October is year end for a lot of institutions and funds; a calendar year anomaly that equity market participants can be excused for forgetting. This leads to a lot of book squaring and profit taking, which can distort the true fundamental dynamics of the market. The S&P 500 is up 6.3% in October alone, along with other developed markets. The global market cap is now greater than $80 trillion, gaining $1.2 trillion just this past week as U.S. fed announced another rate cut, U.S. jobs report and numerous headlines of a trade deal possibly happening between U.S./China.
It appears that the market does not need any facts, just knowledge that something is happening. As we look across the landscape of various asset classes and projected returns for the longer term, it appears investors see no tangible risk whatsoever to derail this upward momentum. It was just one month ago that the market was overwhelmed with Brexit concerns, Fed policy error, repo market liquidity constraints and an overleveraged debt system giving rise to unicorn valuations in Tech starts ups.
The Fed prevails against all concerns. I have to admit that, as has been the case for the past 10 years, the market believes the cure to any market hiccup is the Fed printing even more money. Rather than worry about the longer-term implications of where and how that will be sourced, it just knows that the Fed will always be there to backstop it so has the finger on the "buy the dip" button. Low and behold, the Fed balance sheet is now north of $4 trillion again, increasing by over $250 billion in just two months (after only reducing it by less than $1 trillion since 2009). Oh no, but please let's not call it QE, as it is not.
Since July, the Fed has cut rates three times, expanded their repo operations to $120 billion per day in October and launched a $60 billion Treasury bill buying program. A more appropriate term would be monthly easing than quantitative easing. Regardless, as the Fed balance sheet expands, risk assets get re-rated higher.
So much for "normalizing" the balance sheet. It cannot be done. The system is built on numerous layers of debt all piled up and linked to each other, they can never allow higher rates or reduce their assets, lest the whole system comes crushing down as one big Ponzi scheme.
There is a massive duration mismatch, investors are borrowing money more and more from the future to buy into risky assets today, hoping to make a quick return before being asked to pay it back. Sound familiar?
U.S. debt is now valued at $23 trillion, and Q4 GDP growth is projected to print at 0.8%-1.1%, yet the stock market is trading at a valuation of 145% of GDP? Since November 2008, total debt increased by $12.4 trillion. However, in the same time, U.S. GDP increased by only $6.7 trillion. In the past 12 years, it took $1.85 trillion in new debt to generate just $1 in new GDP growth (sounds like another we-work financial engineering of sorts). As time goes on, the problem gets worse.
What does the Fed need to do? Print more and more to generate less and less growth.
So, the question I ask today is how much of this recent October rally is truly "fundamental," and how much is just a way for funds to chase markets higher into year-end marked to marking? October also showed some interesting factor and sector rotation plays. After outperforming for most of 2019, growth momentum stocks were sold off at the expense of yield value oriented sectors as money rotated out of the winners into the laggards. Profit taking?
A little over a month ago, the whole world was convinced bonds were the asset class to invest in, as $17 trillion in global bonds were trading in negative yielding territory. In October, we saw a noticeable selloff in bonds vs. a push higher in equities as asset allocation adjusted or squared off the bets of 2019. All these factors contributed to ending October with a bang. Now what?
November will prove to be interesting. Earnings season is still ongoing. Around 80% of companies have reported earnings about 3% higher than consensus, which is lower than the five-year average. So this rally is clearly not coming from earnings season. October has seen a massive multiple expansion, with the 12-month forward P/E ratio at 17.2x, above the five-year and 10-year average. To go long here today, now, takes a slightly trigger happy, blind investor. It may prove right in the longer term, but one must be cognizant enough to price in some risks -- at the least to a market that is fully valued given current dynamics.
The Communist Party of China had its October session and announced that 2020-2021 will see GDP growth slowing down to 5.9% and 5.8% respectively, from 6.1% this year. In addition, there are no more rate cuts or reserve requirement ratio cuts; no more stimulus to be seen this year. Commodities and China-oriented sectors are at the mercy of other central bankers and their stimulative monetary policy.
Perhaps the most prevalent risk is that of U.S. political process, as we know if Elizabeth Warren is elected, albeit a much smaller chance, there will be a big hit to all monopolistic Big Tech, Big Financials and the capitalistic institution itself. However not even a small remote chance of that risk is being priced in at all. The market is never a one-way bet. As the new financial year starts for a lot of funds, perhaps this risk-adjusted return will need to be priced in by the market -- or at least it should arrest some of the euphoric buying that has ensued.
A sector that is at big risk of falling apart is U.S. Shale. Elizabeth Warren's task on day one would be to stop U.S. fracking. A ban on fracking would kill the $1.2 trillion junk bond market, which could spill over into the $3 trillion corporate bond market. According to Moody's, about $240 billion of debt is maturing through 2023 that will need to be refinanced. the SPDR S&P Oil & Gas Exploration & Production ETF $ (XOP) is down over 40% over the last 12 months as U.S. shale fracking companies continue to borrow yet not have enough capital discipline to turn in a profit.
Investing is about risk vs. reward. Investors would be wise to ask themselves what is the risk-adjusted return today going forward? Other than chase algos and futile non-value-added headlines regurgitating the same thing with no conclusion in sight of an end to global growth uncertainty, they would be wise to say thank you and sit this one out for now.
Better to be lucky than smart, as they say.