As we enter the end of the third-quarter 2019 earnings season and the market claims newer highs, 90% of companies have reported so far and 75% of companies have beaten earnings per share consensus estimates, which is higher than the five-year average. However, looking at guidance for Q4 2019, 72% of companies have issued a negative guidance outlook, which compares to the five-year average of 70% (source Factset).
The S&P 500 is up 7% since touching the lows in early October, it has been up in a straight line and not looked back since. The 12-month forward ratio trades on 17.4x PE, the highest level since January 2018, while forward Earnings Per Share (EPS) have fallen 0.3% on downward revisions. That is multiple expansion on a whole new level.
Judging by the cyclical/defensive ratio, which has rallied aggressively, and the squeeze in U.S. 10-year yields back to 1.94% from lows of 1.4%, it appears the market is pricing in a massive bounce in global GDP growth. In the months to come, it needs to see better economic data not only from U.S. but also from China and other cyclically geared regions to justify this price action. Hopium can only go far if not met by actual facts.
So, who is right? Clearly there is a disconnect and the market is torn between bulls and bears. Although judging by the recent Bank of America Merrill Lynch Fund Manager survey, cash levels have fallen to record lows once again. Even the bears are being forced to invest in this rally. FOMO (fear of missing out) has taken over. A TINA-type (there is no alternative) rationale is officially quoted in investor meetings as people do not know what to do with cash as interest rates head towards 0% and possibly negative, even.
Most will not admit this -- well certainly not the Fed, which is refusing to even acknowledge that they are doing any sort of quantitative easing to begin with -- but the aggressive rally in markets in October came purely because the Fed has now gone into full-throttle easing mode, expanding the balance sheet by $200 billion and taking it above $4 trillion in just a few weeks. If we annualize this rate, the Fed's balance sheet will be back at 2018 highs by February 2020.
The Repo operations that were supposed to be a one-time fix for the September quarter end have been extended out indefinitely, from $75 billion daily injections to now $120 billion. There are bids close to $100 billion+ being submitted every day, and the Fed is accepting and injecting the system with liquidity. If this is not quantitative easing, then I'm not sure what is. It is simple, money is going in the system, which is to be recycled and lent back out to boost the economy. Where does it go? Risky assets and equities, as there is a direct correlation between the S&P 500 and the Fed's balance sheet. Anyone who denies this is either a fool or just too embarrassed to call a spade a spade.
There is a serious dollar shortage, as can be seen by the Eurodollar deposits. At times of stress, some foreign banks need to top up their dollar deposits, and judging by the daily auction demand, there is a bank/s that needs some serious dollar liquidity. Could it be Deutsche Bank (DB) given its past troubles, or JP Morgan (JPM) cornering the market as they expect times to get tough? Who knows.
Instead of trying to understand why there is such a demand for liquidity every night and why banks are not lending to each other, the Fed is instead throwing money at them every night. It seems the Fed is just too scared to have a repeat of 2008. On top of the repo operations, the Fed is also buying Treasury bills at a rate of $60 billion/month till Q1 2020. Take a look at the U.S. yield curve, it has gone from full inversion to now a steepening structure, which tends to define "normal" times. History has taught us that when yield curve goes from a recessionary inversion to steepening very quickly, that means a recession or a downturn is about to ensue. But the markets can't fall when the Fed is injecting the system with steroids. Plus, company buybacks have been the highest ever this past week, which is also boosting the S&P 500.
The Fed lowers rates, floods the system with cheap money. Corporates use that free money to raise more debt or buy back their shares, inflating their EPS, and showing a "beat" when they report. The stock goes higher. Rinse and repeat. That has been the name of the game for past few years.
If one were to look just at profit margins and earnings growth (not the bottom line that is distorted by less shares outstanding), the growth has plateaued, yet the market makes new highs? The argument given to counteract that is that the Equity/Bond ratio implies that equities are more attractive on a yield basis. Why wouldn't they be, if central banks are taking rates down and about $12 trillion of global bonds are trading at negative yields? That number was as high as $17 trillion, but October/November's massive collapse in bonds saw yields squeeze higher as positions unwound.
There are definitely troubling points in this economic growth picture. The data across the board -- ISM, goods orders, export orders, etc. -- have not improved at all. The CLO (collaterals loan obligation) market has seen a massive fall in October of 5% and has been falling for the past three months. There is stress in the leveraged loan market and subprime auto market. High-yield energy is getting crucified as we see names such as Chesapeake Energy (CHK) and other Shale producers close to bankruptcies. They have overspent and do not have enough cash flow -- and the credit markets are closed to them as lenders have learned from their mistakes of the past. When does all this spill over to the main indices? It is hard to say. But there is serious underlying stress in the system.
Trump tweets of a trade deal going well with China is the same headline recycled 1000 times since last year. It appeals to the algos -- and they keep squeezing the market higher, as the word "deal" appears in any tweet. Trump cannot afford a collapse in his precious stock market rally, as his entire campaign depends on the slogan "we have record unemployment, markets at all-time highs great for 401k's." He is tempted to go easy on this entire Trade War just to get something signed to show to the people how he got the best deal ever. Any signs of a trade deal getting close to done is why "growth and cyclically geared" names are shooting higher, as it is the expectation that global GDP will pick up. Taking a look at soya beans prices, which have been falling since October, I am not sure they would agree with this theory.
The market is disconnected from reality. But as they say, follow the liquidity. For now, the U.S. Fed is in full easing mode. The liquidity boost should expect to show up in the economic data over the next few months. If it does not do so, or we have no trade deal soon, the market will go back to trading the fundamentals, which are weak.
There is no way to capture alpha right now. You either take a view of long economic growth or short recession trade. The former will see commodities and cyclical entities fly at the cost of bonds, utilities and gold, etc. The latter, vice versa. The technical gurus point to how the S&P 500 has been range-bound for the past two years and is now showing a break to the upside. I cannot deny that, but technicals usually need the fundamentals (earnings) to justify the move. For now, after this vicious rotation these past few weeks, the market is torn and investors are even more confused as logic has not prevailed.
