In last week’s missive I stated:
“There has been a pretty well defined upward trendline (gold box) since the April lows which has consistently provided better entry opportunities to increase equity exposure.”
“As stated, our existing portfolios are currently fully weighted toward equity risk as there seems to be little which can derail this market currently. We have moved stop-loss levels up to recent lows, added some defensive positioning, and have added bonds as rates have climbed above 3%.
Speaking of rates, each time rates have climbed towards 3%, the market has stumbled.”
Chart updated through Friday close.
I got lot’s of emails early last week suggesting “this time was different.” Rates were rising because of strong economic growth and as such, it wouldn’t affect the stock market. (More on this in a moment.)
If you note in the chart above, a short-term “warning signal” has been triggered which suggests that if rates remain above 3%, stocks are going to continue to struggle. The last time this occurred was in May when rates popped above 3%, stocks struggled and bonds outperformed.
Over the last couple of weeks, I have noted that after increasing equity exposure in portfolios, the short-term overbought condition needed to be resolved before the markets could make a year-end push higher to 3000.
Not surprisingly, the statement triggered a lot of questions as to why, at a time when the market was at 2950, I was only giving the markets 50-points of upside? The reason was that a pullback was needed to open up the potential for a year-end push. On Thursday and Friday, as the markets woke up to the recent surge in rates above 3%, markets sold off back to support at the January breakout highs. That sell-off does provide enough of an oversold condition to support a year-end push which has now expanded from just 1.6% last week, to 3.33% over the next couple of months.
I also noted last week, that we would be updating our pathway chart, as first shown above, which has remained unchanged for well over a month (prices have been updated through Friday’s close.) What was most surprising to me was how closely the markets had traced out the projected #2a pathway.
With this background, we can update the pathways which hold the highest probable outcomes over the next couple of months.
There has been a pretty well defined upward trendline (gold box) since the April lows which has consistently provided better entry opportunities to increase equity exposure. While there are literally thousands of potential outcomes over the next couple of months, I have refined what I think are the most likely outcomes down to four possibilities.
Pathway #1: The market sold off to the peak of the January highs which is support. With the market now short-term oversold a rally to new highs through the end of the year is possible (20%)
Pathway #2a: The first of two most probable outcomes at this juncture is a rally from the current support at the January highs but the rally fails at 2900 which forms the right should of a “head and shoulder” topping pattern from the August left shoulder peak. The bullish outcome is a selloff back to the January highs and the market then rallies to new highs by year end. (40%)
The bearish outcome, is a violation of the “neckline” at the January highs and the market continues to track Pathway #2b
Pathway #2b: Rising interest rates continue to weigh on stocks next week and the market breaks the January high support level. However, given the short-term oversold condition, the market rallies from the bottom of the current bullish trend (gold box) but fails to rise above the January highs and turns lower putting in a more major top for the year. (30%)
Pathway #3: The issue of rising interest combines with a break in the economic data, or another credit-related event, and sends the market heading back to test supports at 2800 and 2750. This would likely coincide with a more severe contraction in the economic data which is not an immediate threat. Nonetheless, we should always consider the risk of an unexpected, exogenous, event. (10%)
Next week, I would expect to see a rally from the short-term oversold conditions. However, it will be the breadth and strength of that rally that will be important to watch.
If it is a weak, narrow bounce with little conviction, we will use the rally to lift positions, trim losers, raise cash and potentially look at initiating some hedges.
Our bigger concern remains interest rates simply for one reason – you can NOT have higher stock prices AND higher interest rates. Period.
One or the other will have to give.
Over the last few days, the internet has been abuzz with commentary about the spike in interest rates. Of course, the belief was that rising rates were “okay” because the market was still rising. As noted on Wednesday by Charlie McElligott (via Zerohedge):
“Effectively the market is saying that in the absence of an ‘inflation shock’ (which would drive a front-end yield spike / ‘power flattening’ on ‘accelerated Fed),’ that we are on track to ‘grow faster than we are tightening’
Another way of putting it is that Wednesday’s ‘economic assessment upgrade’ and view that we are ‘growing faster than we are tightening’ is why we are not seeing that same ‘rate – and VaR shock’ contagion into risk-assets that defined the market in late January, early February, and which – as McElligott notes – ‘was BY-FAR the #1 client inquiry, i.e. ‘Why are higher yields not negatively impacting Stocks here?.’”
On Thursday and Friday, stocks crumbled as the reality that higher rates and tighter financial conditions will begin to negatively impact growth data. With housing and auto sales already a casualty of higher rates, it won’t be long before it filters through the rest of the economy.
The chart below shows nominal GDP versus the 24-month rate of change (ROC) of the 10-year Treasury yield. Not surprisingly, since 1959, every single spike in rates killed the economic growth narrative.
As Doug Kass noted on Friday:
“No, it’s not the economy, stupid. It’s interest rates, stupid.
Their course and trajectory have had a profound influence over time on our markets.
For as James Carville also famously stated in emphasizing the potency of the bond market:
“I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”
Precisely when that rate influence ‘bears’ on our markets is always hard to ascertain.
Perhaps with the benefit of hindsight, we over thought what factors ultimately would debilitate the capital markets.
Perhaps concerns over possible policy issues and or policy mistakes, never-ending political surprises, continued sovereign debt crises, and other issues were simply decoys.
Perhaps it was in front of us all the time, just as it has been in almost every meaningful markdown in history.
In a global economy that never has been more flat, interconnected and filled with multiple and interrelated dominoes, the process of a quickened rate rise becomes ever more problematic in a mountain of public and private debt as the winter cold descends upon us.”
He is absolutely correct.
In the U.S. we have dismissed higher rates because of a seemingly strong economy.
However, that “strength” has been a mirage as I noted last week:
“While the markets have been the beneficiary of the tax cut legislation, which gave a short-term boost to corporate profitability, the economy has enjoyed a boost from the massive increases to spending from what should have been more aptly termed the ‘Bipartisan Non-Budget Act of 2018.’ Notice in the chart below the pickup in economic activity has coincided with a surge in the deficit. Spending on natural disasters and defense simply ‘pulls forward’ future economic growth which gives an illusion of an economic turn.”
That illusion of economic growth has kept investors blind to the economic slowdown which is already occurring globally. As Mehul Daya and Neels Heyneke via Nedbank recently penned:
“Global bond yields are on the rise again, led by the US Treasury yields, which as we have highlighted in numerous reports, is the world’s risk-free rate.
The JPM Global Bond yield, after being in a tight channel, has now begun to accelerate higher. There is scope for the JPM Global Bond yield to rise another 20-30bps, close to 2.70%, which is the ‘Rubicon level’ for global financial markets, in our view.
If the JPM Global Bond yield rises above 2.70%, the cost of global capital would rise further, unleashing another risk-off phase. Our view is that 2.70% will hold, for the time being.
We believe the global bond yield will eventually break above 2.70%, amid the contraction in Global $-Liquidity. A stronger US dollar and the global cost of capital rising is the perfect cocktail, in our opinion, for a liquidity crunch.”
“Major liquidity crunches often occur when yield curves around the world flatten or invert. Currently, the global yield curve is inverted; this is an ominous sign for the global economy and financial markets, especially overvalued stocks markets like the US.
The US economy remains robust, but we believe a global liquidity crunch will weigh on the economy. Hence, we believe a US downturn is closer than most market participants are predicting.”
And if they are right, this is going to leave the Federal Reserve in a tough position of having tightened monetary policy to much. With bond traders more short than at any point in history, the ultimate “reversion to the mean” in Treasury’s will drive rates towards zero.
The chart below strips out all periods EXCEPT where net-short bond positions exceeded 100,000 contracts. In every case, interest rates turned lower.
Back to Doug Kass for a moment:
“The disproportionate role of quant strategies also represents a profound market risk when rates are advancing, particularly relative to consensus disinterest and even lack of understanding of the role of this dominant market player. This is important, because if the correlations that underpin risk parity begin to fail — basically when both bonds and stocks fall simultaneously — as they have in the last week, they likely will cause an impactful unwind of risk-parity portfolios that are sizable and very leveraged.”
The recent blow out in risk parity, as noted by a surge in volatility, is evidence that something likely just broke.
History bears this out as well.
Whenever the 10-year yield has traded at, or above, 2-standard deviations above the 2-year moving average, bad things have tended to occur from recessions, to corrections, to outright crisis. Given the 2-year rate of change on the 10-year has surged to the highest level in over 50-years – if something hasn’t already broken, it likely will soon.
The table below looks at the rate of change from the preceding low to the subsequent peak and the outcome of rising rates. Again, there has NEVER been a period where both rates and stocks rose simultaneously. Also, as shown above, the current percentage change in rates is the highest since 1957.
More importantly, rising rates are NOT JUST a consideration of stocks versus bonds.
If the stock market falls, the top-20% of the economy gets a little depressed because their wealth declines a bit.
However, given the bottom 80% have very little invested in the financial markets, when RATES surge higher, it is 100% of the economy that feels the pinch. As Doug notes, interest rates run through the entirety of the financial and economic backdrop.
The private and public sector have inflated debt loads today. Rising interest rates raise the cost of servicing that debt and reduce spending and productive investment.
Private-sector activity is importantly influenced by interest rates:
Rising mortgage rates and higher mortgage payments reduce home affordability and hurt home turnover and refinancings.
Slowing home sales and reduced refinancings hurt spending on renovations and remodeling.
Consumer, mortgage and corporate loans that are variable rate are hurt by climbing interest rates.
The credit markets fall when interest rates rise, serving to have a negative wealth effect on consumers and corporations that own bonds.
Debt is often issued by corporations in order to buy back stock and pay dividends. Advancing rates reduce a company’s return on investment on those buybacks.
Corporate capital spending is partially dependent on borrowings. Higher borrowing costs could lead to lower capital spending.
Public-sector activity and profitability are also importantly influenced by interest rates:
The deficit/GDP ratio will increase as interest rates rise and the consensus expectation for lower future deficits will crumble.
Dividend discount models are based on future estimates of cash flow discounted back at an appropriate interest rate:
Rising interest rates reduce the value of those future cash flows and, in turn, the value or worth of a company’s stock.
There is now an alternative to stocks as the yield on the one-month bill (2.16%) and the two-year Treasury note (2.89%) compare favorably to the S&P 500’s dividend yield of only 1.77%. Further rises in interest rates will serve as an even more competitive and attractive alternative to stocks.
Rising interest rates in the U.S. will buoy the dollar, exacerbating the ability of weaker countries and corporations to service their dollar-denominated debt.
The issue of rising interest rates may have finally woken overly complacent investors from their bullish slumber.
We won’t know until we get a rally that fails to set a new high.
But one thing is for sure… if something hasn’t already broken, it will break soon if rates keep rising.
That day may be much sooner than most expect.
As noted above, we have tightened up stops considerably and next week will begin to start rebalancing and hedging risks accordingly.