There are periods when one spends enough time in a wilderness environment that boredom sets in. One might do (and probably has done) something stupid. One might try to follow a big cat or a bear upon finding such tracks or fecal remains. One might come to realize that those tracks weren't quite as old as previously thought. Was it Forrest Gump in the similarly titled movie that profoundly stated that "Life is like a box of chocolates...." He was right. We never know.
On Tuesday, equity markets roared out the gate, sold off hard, and then rallied nearly as hard into the closing bell. The VIX increased in value on a day that saw the major equity indices all close strong. The VIX is now 9% higher than it was last week at this time. Breadth was solid. On the trading floor of the New York Stock Exchange, winners beat losers by a three to one margin, while uptown at the Nasdaq market site, the ratio was also slanted toward the winners, by a two to one measure. Volume, however cooled a bit on both of the primary exchanges.
The Silver Tongue
Outgoing ECB president and wordsmith Mario Draghi spoke while you were sleeping. Apparently, Draghi feels that though the ECB has already this month downgraded their own 2019 projections for Eurozone GDP from 1.7% to 1.1%, that this temporary slowdown does not necessarily imply that serious contraction lies ahead. Still, Draghi said what sounds nice, yet the words might have been spoken by any high school sophomore. "It was clear that the loss of growth momentum could become more broad based and persistent if two risks were to materialize: first, if external demand were to remain weak; and second, if this were to spill over into domestic demand." Well, thank you Sherlock Holmes, master detective. Don't need graduate school to figure that one out. Basically, he's hoping that investors don't run for the hills, and that new orders magically flow back into Germany.
We have discussed Complexity Theory in recent months, supported by research done by noted author/ economist Jim Rickards. Esteemed colleague Peter Tchir has been doing some excellent work of late on self-fulfilling prophecies. Others have chimed in on the length of time, the lag so to speak between the inversion of the U.S. Treasury yield curve and the onset of actual economic contraction. Still others correctly point out that equities can and often do outperform their own track records before the economic recession forces a bear market. (A real bear market, not the Fed inspired fourth quarter melt-down, that brought about the also Fed inspired first quarter bull market.)
So what if one shoe dropping does lead to another? There is no doubt in my mind that given the perception of a coming lower short-term interest rate environment, coupled with fiscal policy that might be politely referred to as irresponsible, then wrapped with foreign economies that appear far worse off than us... that there has to be an expansion in earnings multiples for equities, deserved or not. This is part of the reason that I often preach playing the game both ways with segregated funds. Use different accounts if that helps. Write a mission statement for each.
The San Francisco Fed, in a research paper published this past August, referred to the 10 year/3 month spread as the most reliable predictor of recession. The Cleveland Fed in a paper published about a month ago, notes that inversions of the 10yr/3mo yield spread have predicted nine of the last seven actual recessions (two false positives in 1968 and 1998). Has gross perversion of price discovery at the point of sale changed this economic truth? Hard to say. Policy did destroy the Phillips Curve.
Now, one would think as the 10yr/3mo spread has contracted, so might the rest of the curve. This has not yet occurred. Will it? I don't know. I want you to take a look at spread behavior comparison over several months. First the 10yr/3mo. These charts are based on Tuesday night pricing.
You easily see erosion of the spread taking place over months as the central bank's series of 2018 increases to short-term interest rates continue to work their way through the economy. That skewing of a natural form of price discovery has been orchestrated over decades of unnatural interference with risk and the ability to properly assess it's impact. This impact is ongoing. Now take a look at the 10yr/2yr spread. You will see nothing but stabilization here.
Look at that. Not only at 17 basis points does this spread stand at the top of it's range for March, it also went out last night at it's 50 day simple moving average. Indeed something eerily strange is going on here.
What Does This All Imply
Well, obviously, the Fed erred in their aggressiveness in late 2018. I don't even think the most hawkish among us (I am hawkish by nature) would argue this point if they truly understand the trail of policy mistakes that have gotten us as a people to this point. I will grant the hawks that we should not be here, but the fact is simply that we are. The implications as far as this simple mind can tell are that unless there is compression in the 10/2 spread, that bet is on a troubled period for the economy that will suppress growth, but somehow leave current projections for consumer level inflation in tact. In case I am not simplifying this enough, that's bad for the average nine to fiver with a few mouths to feed.
I have not found research on this yet, but my guess is that the longer the 10yr/3mo spread remains inverted, the greater the prospect of a general recession brought about by this self-fulfilling prophecy if nothing else, but there by then, there would indeed be something else. Today is day four of this inversion. If nothing is done to counter-act this inversion, look out nine to 18 months. I do expect, however, that there will be an attempt made to correct this condition and soon.
What We Know, What Can Be Done
I think it is apparent that equities will offer more yield as valuations expand, than will other investments as debt securities push into areas they probably should not, and growth in real estate pricing slows significantly. The Fed will start to taper the quantitative tightening program. That should help, but is still draining $50 billion per month from the economy per month through April.
I have spoken often enough of an "Operation Un-Twist" This would put downward pressure on short-term yields and upward pressure on longer-term yields. That could upset financial markets and would further damage the rate of home ownership in the real economy. So it fixes this problem, but not clean if anything truly is. Futures trading in Chicago are not pricing in the first rate cut by the Fed in this potential easing cycle until September 18th. If they trust their own research done at the district level, the FOMC will have to signal a rate cut by May, and then act by June.
That should in theory, at least remove some heat currently being felt across the spectrum of short term debt. Do my plans and theories work in reality? Better than sticking one's head in the sand, I would think. Understand that the talking heads that you see on television cautioning against overreaction to this inversion might be right. Understand also that many of these talking heads work for financial institutions and in may cases will not appear unless they are given the questions ahead of time and their legal departments are permitted to manicure their answers. It's perfectly fine to mentally prepare to defend oneself for all eventualities.
Just in case you've managed to sleep through the early part of the week, the battle lines are being drawn and are visible to see from both sides. Fresh off of the president's dramatic political victory over the weekend, the Justice Department has asked a Federal Appeals court to strike down what's left of the Affordable Care Act. A risky move, I would think, politically at a time like this. This gives Democrats, fresh off of a highly embarrassing political defeat, a line to retreat to that one would think their base to be passionate about. The victims here, at least while the issue is argued over and nothing actually changes, will be corporate health care industries that have flourished under the ACA. By the way, I have no dog in this fight other than equity performance. This law has helped many, while making victims of many others, and I have witnessed both in person.
With this ball now in play, it for me becomes difficult to own for anything other than a trade, managed care stocks and those that most benefit from Medicare expansion. This once again unsettled turf puts names like Centene (CNC) , and WellCare Health (WCG) in a tough spot, not to mention UnitedHealth (UNH) , a name that I am long and see as best in class. Hospital stocks such as HCA Healthcare (HCA) and Tenet THC will also likely see sustained pressure as well. Add healthcare to the financials as sectors that I for one will remain underexposed to, likely for the rest of the year. Perhaps longer.
Note: This article written ahead of the CNC/WCG news. Perhaps this is an attempt to increase scale in the face of this coming political battle. The general thesis remains in my opinion, one of pressures on the industry.
Economics (All Times Eastern):
07:00 - Fed Speaker: Kansas City Fed Pres. Esther George.
08:30 - Balance of Trade (Jan): Expecting $-57.5B, Last $-59.8B.
10:30 - Oil Inventories (Weekly): Last -9.589M.
10:30 - Gasoline Stocks (Weekly): Last -4.587M.
Today's Earnings Highlights (Consensus EPS Expectations):
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