At the start of June, we wrote the following:
For much of 2019, the big conundrum facing investors has been justifying the unprecedented divergence between institutional sentiment as represented by historic outflows from equities on one hand, and the market's honey badger-like ascent to new record highs in 2019 on the other, ignoring the continued redemptions, and propelled higher on the back of record stock buybacks, recurring waves of rolling short squeezes, and dealer gamma positioning.
Fast forward six months and compare that to what SocGen just wrote yesterday in its 2020 year ahead outlook:
We are currently facing a conundrum. Despite the S&P 500 rising 24% ytd to record-high levels in recent days, we have yet to see any signs of exuberance. Indeed, both the positioning and market sentiment indicators do not seem to point to excess complacency.
And, as if on cue, at almost the same time yesterday, JPMorgan's Nikolaos Panigirtzoglou came up with an almost verbatim statement, only instead of "conundrum", he used "puzzle":
One of the major flow puzzles of this year has been the extremely cautious stance of retail investors. Despite the strength of the equity market this year, retail investors have been unwilling to participate in the equity rally. In fact, they have acted as a drag for equity markets so far this year by selling equity funds in the worst outflow for a calendar year since the financial crisis of 2008
While we are flattered to find that SocGen (and JPMorgan) finds not only our market takes, but also specific phrasing imitatable, it is more notable that SocGen (and JPM) have stumbled on what only "tinfoil" blogs discussed half a year ago as the biggest "conundrum" (or "puzzle") facing the market - the lack of virtually any investor enthusiasm even as the S&P hits new record highs day after day (and the subsequent question: if not investors, then who is pushing this market to record highs).
So, as we did back in June, so SocGen now asks "how can we reconcile the fact that there are no signs of exuberance in the positioning and market sentiment indicators with the S&P 500 trading at an all-time high and up 24% ytd? And what does this mean for our 2020 outlook?"
This conundrum gets even more bizarre when one considers that equity fund outflows in 2019, the best year for the S&P since 2013, are on pace to surpass even the financial crisis year of 2008 some $209 billion in funds was redeemed; meanwhile so far in 2019, the YTD total is a record $215 billion... and yet the S&P keeps hitting new record high after record high. What gives?
As SocGen writes, picking up where we left off back in June, "the answer to this conundrum can partly be found in the reduced trading volume on the US equity market and the massive wave of buybacks over the past two years in the aftermath of President Trump’s Tax Cuts and Jobs Act (TCJA). In recent weeks, with the de-escalation of the US/China trade war, we think market participants have started to price in a potential improvement in the soft data indicators, and this could go on for a while if the de-escalation momentum continues."
So what happens next? Well, if one looks at the Conference Board US Leading Economic Index, one can see that the US has undergone three mini-cycles since the 2007 Great Financial Crisis (GFC). Meanwhile, as SocGen's Alain Bokobza writes, "the announcement of “Phase 1” agreement on the 11 October 2019 by President Trump, after 463 days of twists and turns between US/China was welcomed and came as a relief to the financial markets, lifting in a dramatic way the price of risky assets."
Which lays out the key question for 2020 as framed by the French bank: "market participants have started to factor-in the start of a fourth mini-cycle. Can it last?"
To answer this question, one first has to look at how we got to where we are in 2019, and here SocGen echoes Goldman's recent assessment, pointing out that if one looks at a breakdown of S&P 500 total returns, we can make two observations: First, since October 2018, the market’s performance has been driven entirely by earnings growth, while P/E has been a negative contributor: end-2018 recession fears and Fed tightening are factored into the numbers. Second, and more importantly, the Fed’s dovish shift in early 2019 facilitated an extraordinary P/E expansion. Indeed, as shown in the chart below, since January 2019, the biggest contributor by far to S&P returns has been PE expansion.
As a reminder, this is what Goldman said last week in its own 2020 year ahead preview: "With S&P 500 earnings on track for roughly zero growth from this time last year, solid returns likely would not have been possible without central bank support." Of course, 2019 was a year in which both the Federal Reserve and the European Central Bank eased monetary policy, pushing long-term real interest rates down about 100bp in the US and 50bp in the Euro area. About how much did this lift risky assets? A standard approach based on the equity risk premium concept would say that central bank intervention accounted "for almost all of the price return since the start of the year." That's not us, that's Goldman.
Why is the above important? Because to have a view on asset returns in 2020 one has to understand what caused the market's impressive 24% increase in 2019. Here, as SocGen notes, the question to ask is "what drove this P/E expansion since the start of the year, apart from the Fed’s dovish shift? And is that sustainable? Buybacks and a lack of market liquidity played a major role."
The answer, for those who have been reading our weekly observations on this big "conundrum", is well-known. For everyone else, SocGen notes that Trump’s late-2017 Tax Cuts Tax Cuts and Jobs Act marked a shift and contributed massively to the wave of share repurchases over the past two years. The amounts steadily increased to a record high in 2Q19 – equivalent to a 3.2% buyback yield, which comes on top of a 2.2% dividend yield. Meanwhile, the S&P 500 return on equity is currently at an all-time-high.
Here, it is also worth pointing out that the vast majority of these buybacks were funded by new debt issuance, most of it in the BBB bucket. Ironically, none other than former NY Fed president Bill Dudley was lamenting last week the "BBB-Bulge", warning that trillions in fallen angles could soon flood the junk bond market. They certainly can, and the irony is that the next bond crisis will be the result of massive issuance to fund buybacks, which in turn sent stocks to all time highs and boost management cash compensation to record levels. Needless to say, the reverse will not be pleasant for equities.
Besides ruinous central bank policies encouraging management teams to go out and issue record amounts of debt which they can then use to repurchase stock, there is another reason behind the year's tremendous, if euphoria-less, ascent: "the lack of market liquidity, as measured by S&P 500 turnover – the ratio of trading volume vs free float market capitalization – has exacerbated the impact of share repurchases on US equities", according to the French bank. Indeed, trading volume has been on a downtrend since 2008, and Socgen expect this to continue.
The implication is simple: one substantial buyback program, like say Apple's latest $75 billion stock repurchase authorization, (after it bought back $100 billion in 2018) has an outsized impact not only on the price of AAPL stock, but the entire market too. That's precisely what has happened in a year which started with AAPL cutting guidance, only to soar 86% since.
Meanwhile, a third of AAPL's stock has been repurchased ever since Tim Cook decided to engage in financial engineering instead of actual engineering, for a company whose actual engineers have failed to come up with a new, engaging, must-have product ever since the death of Steve Jobs. Is it any wonder that the only thing keeping AAPL stocks up is... itself?
Putting these together, SocGen concludes that "share buybacks and a lack of trading volume have supported the S&P 500 at a time when the global recoupling of growth to the downside put global equities in a tough spot. However, we believe market participants in recent weeks have started to price in an alternative scenario."
Which brings us to the forecast phase. Here, JPMorgan comes first with a rather simplistic assumption. The bank's Greek quant proposes a similar deus ex explanation as the bank's Croatian quant, and postulates that the same retail investors that pulled money out of the market for all of 2019 will make a thunderous return in 2020, and be the catalyst to push the S&P to new all time highs. This is what Nick Panigirtzoglou calls the "Great Rotation II", modeled after a similar rotation out of bonds funds and into stocks in 2013. To wit:
If this view proves correct and the overall cyclical picture looks better over the coming months and quarters, retail investors are more likely to shift from a risk-off mode to a risk-on mode next year, by reversing this year’s equity fund selling and by reducing drastically this year’s extreme bond fund buying. Such a dramatic flow shift would be equivalent to another Great Rotation, i.e. a repeat of the abrupt shift away from retail investors accumulating bond funds to buying equity funds seen previously in 2013. In other words, 2020 would be the year of Great Rotation II, in a repeat of 2013 the year of Great Rotation I.
While on the surface, this thesis makes sense, Panigirtzoglou himself points out the weakest link: contrary to conventional wisdom, investors already have near record equity exposure:
[Investors] equity fund share has exhibited some mean reversion since the mid-1990s. It had increased sharply over the five years to 2017 as a result of the equity rally, with most of the increase taking place during 2013 and during 2017. The metrics in Figure 5 declined sharply during the equity market correction of Q4 2018 but most of that decline reversed this year. This implies that retail investors are entering 2020 with only modestly lower equity position relative to the highs of Q3 of 2018 or end 2017. In addition, the current equity position is very close to the two previous equity market peaks of 2007 or 2000.
So for JPM's Great Rotation II thesis to play out next year, retail investors would need to accept equity weightings that are even higher than the previous equity market peaks of 2007 or 2000.
If they do, this would represent a structural change in retail investors’ asset allocation, perhaps justified by structurally lower cash and bond yields vs. equity yields, compared to the previous 2007 and 2000 cycles.
Paraphrasing JPM in a slightly less politically correct way, there is an unprecedented need for institutions to dump their stock holdings on retail investors, and only a reversal in retail outflows can help push stocks to new all time highs in 2020. It would also explain why central banks have been so forceeful in stepping on the accelerator and either easing or launching "NOT QE", as stocks threatened to anything but go straight up.
That is JPM's take on 2020. What about SocGen's?
As the French bank explains, "last month's announcement of a “Phase 1” agreement in US/China trade talks on 11 October by President Trump, 463 days after the trade dispute began, was a welcome relief in the financial markets, significantly lifting risky assets." Sure enough, over the past month the S&P 500 reached an all-time high of 3,125, driven mostly by cyclical sectors. This marks a real shift in sentiment, as defensive sectors had been showing higher yoy growth in sector market cap in the S&P 500 over the year. On the other hand, as we noted last week, this reversal in sentiment appears to now be over and as markets once again price in an economic slowdown, the outperformance of cyclicals has faded sharply - with value stocks down 9 out of the past 11 days - and defensives are once again leading the market's ascent.
Why is this important? Because as both Marko Kolanovic recently, as SocGen on Friday suggest, for the market to have material upside in 2020, it will be key for the leadership to shift from defensives to cyclicals, as the global economic outlook shifts to an optimistic one. Alas, that would also mean that bond yields would surge well above 2%, effectively planting the seeds of the market's own destruction, because the higher yields rise, the more likely central banks will be to turn hawkish again, and so we would go back to a Q3 2018 scenario.
Incidentally, as we first wrote two weeks ago, and as Bloomberg finally picked up on Friday, not only is the recent bout of bond selling over, but so is the "great rotation" as we first dubbed it (well before JPMorgan).
Rotation aside, SocGen also points out that if one looks at the Conference Board US Leading Economic Index, the US has undergone three mini-cycles since the 2007 Great Financial Crisis (GFC).
SocGen also points out a close link "with the yoy performance of the S&P 500. More recently, while the US Leading Economic Index bottomed (+0.4% yoy), the S&P 500 seems to have started to factor in a fourth mini-cycle. What are the characteristics of a mini-cycle and how does this impact our view on US equities?"
Putting all of this together, SocGen believes that we are facing two possible scenarios in 2020:
- 1) a mild recession in 2020, which is the bank's central scenario, with two quarters of negative GDP growth in 2Q and 3Q, at a respective -0.7% and -0.8%, with full-year GDP growth at +0.7%; or
- 2) the start of a fourth mini-cycle. The bank considers here the latter scenario and its potential impact on the S&P 500. Given the characteristics of the previous three mini-cycles – the French bank determines the exact dates by looking at the US Leading Economic Index and the UST 10y bond yield – and finds they last 3.5 years on average. In other words, should there be a fourth mini-cycle thanks to the massive central bank liquidity injection in 2019, the current economic cycle would be extended to 2023-24.
More importantly, SocGen focuses on the period between the start of the mini-cycle and the peak – reached previously in April 2010, August 2014 and October 2018 – which usually last 1.0-1.5 years. The bank then notes that the third mini-cycle was very likely spurred by President Trump’s late-cycle fiscal boost, and highlights the following impacts on US assets from these mini-cycles: higher equity markets, a weaker dollar, and higher Treasury yields.
Next, SocGen focuses on the drivers of the S&P 500’s total return during the second and third minicycles since 2009, paying attention to the period from the bottom to the peak. P/E expansion was not exuberant, in tandem with strong earnings growth. Looking at the recent market moves, the S&P 500 is already up 6% since 7 October 2019, the start date of the fourth mini-cycle based on the US Leading Economic Index, thanks entirely to the abovementioned P/E expansion.
It would also put the recent S&P meltup in its proper context, because from a price perspective, SocGen believes that "the lessons of previous mini-cycles could support a melt-up in the S&P 500 to 3,400." However, for that to be sustainable, the French bank believes there will be a need for earnings to grow next year, as the divergence between fundamentals (E) on the one hand, and market anticipations and low interest rates (P/E) on the other, cannot be that wide. For now, that appears unlikely.
Still, even though SocGen expects that early 2020 will see another economic recession, it concedes that another mini-cycle "is not outside the realm of possibility," as US consumer confidence and retail sales remain healthy for now, and given the possibility that a trade deal between US and China could put a floor under the current “manufacturing recession."
Unless of course, China decides to open a trapdoor in the floor should it decide that it no longer wants to deal with President Trump, and crushes hope of a trade deal in 2020, in which case the likelihood of a full-blown recession soars.
But even then the story does not end, because in a worst case scenario, one has to consider that the Fed still can cut rates another 6 times before its hits 0%. What then? Well, the central bank will likely be compelled to first buy even more assets, potentially including ETFS and single stocks, while it will likely also cut rates to negative.
The bottom line is simple: as Saxo Bank earlier noted, "so much liquidity has been injected in the stock market over the past years, it is now almost impossible to withdraw it." It also means that the Fed can no longer afford even a modest drop in the market (as we saw in Q4 2018) because as Saxo Said, "as it would lead to contagion effect to the real economy" and would cultminate with a full-blown economic depression, one with catastrophic consequences for the status quo, and the Fed itself.
It's also why virtually every bank, analyst and strategist now has no choice but to be bullish for 2020 and onward: central banks are henceforth perpetually trapped into injecting liquidity at even the slightest sign of trouble, as the alternative - after 10 years of constantly bailing out the market - is unthinkable. The alternative? A recession, or a bear market, would likely be the trigger event that ends the fiat system as we know it, one intermediated by central banks.
Which is why BTFD - if you can find one - and pray that central banks keep it all under control without i) sparking hyperinflation or ii) resulting in too much social conflict and unrest over the wealth inequality they create, as such an outcome would promptly result in a substantial amount of guillotines appearing on town squares, and even more promptly ending any hopes for a fourth, or any for that matter, mini bull cycle.