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Incubation Phase: Gradually and then Suddenly
Incubation Phase: Gradually and then Suddenly
Key points
1) The May jobs “shocker” was largely a reflection of CARES coverage of corporate payrolls.
2) The gap between Wall Street and Main Street appears similar to the “incubation phase” of other major downturns.
3) Federal support remains essential, but is best targeted toward preserving the “circular flow” of the economy by supporting the basic incomes of families and incentives for productive investment, limited to those actually experiencing economic damage.
4) After years of overborrowing to finance stock repurchases (partly to offset dilution from stock-based compensation), many corporations were overleveraged coming into this crisis. Bankruptcies are likely to increase, but the government can support packaged restructurings and bank purchase-and-assumption transactions without bailing out private investors, who agree to accept these risks in a free-enterprise system.
5) Fed “leverage” of CARES funds to purchase uncollateralized corporate bonds violates FRA 13(3), CARES 4003(c)(3)(B), and potentially Article 1 Section 8 of the U.S. Constitution.
6) Projects that are enabled only by zero interest rates are most likely projects that are speculative and unproductive.
7) Improved market internals currently encourage an agnostic near-term outlook (though not a bullish one) despite several features that suggest the improvement is fragile.
8) Valuations are again near historic extremes.
9) Continued dispersion within the U.S. equity market suggests particular risk for richly valued large-cap stocks.
Incubation phase
On Friday June 5, the Bureau of Labor Statistics reported that U.S. nonfarm payrolls jumped by 2.5 million in May, following a (downwardly revised) loss of 19.7 million jobs in April, sending Wall Street on a full-tilt, dubstep remix of “Happy days are here again.” It was a fitting choice, given that the song was written in 1929. Of course, the Great Depression also began with a spectacular financial rebound that bore no relationship to the underlying deterioration on Main Street.
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Risk-Aversion Meets a Hypervalued Market
Risk-Aversion Meets a Hypervalued Market
Sooner or later a crash is coming, and it may be terrific.
– Roger Babson, September 5, 1929
Roger Babson’s first rule of investing was “keep speculation and investments separate.” He is remembered not only for founding Babson College in Massachusetts, but also for his speech at the National Business Conference, warning of an impending crash just two days after the 1929 peak, at the very beginning of a decline that would wipe out 89% of the value of the Dow Jones Industrial Average.
As I’ve observed before, the back-story is that Babson’s presentation began as follows: “I’m about to repeat what I said at this time last year, and the year before…” The fact is that Babson had been “proven wrong” by an advance that had taken stocks relentlessly higher, doubling during those two preceding years. Over the next 10 weeks, all of those market gains would be erased. If Babson was “too early,” it certainly didn’t matter. From the low of the 1929 plunge, the stock market would then lose an additional 79% of its value by its eventual bottom in 1932 because of add-on policy errors that resulted in the Great Depression.
To slightly paraphrase Ben Hunt, how does something go down 90%? First it goes down 50%, then it goes down 80% more.
This lesson has been repeated, to varying degrees, at every market extreme across history. For example, the 1973-1974 decline wiped out the entire excess total return of the S&P 500 Index (market returns over and above T-bill returns) all the way back to October 1958. The 2000-2002 market decline wiped out the entire excess total return of the S&P 500 Index all the way back to May 1996. The 2007-2009 market decline wiped out the entire excess total return of the S&P 500 Index all the way back to June 1995. I expect that the completion of the current market cycle will wipe out the entire excess total return of the S&P 500 Index all the way back to about October 1997.
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Sizing Up the Bubble
Sizing Up the Bubble
“In the ruin of all collapsed booms is to be found the work of men who bought property at prices they knew perfectly well were fictitious, but who were willing to pay such prices simply because they knew that some still greater fool could be depended on to take the property off their hands and leave them with a profit.”
Chicago Tribune, April 1890
Presently, the broad NYSE Composite Index is at a lower level than it set more than 2 years ago, in July 2014. Including dividends, the index has gained hardly 2%. Several indices dominated by large capitalization or speculative growth stocks, particularly the S&P 500, have performed better, but even here, the index is only a few percent above its December 2014 high. Over the past two years, the behavior of the stock market can be described less as an ongoing bull market than as the extended topping phase of what is now the third financial bubble since 2000.
The chart below shows the current setup in the context of monthly bars since 1995. After the third longest bull market advance on record, fresh deterioration in key trend-following components within our measures of market internals (see Support Drops Away) recently joined this extended, overvalued, overbought, overbullish peak, even as the S&P 500 hovers at the top of its monthly Bollinger bands (two standard deviations above the 20-period average) and cyclical momentum rolls over from a 9-year high. Taken together with other data, we continue to classify present conditions within the most hostile expected market return/risk profile we identify.
The great victory of the Federal Reserve in the half-cycle since 2009 was not ending the global financial crisis; the crisis actually ended in March 2009 with the stroke of a pen that changed accounting rule FAS157 and eliminated mark-to-market accounting for banks (instantly removing the specter of widespread insolvencies by allowing “significant judgment” in valuing distressed assets).
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