Well, here we are. All roads have led to here. The combustion case outlined in April, the technical target zone outlined in January of 2018. Trade wars, 20% correction in between, Fed capitulation in response, slowing growth data, inverted yield curves, political volatility, deficit and debt expansion, buybacks. All the big themes that have dominated the landscape in recent memory, they all have led us to here: Record market highs and high complacency into a historic Fed meeting where once again a new easing cycle begins.
Like flies drawn to a light investors have ignored everything that may be construed as negative as the market’s primary price discovery mechanism, central banks, are once again embarking on a global easing cycle from the lowest bound tightening cycle ever. By far. Many central banks such as the BOJ and ECB have never normalized, the Fed barely raising rates before capitulating once again to macro and market reality:
What’s the end game here? I have to ask given the larger backdrop:
Central banks 2009-2018:— Sven Henrich (@NorthmanTrader) July 27, 2019
We will print $20 trillion & cut rates to nothing & that will reach our inflation goals.
Central banks 2019: Ok, none of that worked so let’s print more & cut rates again.
Trust us we know what we’re doing.
What has all this produced? For one the slowest recovery on record, but also the longest expansion. But this expansion has come at a very steep price as artificial low rates have led to massive record debt expansion, $250 trillion in global debt:
The world is sitting on over $13 trillion in negative yielding debt, corporate debt ballooned to all time highs is keeping zombie companies afloat, the desperate search for yield is forcing pension funds into riskier assets, 100 year bonds, BBB rated credit is the largest component of debt markets, everything is distorted and the desperate search for yield has produced another market bubble.
How to define a market bubble? Simple, take the valuation of stock markets over the underlying size of the economy and the size of this bubble is self apparent:
Perspective:— Sven Henrich (@NorthmanTrader) July 27, 2019
Current US Stock Market Capitalization: 144.8% of GDP
Peaked in 2017 at 154%
For reference: The previous 2 peaks came in at 146% in 2000 & 137% in 2007.
Asset prices remain historically disconnected from the size of the underlying economy.
Sustainability: Questionabl pic.twitter.com/EIypajbIu1
I don’t know what fair value is in this distorted world, but the historic mean is significantly lower and it’s only truthful to acknowledge that central banks have sizably contributed to an artificial excess in the ratio.
It’s not a central bank put, it’s a central bank bubble. In other words: To be buying stocks here based on the Fed put is to believe that central banks can maintain asset values above the underlying size of the economy at a historically unsustained level especially in a period of slowing growth.
Following the period of the largest global central bank intervention on record (2016-2017) US tax cuts were promised to deliver 4% growth:
“With the tax plan, we’re going to easily see 4 percent growth next year” – National Economic Council director Gary Cohn December 2017
Gary was of course not the only one, Kudlow, Trump, Ryan, all the pushers behind the big tax cut were promising the moon. None of that came to fruition.
Reality: We didn’t even get 3% growth. US GDP for 2018 was just revised down to 2.9%. Second quarter 2019 GDP has just slowed down to 2.1% and the entire globe is struggling with growth across the board. “Things are getting worse and worse” Mario Draghi head of the ECB said this week.
And it is:
So let’s acknowledge reality here: US tax cuts have done absolutely nothing to change the growth trend in GDP in this cycle:
Has it translated into cast corporate profits? Not really.
Corporate profits before taxes in aggregate peaked in 2014:
This is not an image of expanding profits. What tax cuts have done is minimize the fallout of the decline:
And this is what it took:
A total collapse in tax receipts on corporate income. Corporate tax receipts are now lower than in 1995 with an economy that is much larger.
And we know what corporations are doing with the windfall. It’s not an increase in Capex, or business investment (both of which are declining), but it’s been a massive expansion into share buybacks. Via Yardeni research:
We can observe an accelerating trend similar to the one in the lead up to the 2007 market top when the Fed was also forced to cut rates. And forced the Fed is. It has boxed itself into a corner where it hardly can afford to disappoint markets. After accidentally setting expectations for a 50bp rate cut via ill communicated speeches just one a week ago, the Fed quickly corrected market expectations and consensus is now for a 25bp rate cut. An insurance cut it is advertised as.
The yield curve picture is sending a message that suggests this is no insurance cut:
These yield curves is what has the Fed freaking out and cutting. The problem of course is this: In 2001 the Fed had to cut by 525 bp. In 2007 they had to cut by 500 bp. This cycle they’re starting from 225bp. Never before has stock market capitalization versus the economy been this high with the Fed having such little ammunition.
There are historical examples where “insurance” rate cuts helped delay the inevitable, notably 1998 and the 1980s. But the 1980s also had a market crash and the 1998 example resulted in the tech bubble and subsequent crash making both examples not exactly inspiring examples of success. Is this the end game, blow a massive market bubble?
With a stock market running at a capitalization of 145% of GDP with no history of being able to sustain above these levels, is this the end game here? Blow an even bigger bubble? And that’s the issue I see with talking about an insurance cut being successful here: Markets are already in historically extended valuation territory relative to the size of the economy. Buyers beware.
So what is the world doing to combat slowing growth? Nothing. Everybody is relying on central bankers to save us all again. Politicians have given up, if they ever really tried. There is zero discussion of structural solutions by anybody. Nobody is even trying to have a discussion. Economists are increasingly talking about MMT (money printing forever) and central banks are talking about people QE in light of rates going more negative in Europe.
In the US deficits are hitting trillion dollars with no end in sight. As divided and distracted the country is by political inflammation, propaganda and hate both parties agree on one thing: Spend more money. A monstrosity of a budget was agreed to by the House this week further exacerbating deficits and raising the debt ceiling for another meaningless deadline. We’ll see if it passes the Senate, but here’s what we’re faced with:
“The deal suspends the debt limit through July 2021 and sets top-line levels for defense and nondefense spending for the next two fiscal years. It establishes a $1.37 trillion budget agreement in the first year, with $738 billion for defense spending and $632 billion in non-defense spending for fiscal year 2020.”
$738B for defense versus $632B non-defense spending. Now let’s cut food stamps to save.
I’m highlighting all this to make clear: There are no solutions on the horizon. There is no dedicated serious leadership on either side of the political isle to address any structural solutions. None. There is nothing but debt expansion and hope that the Fed can extend the business cycle by inflating stock prices to above 145% of GDP.
Businesses are not investing in growth while consumers are loading up on credit card debt. What do businesses know that consumers do not yet?
Are businesses simply waiting for a China deal? Well, then they may be waiting for a long time as Donald Trump dialed back expectations on Friday suggesting China may want to wait to make a deal until after the 2020 election.
Whether posturing or not fact is there is no China deal and absolutely nothing has changed on the structural growth front.
But here we are:
New highs $SPX on a negative divergence amid volatility compression, right into the upper trend line outlined in the megaphone structure we’ve been discussing.
I’ve repeatedly outlined the 3000-3050 $SPX area (see also recent Weekly Market Briefs , Distortion) to be a key technical resistance zone and markets have pushed into the middle of this zone right ahead of the Fed.
I’ve outlined several technical concerns about this rally (see also This Week on NT).
To highlight two: Open gaps and volatility compression:
A subject I discussed on Friday on CNBC:
What’s the risk profile into this important Fed meeting then?
On the $VIX its further compression into the lower trend line, but in context of a pattern that is looking to break out hard at some point.
In regards to markets 2 key charts from the previous risk profiles:
$SPX is a stone’s throw away from its 2.618 fib:
$ES has further theoretical room to go (Per Combustion):
On the larger trend profile there’s also room into 3052 or so:
Off of the 2018 lows the Fed capitulation and policy turn has produced a massive rally into a key resistance zone. Markets are fully expecting a rate cut his week and have ignored all negatives in markets with the expectation that the Fed will spark another squeeze in equities. In 2007 the first cycle rate cut of 50bp led to a two week rally for the final top. This rally here has entered a key resistance zone we’ve outlined to be a potential massive sell zone in equities. This week and the one that follows may then be pivotal for this market. A breakout cannot be excluded as a possibility, neither can a fake breakout that reverses or an outright violent rejection of the risk zone. What the Fed can’t afford is disappoint markets or the political establishment that wants the Fed to cut rates aggressively. Investors are apparently unconcerned either way and are betting on a positive outcome as evidenced by a very low put/call ratio:
We are in a unique period in history. The end game is approaching. An extension of the market bubble above 145% stock market capitalization to GDP or a reversion back toward more of a historical mean which is what the current technical and macro environment suggests:
As suggested last week this is a big battle for control. Investors as of now are pursuing a 10 year standing motto:
In Fed we trust.
Best of luck.
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