In the financial markets, head fakes happen when the market appears to be moving in one direction, but ends up going in the opposite. In January 2018, after an exponential rise on low intraday volatility from August 2017, it unexpectedly reversed course through April. From there, through late September it ascended to an incremental new high, with spectators making note of each new record along the way. Lulled into the invasive complacency that attends such market moves, apathy morphed into shock when the S&P subsequently dropped like a rock, giving up 20% by Christmas Eve. In an abrupt reversal of policy, the equally blindsided Fed went from hawk to dove overnight. In the first six months of 2019, all the ground lost, and a little more, has been recovered.
In the midst of the advances and reversals over the last 18 months, the S&P 500 managed to eke out a gain of 3%, before dividends.
To be sure, one could’ve taken the opposite tack. The selloffs could be the head fakes, assuming the market is destined to eventually resume its upward trajectory. The fallacy in that assumption, in my judgment, is that the foundation on which the capital markets ultimately depend has been deteriorating for months. Like rotting pilings beneath a newly painted pier, the fundamentals temporarily buttressed by the Tax Cuts and Jobs Act of 2017 are fading.
The cost of money often serves as a bellwether of the economy’s strength, rising during expansions and falling during recessions. When the real yield on the five-year Treasury note is down to 30 basis points and the 10-year note is 40 basis points, history would suggest that those real yields portend a darker future. Likewise, when the Fed funds/three-month bill and the three-month/10-year curves are inverted as much, and for as long, as they have been, trouble is surely brewing. It may surprise some to learn that the near 50-basis-point negative spread between the two-year note and the Fed funds rate accurately predicted the past two recessions.
Despite the tax cut, corporate capital spending on physical and human assets has not measured up to the predictions of the bill’s advocates, no doubt in part because the additional capital wasn’t required to meet projected end demand. Rather, much of the indebtedness incurred in this cycle was for the purpose of financial engineering, most notably share buybacks. In rough numbers, think of it as a $4 trillion bubble—$4 trillion of quantitative easing (QE) matched by $4 trillion of new-business debt expansion, which in turn funded $4 trillion of share buybacks.
We’ve never witnessed a junkier investment-grade bond market nor a more covenant-lite CLO (collateralized loan obligation) market either. The degradation in corporate credit is another rotten piling.
The anemia in capital spending is manifesting itself in another indicator, which also reflects the diversion of funds toward share buybacks and acquisitions. The chart below plots the tangible book value per share for the S&P 500 against the index itself. Tangible book is back to levels last seen in 2010, having contracted for 15 of the last 17 quarters. Since peaking in 2014, tangible book is down almost 30%, while the stock market has advanced 45%.
The obvious result is that the price-to-tangible-book ratio has ballooned to its highest level on record. With the ratio increasing to 11.2 times from 5.4 times in 2014, investors are paying nearly $11 for every $1 in physical assets, net of liabilities. The long-term average is 6.2 times, so the current reading is nearly three standard deviations above the norm. Their divergent paths are disconcerting, to say the least.
To give the opposing view its due, the argument is made that the economy is making the transition to one led by services—and is thus “asset light.” Obviously, at the margin we’re talking about the tech sector. The FAANGM (Facebook, Amazon, Apple, Netflix, Alphabet’s Google, and Microsoft) share of the overall market rose from 9% in 2014 to 21% currently; at the same time we saw a decline in tangible book value. That raises the challenging issue of appropriately valuing intangible assets. Anecdotally, what we learned from the dot.com bubble in the late 1990s is that the valuation of non-physical assets is far more subjective (i.e., volatile) than physical ones: the NASDAQ composite, more heavily weighted with tech companies, went from 1100 to 5000 and back to 1100 between 1997 and 2003. The S&P, its movements truncated because of comparatively asset-heavy companies, fluctuated between 1000 and 1500 over the same period.
The Pilings
Adding to our concerns about the market’s underpinnings, we know that in last Wednesday’s (June 19) press conference Fed Chairman Powell uttered the word “uncertainty” in relationship to the macroeconomy an unprecedented seven times. Trade issues and deteriorating global economic conditions led by Europe were no doubt front and center in his thinking. Domestically, the manufacturing sector has seen atrophy. Though only about 12% of the economy, it produces a disproportionately large economic multiplier. Further, housing has been in a funk for a long time.
Most pundits expect a Fed rate cut of 25 to 50 basis points during its late-July meeting. That could be an ominous sign. The first Fed rate cut on January 3, 2001, during the dot.com unwinding was announced just before the recession no one saw coming, which began two months later in March. Six years later, the Fed cut rates for the first time on September 18, 2007. The recession everyone saw as a soft landing commenced just two months later, in December 2007. The S&P made a new high within a month of that rate cut. Only with the benefit of hindsight do we know the recessions began in those months. Unfortunately for investors, notice of the arrivals of these recessions was pronounced by the Business Cycle Dating Committee some seven and 12 months later, respectively. See our post on this important but often overlooked subtlety.
The S&P’s reflexive action in December 2018 and June 2019—the
head fake—is in response to the presumed cure (rate cuts). Then the focus will
shift to the disease (recession). A bear market is virtually certain to
accompany it. The three prior “balance sheet recessions” have required
increasing amounts of firepower from the central bank to stem and reverse the
tide.[1]
This time the antidote may well include negative rates, renewal of QE, and
interest rate targeting out the yield curve. When the pier begins to shake as
the storm approaches, concerns will surely arise as to whether the central
bank, having played the easy-money trump card with increasing frequency dating
back to 1987, will have any strong pilings left upon which to bear the weight
of the next requisite intervention.
[1] Excerpted from the MCM 2011 annual report: We view the ongoing economic malaise as a “balance sheet recession,” where insufficient aggregate demand is a symptom of excessive indebtedness. “Spend or print money as U.S. leaders will, the economy remains unresponsive to either Keynesian (federal government borrows and spends) or monetarist (the Fed increases the money supply) stimulus during the Great Deleveraging. The downside of excessive indebtedness is equally problematic, particularly when it reaches levels that greatly exceed the present value of future revenues necessary to pay it down to more manageable levels. Trying to surreptitiously shift the burden to savers through inflation and to our foreign creditors through currency devaluation—precisely what we believe to be the Fed’s unspoken intent—brings it face to face with an intransigent paradox. On the income side of the ledger, the main (and unwanted) effect of quantitative easing in 2011 has been to reduce real income. On the expense side, interest costs are sure to rise with inflation. Together, the result is that as real incomes decline the interest cost on the debt surges, likely putting an end to any attempt at taking the inflationary way out.” Eight years later the paradox remains, just as the threat to stability increases.