Dow Jones 20,000

Dow Jones 20,000

In the US, record US stocks has prompted for a wild bacchanalia over what has appeared to be “this time is different”.

Major US bellwethers have EXPLODED higher since TRUMP’s surprise electoral triumph.

Interestingly, candidate Trump repeatedly excoriated US stocks as “one big fat ugly bubble”. As US president,sentiment apparently has reversed. “One big fat ugly bubble” has slipped into oblivion and have been replaced with approval; Dow 20K “Great”!

Mr. Trump’s U-turn in sentiment has been a manifestation of what’s been going on throughout developed market stocks.

BREXIT seems as a key catalyst to markets looking for an excuse to rampage higher.

During the impassioned campaign, a BREXIT victory was portrayed as leading to a gloomy or even an apocalyptic outcome. Yet days immediately after the unexpected (for the mainstream media) victory by BREXIT, global stocks went into a bidding frenzy.

The Trump phenomenon short circuited this process.

Having been almost ruled out from a victory, when electoral results were initially tabulated where Trump was in the lead, US stocks crumbled (Dow was down 800 points). But as a Trump victory seemed imminent, US stocks found footing not only to reverse losses but to post sharp gains!

From then, key US benchmarks went vertical!

As I have been saying here, vertical phases are symptoms of emboldened convictions and of desperation. And because they signify as hardened beliefs, they are mostly “rationalized” or reasoned from price changes. Regulatory and tax cuts, infrastructure and military spending and the supposed growth agenda from these has served as justifications.

Yet record stocks have shown signs of being a statistical anomaly.

And as proof of the tail event, last December, the Gavekal Team reported (bold mine): “A three standard deviation price change is a pretty rare event especially outside of a crisis period. The US presidential election has clearly been that rare event catalysts. In the charts below, we have identified five different examples of a three standard deviation 1-month price change in four different asset classes: equities, commodities, fixed income, and currencies. In equities, we have experienced an extreme move in the relative price change between small cap stocks against large cap stocks. As of 12/8/2016, the S&P 600 had outperformed the S&P 500 by over 12% over the previous month. This was the best 1-month outperformance since March 2000 and the first positive three standard deviation move since 2002.”

Even more, while small caps stocks soared, hedging costs stumbled to a 16 month low.  This has been indicative of a deepening one way trade. The Gavekal team again in December noted of more fat tail developments: “Over the last ten years, on average, the Russell 2000 has returned ~2% more than the Russell 1000 (dark blue line with 1st, 2nd, and 3rd standard deviations noted in dotted lines). This year, the price performance gap between small and large caps rose from a relative low (two standard deviations below average/ not seen since early 2008) to a multi-year extreme (two standard deviations above average) onDecember 8th. The last time small caps rose this much versus their large cap peers was in late 2013/2014. Back then, small caps went from a near three standard deviation extreme on the upside to a one standard deviation extreme relative underperformance, finally bottoming in October 2014.”

And it’s not just record stocks, during the frenzied market bidding, correlations between inflation and the US dollar appears to have broken down. Again from the Gavekal Team (bold original): Said differently, when the dollar strengthens (as it has done recently) inflation expectations tend to fall and vice versa. A strong negative relationship has been especially true since 2010 when the correlation between the USD index and 10-year TIPS implied breakeven inflation has increased to a robust -80%. We know, of course, that in the short-term strong relationships can break down and sometimes completely reverse. This type of complete reversal is what has occurred since this summer. Since 6/30/2016, the correlation between the dollar and inflation expectations has skyrocketed to +92%. So the dollar has gone up AND inflation expectations have increased as well step for step. Ultimately, we believe that these two series will likely revert back to the more traditional relationship and the “gap” that has opened up in the first and second chart below should close (note: the USD index is inverted in all the charts below). A similar episode, granted to a much lesser degree, occurred at the beginning of 2015 and by August 2015 the dollar and inflation expectations had synced back up. To us, a similar reversion to the norm seems like the most probable outcome at the moment. 

Moreover, the quality or the structure of the stock price changes matters.

The current stock market rampage appears to be led by low quality—high debt stocks. Again from teamGavekal in January 9: (bold mine) ‘Quality’ is one of the those terms in finance that if you ask three different investors to define you get four different answers. Generally, however, companies with higher profitability, lower debt, and higher sales growth are considered to be higher quality companies. Lower quality companies tend to have the opposite characteristics. Over the past three months, investors in developed market equities have been bidding up lower quality stocks...stocks with the lowest sales growth have outperformed stocks with the highest sales growth by nearly 8% in just three months. Stocks with the lowest sales growth have returned 7% while stocks with the highest sales growth have returned -0.9%. Lastly, stocks with the highest net debt as a % of total capitalization have compete trounced all other stocks during this period as well. The decile of stocks that have the most debt have returned 9% over the past three months while the average return for the other nine deciles is just 1.3% and stocks with the least amount of debt have fallen by -1.4%. All in all, the rally in developed market equities over the last three months has been clearly led by stocks with the shakiest fundamentals. 

Moreover, market internals has not only been diverging from headline performance but has been “fraying”. The BCA Research (January 26) noted that: “The number of groups trading above their 40-week moving average has been diverging negatively from the broad market in the last few months, suggesting diminishing breadth. The industrials (I) and financials (F) sectors (i.e. “IF”) have carried the market since November. Other deep cyclical sectors, such as energy, materials and tech, have mostly matched market performance. The “IF” rally is based on an expected upgrade to the economic growth plane that matches the surge in various sentiment gauges. If validation does not occur, then the “IF” rally will become iffy indeed, unless sector breadth improves. Another unconventional sentiment gauge is observed from sub-surface market patterns. The number of defensive groups with a positive 52-week rate of change, in relative terms, is in freefall, plunging to virtually nil. In the last two decades, investors eschewing capital preservation and non-cyclical sectors so aggressively has typically preceded major market peaks.”

The point of this exercise is to demonstrate that record US stocks, which has occurred in the face of the emergence of various statistical fat tails, has been anchored upon what looks increasingly as very fragile foundations.

Here’s more. The Gavekal team noted of the divergence between the US dollar and inflation expectations. Let me add that there has been one critical inflation variable that seems to dispute the surge in inflation expectations.

 

That key factor is no other than gold. Gold prices have largely tracked the actions of the US dollar index.

Gold’s lagging performance looks more like a symptom of developing liquidity strains. For instance, gold prices have been accompanied by rising accounts of primary dealer’s repo fails (December chart in the left pane, courtesy of Alhambra Partners), which have been emblematic of interbank collateral shortages.

And along with repo fails have been rocketing USD Libor OIS rates across the curve (only overnight and 1 month rates have been shown above (right). 3 months, 6 months and 1 year rates can be seen through their respective embedded links.

In short, markets have been rising even as risks (internal as well as external) have been intensifying.

I omitted here the discussion of geopolitical risks. For instance, former USSR honcho Mikhail Gorbachev has been anxious of a “world in preparation for war” (NBC January 27)

Yale professor, famed author of Irrational Exuberance, developer of eponymous market indices such as Shiller CAPE PE ratio and Shiller housing data, Robert Shiller wrote that record stocks signify an illusion (Project Syndicate, January 18, 2017): “In the United States, two illusions have been important recently in financial markets. One is the carefully nurtured perception that President-elect Donald Trump is a business genius who can apply his deal-making skills to make America great again. The other is a naturally occurring illusion: the proximity of Dow 20,000. The Dow Jones Industrial Average has been above 19,000 since November, and countless news stories have focused on its flirtation with the 20,000 barrier – which might be crossed by the time this commentary is published. Whatever happens, Dow 20,000 will still have a psychological impact on markets.”

And part of that illusion has been about the construct of the headline indices, where big issues have outperformed and have buoyed the index (rings a bell?).

As Allianz chief Mohammed El Erian has pointed out in a Linkedin post (January 25): “Let’s start by acknowledging that the DJIA is far from comprehensive when it comes to analytical content. The index covers a very narrow set of stocks and therefore is lacking in representation. Its calculation methodology also is problematic, placing way too much emphasis on the absolute share price, as opposed to market capitalization. As a result, a few names can move the index significantly -- as has occurred recently with Goldman Sachs and JPMorgan Chase, which account for a substantial part of the upward surge since early November.”

Lastly, record US stocks has been reasoned or rationalized from alleged regulatory and tax reforms via cuts, infrastructure and military spending and the supposed growth agenda

Yet just how will regulations be trimmed when walls will be imposed on trade and social mobility (migrations)?  Trump's migration ban allegedly may even affect green card holders.

Would such need MORE and NOT LESS regulations for enforcement to have such political agenda be implemented?

Next, just how will massive infrastructure and military spending be financed? Manna from heaven????

 

The 2016 Philippine elections have had the same story to tell: tax reforms, infrastructure spending, blah blah blah…

The PSEi rallied 15.88% in 52 days. Yet where is it now?  Below the 7,400, a May 15, 2013 (3 year old +) record. That’s even when the index has been manipulated higher!

To add, record US stocks have reached the almost same age (54 days since November 8, 2016) as when the PSEi Duterte rally peaked.

Will history rhyme?