, uses 10 years of earnings in its calculations. Considering the decimation of profits during the financial crisis, the calendar alone will pull that valuation metric lower as the catastrophic years of 2008 and 2009 drop out of the math. Another standard, known as the PEG ratio, used by investors such as Fidelity Magellan Fund legend Peter Lynch, divides p-e ratios by expected profit growth. The current PEG of 1.4 is above average but well below a record of more than 1.7 in early 2016.

“Yes, markets are arguably expensive by history, but this environment of accelerating not only earnings but also economic strength is what’s catching the market’s attention right now,” John Augustine, chief investment officer for Huntington Private Bank in Columbus, Ohio, recently told Bloomberg.

It’s hard to know to what degree stock prices already reflect the benefits investors expect from tax reform. Goldman Sachs’s basket of companies with high tax rates has outperformed low-tax stocks by almost 10 percentage points since the middle of October. But taxes are complicated, and there could well be more positive than negative surprises as the details are sorted out. Consider the $37 billion boost to book value that Barclays Plc analysts estimate Warren Buffett’s Berkshire Hathaway Inc. will enjoy because of reduced tax liability on its appreciated investments.

Yes, 2018 will probably see more complaints that tax reform didn’t benefit the little guy as much as it could have. Yes, there will be complaints about how much of the windfall is spent on share buybacks, dividend increases, and mergers and acquisitions. Yes, there will be complaints about the eventual consequences of a swelling federal budget deficit and the massive, business-friendly deregulation under way. These are worthy, important topics for society to debate. The stock market, though, is all id and no superego, and most CEOs will continue to abide by its demands to reward shareholders first and foremost.

Stocks are always risky, and euphoric rallies like this may be the riskiest. How long FOMO reigns at the top of the fear charts is anyone’s guess. Tax cuts may overheat the economy, finally lighting the inflationary fuse and pushing interest rates higher quickly enough to induce a recession. There’s also a “live by America First, die by America First” concern that’s worth considering if Trump’s protectionist trade policies provoke retaliatory responses from trading partners.

Two recent reports out of China highlight this risk. What may sound like a minor tweak in the way Beijing fixes its exchange rate created big ripples in the currency markets —and stocks don’t often react well to big ripples in other markets. Many traders took the exchange rate tweak as a signal that the People’s Bank of China wasn’t pleased that the yuan had strengthened 7 percent against the dollar since the election of Trump, whose platform included harsh rhetoric about China keeping its currency weak. The following day, on Jan. 10, Bloomberg reported that senior officials in Beijing were recommending the nation slow or halt purchases of U.S. Treasuries, sending 10-year yields to their highest level since March and causing a rare weak open in the stock market.

In the near term, there’s a risk that the coming earnings season will result in corporate outlooks that aren’t quite as euphoric as the share-price gains that preceded them. And we’ll probably spend another year worrying if we’re one tweet away from nuclear war, or one Robert Mueller indictment or midterm election away from impeachment proceedings that will paralyze Washington.

For now, FOMO is the biggest fear investors need to grapple with. That could change quickly, and anyone with the gumption to think they can time the market will need to be on alert. Fear, like love, has inspired much great work—and a lot of mediocre results—from poets and investors alike. For investors, the best advice about today’s market comes from the 19th century poet Ralph Waldo Emerson: “In skating over thin ice our safety is in our speed.”
Indeed, one can argue that it isn't euphoria but fear of missing out (FOMO) that is driving this market melt-up.

I've long argued there are two big risks keeping risks managers and senior managers at large institutions up at night given how markets just keep soaring higher:
  1. The risk of a meltdown, unlike anything we've ever seen before, making the 2008 crisis look like a walk in the park.
  2. And more worrisome, the risk of a melt-up, unlike anything we've ever seen before, making the 1999-2000 tech melt-up look like a walk in the park.
I've also stated it's the second risk that petrifies risk managers and porfolio managers because it forces them to keep chasing risk assets (not just stocks but corporate bonds and other risk assets) higher even if valuations are stretched.

Also worth bearing in mind, these markets aren't like other episodes for the simple reason that central banks around the world have been directly or indirectly buying risks assets to reflate them, contributing to creeping market euphoria as well as the silence of the VIX and the silence of the bears.

Why did central banks actively engage in non-traditional monetary policy to such a large extent? Because they fear the bubble economy is about to burst and have done everything to reflate risk assets in a foolhardy attempt to prolong the bull market and avoid a prolonged period of debt deflation.

In effect, the financialization of the economy, meaning an economy heavily leveraged to asset inflation, has led to the excesses of the markets which David Rosenberg is warning of:
My recommendation is to take a good hard look at the charts below and come back and tell me that we are in some stable equilibrium. The excesses are remarkable and practically without precedent. This is not a commentary as to whether the economy is doing well or not well, or whether fiscal stimulus at this stage of the cycle will be impactful. It is to say the following:
  1. The US economy has never before been so dependent on asset inflation for its success. The ratio of household net worth to disposable income has soared to a record 673%, taking out the 2006-2007 bubble high of 652% and even the dotcom peak of 612% posted in 1999. This surge in paper wealth has enabled the savings rate to decline to a decade low of sub-3%, a move that has made the difference between 3% growth and 1% growth in the real economy.
  2. Financial assets now comprise a near-record 70% of total household assets. Past periods of such excess in the late 1960s (Nifty Fifty) and late 1990s (tech mania) did not end well. Where is Duddy Kravitz when you need him? We are in one of these rare periods of time when financial assets now exceed hard assets like real estate on household balance sheets by a three-to-one margin.
  3. While US households did not participate in this cycle in classic mutual funds, they did so via passive ETFs and their exposure to equities has only been topped once before and that was during the tech bubble of the late 1990s. The equity share of U.S. financial assets is now up to over 36%, surpassing the prior cycle peak of 34% back in 2007; the share of total assets also is at a 17-year high of 26%.
This is not to say anything more than the elastic band looks extremely stretched and the charts below show that we hit similar peaks in the past just ahead of a turning point, and right at a time when investor complacency and bullish sentiment was around where these metrics are today (click on images).





I want to finish off this section with a question and a thought. The question is how can this possibly be viewed as the most hated rally of all time when US household exposure to equities has rarely been as high as it is currently. And the thought is merely a piece of advice to heed Bob Farrell’s rule #4 – exponentially rising markets usually go further than you think, but they do not correct by going sideways.
Scary stuff but when you think about it, with bond yields at record lows, it's hardly surprising to see US household exposure to equities rising to levels we haven't seen before.

And when it comes to potential bubbles, I keep reminding myself of that old market saying attributed to Keynes (or Gary Shilling), "markets can remain irrational longer than you can remain solvent".

All you youngsters and some of you old fogies need to remember that quote because it basically means markets move to their own tune, trends can last a lot longer than anyone expects, especially when central banks are actively trading in markets.

However, in my outlook 2018, Return to Stability, which I hope you all read by now, I went over the wise insights of Cornerstone Macro's François Trahan and provided you with a framework on how to think about the year ahead and why you might want to temper your enthusiasm on stocks and other risk assets.

Are there risks to this scenario? Sure, global growth can continue surprising everyone to the upside and this will boost cyclical shares a lot higher.

In fact, in his Outlook 2018, Martin Roberge who writes The Quantitative Strategist for Canaccord Genuity here in Montreal, wrote that he thinks synchronization will persist in global growth which leads him to overweight global cyclical shares like energy (XLE) and underweight stable sectors like staples (XLP).

[Note: I highly recommend you contact Canaccord Genuity's Montreal office and get a copy of Martin's outlook which goes into a lot more detail and provides industry recommendations and contrarian plays which have historically outperformed the market. His market research comments are excellent and well worth reading.]

No doubt, if you think global growth synchronization will persist, you need to be buying cyclical shares like energy (XLE), metals and mining (XME) and financials (XLF) here.

In fact, if you believe global growth will persist, you should even be looking at sub-sectors of energy (XLE) like oil and gas exploration (XOP) and oil services (OIH).

I am watching these charts closely but as I keep warning, don't confuse a tradeable rally with something which will persist over the next year (click on images):







The charts tell me this rally can continue but I remain highly skeptical that global growth synchronization will persist over the next 12 to 18 months.

I'm not dogmatic, however, as I know Pierre Andurand, one of the most bullish oil hedge fund managers and one of the best commodity traders, is still bullish on oil (admittedly, for supply and demand reasons) and the Healthcare of Ontario Pension Plan (HOOPP) likes the energy sector here over the long run.

I have to admit, when I look at the coal ETF (KOL), I too wonder if there is a lot more economic momentum in the pipeline:


However, given the flattening of the yield curve and the real danger that it inverts if the Fed continues hiking and global PMIs start weakening, I remain very cautious on cyclical sectors and high beta stocks (read my Outlook 2018).

But markets can remain irrational longer...you get the picture, nobody knows what will happen but as I keep warning you, as stocks keep posting record highs, downside risks keep mounting, so hedge accordingly by buying good old US long bonds (TLT) or your portfolio will risk sustaining devastating losses.

At that point, FOMO will become FUBAR, and it will be too late to kick yourself for not taking some money off the table to hedge for downside risks.

Don't worry, there is no imminent danger on the horizon, at least not one I see, but you need to prepare for a bumpier ride ahead.

One last macro point that's been irking me. We can very well see a temporary pickup in US core and even headline inflation (if oil prices rise further) as the US dollar has weakened over the last year and continues to be weak relative to the euro and yen.

Don't confuse a cyclical inflation scare due to currency depreciation with something more structural which can only happen through wage gains. The USD depreciation leads to temporary higher US import prices, not sustainable higher inflation.

Conversely, as the yen and euro strengthen, it leads to lower import prices there, exacerbating deflationary pressures that still persist in their respective economies.

These cyclical swings cannot persist for long because eventually, it will mean deflation will come to America, and then it's game over for risk assets (public and private) for a very long time.

You all need to be extremely careful interpreting macro data and inflation pressures. Global deflation hasn't disappeared, not by a long shot.

Anyway, that's another topic for another day, but I'm a little disappointed at how people interpret macro data, including the so-called scare that China is getting ready to sell US Treasuries (BULLOCKS! China's current account surplus necessarily means it is financing the US capital account surplus and will continue to do so for a very long time).

Below, one of Wall Street's most bullish forecasters, Canaccord Genuity's Tony Dwyer, is out with a near-term correction call, but he's not letting it interfere with his 2018 bull case for stocks.

"What we found is when the yield curve is flattening, it's actually a monster buy signal," the firm's chief market strategist said on CNBC's "Trading Nation" this week.

I respectfully disagree on this last point as the evidence is very convincing, when the yield curve is flattening, it doesn't augur well for stocks and other risk assets.

Also, Ben Luk of State Street Global Markets says a stronger dollar could weigh on Asian equities, but Japan seems to be moving ahead regardless. I see the US dollar rallying over the next year and this will impact commodities, commodity currencies and many emerging markets.

Lastly, Hugh O'Reilly, president and CEO of OPTrust, says managing risk through diversification is key for the pension plan. Listen to Hugh, he's very wise and understands the value of diversification.



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