As we are now in the final quarter of 2016 we thought it would be helpful to revisit the investment themes we outlined at the start of the year. We began 2016 focusing our investment strategy on three main themes:
- Increasing global equity market volatility will lead to lower returns and greater investment risk than we have seen in recent years.
- The probability of currently unknown events shaping market behavior is high due to over extended financial markets and geopolitical uncertainties.
- Divergent monetary policy combined with historically unprecedented Central Bank market intervention could lead to a liquidity crisis in the bond market.
We will briefly update you on each of these themes.
Greater equity market volatility, increasing risk, and decreasing return on investment.
The below chart shows that over the last twenty two months ending today an investor in the S&P 500 would have endured two drawdowns of over 12% while making no money.
The following points illustrate the underlying vulnerability of US equity prices as we approach the ninth year of a bull market.
- The 12 month forward looking Price to Earnings Ratio (P/E) for the S&P 500 is 17. That is well above the 5 year average of 14.7 and the 10 year average of 14.3.
- The ratio of total market capitalization for U.S. stocks vs U.S. Gross Domestic Product (GDP) is 122.4%. The only time it has been higher was just before the Dot.com stock market bust in the year 2000.
- The Shiller P/E for the S&P 500 is currently 27.2. That is a higher value than September 2007, just before U.S. stocks started to roll over. A value of 27.2 has been exceeded only twice. Once was at the peak of the market in 1929. The other time was at the peak of the market in 2000.
- The "Q Ratio" is a measure of market valuation which is the total price of the stock market divided by the replacement cost of all of its companies. It has exceeded a value of 1.06 only 5 times between 1900 and today. Shortly after all 5 instances a significant correction took place. Recently the Q Ratio reached 1.10.
Do we think the above points are fatalistic indications that we are on the edge of a financial crisis on par with 2000 and 2008? No, it does not!
We must also ask ourselves, since the financial crisis of 2008 has the US economy experienced enough growth to justify a return to record high equity prices and the second longest bull market in US history? No, they are not!
These conditions reinforce our conviction that equity markets will continue on their path toward lower returns, higher volatility, and greater investment risk over the course of the next 12 to 24 months.
The probability of currently unknown events shaping market behavior is high due to over extended markets and geopolitical uncertainties.
Overall, what has transpired this year on the geopolitical front has far exceeded our expectations.
When we began focusing on this theme in mid-2015 our assessment was that geopolitical instability has two potential flashpoints:
1) The still fragile economic recovery of the European Union combined with the intense political infighting resulting from the refugee crisis created by the war in Syria. It is the worst refugee crisis faced by any nation or region since the end of the Second World War.
As you see in the graphic above, the UK has taken in the second smallest amount of refugees; second only to Switzerland. While Germany has been by far the most accommodating of the European nations. Keep in mind that the primary reason UK citizens who voted in favor of BREXIT said they did so in order to help curb the feeling of being overrun by refugees flowing into the UK from the Middle East and Eastern European countries.
The UK vote to exit the EU was as much a surprise to us as it was to the rest of the world. Before the vote, the global financial community made it clear that a vote in favor of the UK leaving the EU was a vote for what would inevitably be a financial meltdown in the UK and across the region.
Why then has the economic and financial impact of BREXIT been so mild?
- Since BREXIT the Bank of England (BOE) has cut short-term UK interest rates in half and announced several other measures to help pour cash into the British economy.
- The European Central Bank (ECB) with already negative interest rates has pledged to push rates farther into negative territory.
- The Bank of Japan (BOJ) is not only stimulating their economy through negative interest rates, they are actually buying stocks in the open market. The BOJ is now a top 10 shareholder in 90% of the companies listed on the Nikkei 225 Stock Average.
- After stating they would raise rates four times in 2016 the Federal Reserve went silent. The market now puts 70% likelihood on the Fed raising rates 0.25% in December. If that occurs it will be the first raise since December 2015.
The bottom line is, after BREXIT the BOE, ECB, and BOJ actively began pumping capital into their economies while the Fed backed away from all hawkish policy statements. As a result of this systematic suppression of volatility, global markets steadied as investors around the world concluded that "central banks have our back".
2) Potential meltdown in China. The combination of rapidly declining growth, skyrocketing debt as a percentage of GDP, and growing excess in industrial capacity all point to the potential for greater instability in the world's second largest economy.
At the beginning of the year our "base case scenario" was that China would continue with a moderate level of growth in the 6% range. The Chinese government is currently estimating 2016 Q4 GDP growth to be 6.4%. This is well below historic average, yet still remarkable considering China is the world's second largest economy.
As we move forward into 2017 we continue to assess the potential risk created by the increased financial linkage between the US, China, UK, EU, and Japan. The historically unprecedented monetary intervention by central banks as a reaction to the crisis of 2008 has introduced a level of risk that was not present before the crisis. The potential for a meltdown in the Chinese financial system continues to be a risk that we monitor closely.
However, we must also remember that China's capital account is heavily controlled, the government has strong influence on both sides of the balance sheet, and it remains a current account surplus economy with more than sufficient foreign reserves to avoid a balance of payment crisis. This doesn't mean things will get better soon, but it does mean the economic dysfunction can probably grind on much longer than we expect.
Elephant in the Room... what we did not know, we did not know.
After weeks of relatively calm expectations for a status quo U.S. election result putting a Democrat in the White House and mostly Republicans in Congress, investors worldwide are panicking about the possibility of a Donald Trump win on November 8th and the unknown impact this would have on the global financial markets.
In the last 6 days Donald Trump has closed the gap in the polls between himself and rivalHillary Clinton following a surge of support, apparently from independent voters. The following is an average of all national polls. Six day ago this average showed Clinton leading by a margin of +6.8 well above the margin of error. Today, she is leading by +1.3 which is well below the margin of error.
Since the Federal Bureau of Investigation dealt a blow to Hillary Clinton by reigniting controversy over her emails, safe haven assets are rising and riskier assets are falling.
The above is less dramatic than what analysts have said will happen if Donald Trump wins the election or the Democrats sweep the House. Most market analysts predict US market reaction will involve a drop of 9% to 16% in equity prices, while some predict much more. Since October 28th, the day the FBI announced the reopening of the Clinton email investigation the S&P 500 is down 2.58%.
In a report published this week, JPMorgan Chase & Co. raised a third possible surprise outcome, which could produce an even more negative market reaction. The title of the report said it all: "I demand a recount."
At this point the only thing we know for sure is that regardless of the outcome of November 8th the aftermath of this US election cycle will most likely continue to create uncertainty for the foreseeable future. What we also know is that markets tend to have a strong aversion to uncertainty.
Divergent monetary policy combined with historically unprecedented Central Bank market intervention could lead to a crisis in the global bond market.
Divergent Monitory Policy is a key theme influencing our macro view of the economic and market outlook for the coming years. For several decades, the willingness of both lenders and borrowers to embrace credit was a lubricant for economic growth and rising asset prices and, importantly, underpinned the effectiveness of monetary policy. During times of economic and/or financial stress, it was relatively easy for the Fed and other central banks to improve the situation by engineering a new credit upcycle. That all ended with the 2007-09 meltdown. Since then, even zero policy rates have been unable to trigger a strong revival in credit growth in the major developed economies.
In an attempt to engineer a new credit upcycle, fueled by ultra-low interest rates US companies have issued approximately $937 billion in new corporate bonds from January 2016 through July 2016. They are on track to far exceed over $1 trillion of new issuance this year, just as they did in 2015.
Much of that money is finding its way directly into the stock market in the form of share buyback plans. The biggest buyers of the U.S. stock market in 2016 are the companies that make up the market.
According to the Securities Industry and Financial Markets Association (SIFMA) total outstanding U.S. corporate debt was approximately $4.6 Trillion at the end of 2005. As of the end of Q1 2016 it was approximately $8.4 Trillion.
In an attempt to engineer a new credit upcycle central banks have created an environment that rewards excessive credit creation on an unprecedented scale. As long as ultra-low or negative interest rates are maintained, asset prices will remain over valued on a fundamental basis.
This model of growth can only be maintained while there is little to no inflationary pressure in the economic system. Our fear is that the Fed reactionary function will be too little too late, setting in motion a dynamic in which interest rates will be forces higher much faster that the market anticipates. The outcome of this dynamic could potentially trigger a liquidity crisis in the bond market. With low credibility and lacking monetary firepower the Fed will have few recourses to stem contagion into other markets and recalibrate the US economy.
The following chart illustrates the intensity with which bond yields are currently reacting to the slightest increase in inflation.
Again, do we think the above points are fatalistic indications that we are on the edge of a financial crisis on par with 2000 and 2008? No, they are not!
These conditions reinforce our conviction that the bond market currently holds much more risk than it does upside potential. We do not know if the Fed and other central banks will be successful in their attempt to engineering a new credit upcycle. We are eight years from the start of this experiment and the outcome is not looking so good to us.
We cannot say for certain whether higher volatility will last through November and December. They are normally pretty good months for stock market gains. That did not hold true in 2015, but it is true in most years. As well, this is a presidential election year and normally the election is not a big factor in the movement of stock prices. However, this year could be very different. There will likely be more surprises to come in the week ahead.
In the meantime our investment strategies are positioned defensively. Twelve months have passed since we set out the above investment themes and our portfolios are well positioned for the current environment.
Clearly markets can keep rising even when they are overvalued. That is exactly what happened from 1997-2000. It took three years before the market finally corrected meaningfully. It is also clear that central banks will continue to do everything in their power to suppress market volatility by keeping interest rates low and/or negative for as long as they can.
We cannot time the next major market correction. It is our job to be prudent and not get over committed to a highly priced market. We have always believed in preserving our capital first. We have always believed in buying assets at a discount, not when they are overvalued.
We believe that current market conditions dictate that we focus on capital preservation, while we wait for better days to be aggressive buyers of stocks and bonds. We are quite certain they will be on sale again one day. Today is simply not that day.
All the best,
GOVINDA QUISH, PAUL KRSEK, JEFF ROUSH,
THE INVESTMENT POLICY COMMITTEE
5TQ CAPITAL, LLC
595 Coombs Street, Napa, Ca, 94559
(707) 224-1340 Main
Disclosure and Disclaimer - Updated last on July 17, 2016, 2016 by Paul Krsek:
ELLUMINATION is the proprietary newsletter written for clients, friends, and affiliates of 5TQ CAPITAL, LLC .
FROM JUNE 1998 to January 1, 2016 Paul Krsek was the sole author of ELLUMINATION. While the views and representations found in the newsletter generally reflect the attitudes and opinions of the 5TQ CAPITAL, LLC members and staff, Krsek wrote without editing was therefore is solely responsible for the content and opinions contained in ELLUMINATION.
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