PWA 2020 Year-End Letter, Part Seven: Opportunities Beyond Our Borders

In Part Five I explained the relationship -- negative correlation -- between commodities prices and the U.S. dollar.

Morning Note: Capitalist-minded readers may enjoy this one...

Well, it's the last trading day of 2020 -- quite the year! We'll bid it a fond farewell in the upcoming close to our lengthy year-end letter.

PWA 2020 Year-End Letter Part Six: Sectors

In this part six of our year-end letter I'll present an overview of how we see the U.S. equity market setup on a sector by sector basis.

Morning Note: "The Higher The Markets Go The......"

Bloomberg's headline credits vaccine optimism and a weak dollar for this morning's rally in stocks. 

In that the former, while great news!, was a given, I'll take the latter as the primary reason equities are up to start the session.

PWA 2020 Year-End Letter, Part Five: Commodities and the Dollar

While we've beaten the proverbial dead horse, well, to death, when it comes to the utter canyon that separates stock market fundamentals from stock prices these days, there's one asset class -- which currently directly occupies 22% of our core mix, and, indirectly, via resource-driven stocks, another 9% -- where the fundamentals are intact, and, in fact, present quite the attractive setup. 

Quote of the Day: Funny thing about stocks...

From the upcoming Part Five (on commodities) of our year-end letter:

Morning Note: Hmm...

Fear that the senate may not go with $2,000 per person stimulus checks seems to have stocks struggling to find their legs this morning. Given its broad popularity, it'll be interesting to see if senate Republicans can muster, or maintain, the political will to stand in its way.

Macro Update: Still In the Woods

Just a super quick macro update, catching up from the holiday.

Quick Afternoon Update

Typically, holiday trading isn't worth reporting on, so take this one with a grain of salt.

But since I went there this morning, and things have notably changed as the session's worn on, I thought I'd give you a quick update.

Morning Note: We have serious 'fundamental' concerns, however...

You'd expect that a trillion dollars of fresh government spending would have the Dow up triple digits. And you'd also expect that such support for markets would have money screaming in, in a real FOMO (fear of missing out) sort of way.

PWA 2020 Year-End Letter, Part Four: The Good, the Bad, and the Ugly -- And -- Lessons of Nature

For stock prices...

The Good: 

Like no other time in history, stock markets have the support of policymakers.

Years of business cycle manipulation, resulting in persistently low interest rates, have established stocks as the perceived only game in town to capture yield and to beat inflation.

PWA 2020 Year-End Letter, Part Three: Bubbles, Zombification, The Fed and the Future

In 2002, amid the bursting of the 90’s tech bubble, then Fed Chairman Alan Greenspan proclaimed that bubbles are difficult to identify until, alas, after the fact:

''As events evolved, we recognized that, despite our suspicions, it was very difficult to definitively identify a bubble until after the fact -- that is, when its bursting confirmed its existence.''

Well, frankly, that’s a notion I wholeheartedly reject.

In fact, fast forward 16 years, and, ironically, Mr. Greenspan himself agrees that bubbles can indeed be foreseen.

Easily, in fact, based on his conviction in 2018 that bubbles had formed in both the stock and the bond markets:

“"There are two bubbles: We have a stock market bubble, and we have a bond market bubble," the former Federal Reserve chairman told Bloomberg TV.

The trouble in the bond market "will eventually be the critical issue," Greenspan said, adding that "for the short term it's not too bad."”

Yes, as regular readers know all too well, I agree with Mr. Greenspan (the 2018 version, that is) that bubbles can be foreseen (the timing of their bursting is of course another matter), and that the bond (debt) bubble is presently “the critical issue.”

Although, we didn’t begin adjusting portfolios to that reality until our macro index turned red late-summer 2019. At that point odds favored recession over expansion going forward, and our view was that the next recession would pierce the debt bubble and bring on a worse-than-2008 experience.

Here’s yours truly on Halloween Day 2019 in This Week's Message: Absolutely, There is A Bubble:

“...all of that stimulus coming out of the bursting of the mortgage bubble was so effective at inflating asset prices (just like it was coming out of the dotcom bubble), while wedding them (asset prices) to interest rates, that the Fed has boxed itself into the proverbial corner.

And, worse yet -- and this is the fundamental problem -- it created yet another debt bomb that probably can't be diffused; meaning, it more than likely has to detonate, intentionally or otherwise, before we can even begin to get back to something remotely resembling normalcy in the debt markets.

And of course the Fed fears, legitimately!, that that detonation will surely come at the hands of (or be blamed on) voting members who don't pull every possible lever to delay it till the proverbial cows come home. But what will those proverbial cows be able to do??”

Hence, here we are, living a surreality that could only occur at the end of a debt supercycle, amid epic asset price bubbles, and while panicky policymakers who -- in their willful abandonment of capitalism -- are desperate to keep asset markets and failed companies afloat.

I.e., policymakers have zero interest in seeing debt markets back “to something remotely resembling normalcy.” Or, let’s say, in allowing the necessary painful process to unfold...

We are sorely missing Milton Friedman these days!   emphasis mine...

"The economic miracle that has been the United States was not produced by socialized enterprises, by government-union-industry cartels or by centralized economic planning. It was produced by private enterprises in a profit-and-loss system. And losses were at least as important in weeding out failures as profits in fostering successes. Let government succor failures, and we shall be headed for stagnation and decline.”

As I ponder the possibility that -- now that the Fed has utterly breached the dictate of the Federal Reserve Act and is, via a work around with the treasury, intervening into the securities (other than treasuries and govt-backed mortgages) market -- perhaps this time may indeed be different (i.e., no 50+% hit to the stock market, and no true debt market clearing), it’s clear to me that, in that scenario, “stagnation and decline” become serious risks over the long-term…

We’d in many ways be adopting the Japanese model, which emerged in response to the bursting of Japan’s own 1980s debt-fueled asset bubble.

Here’s it is reflected in the Japanese equity market (1970 to current):



To get a feel for how Japan dealt with the fallout, here’s from a February 2003 IMF paper titled Japan’s Lost Decade:

“On the corporate side, rates of return remain low, not least because of the slow progress in reducing the still significant excesses of capital, debt, and employment from the bubble years. Concerns about the impact of restructuring on unemployment may constrain the speed of adjustment…”

In other words, intense pain-aversion inspired Japan’s policymakers to do whatever it took (bailouts, credit creation, huge fiscal deficit, etc.) to essentially keep their debt market from clearing (excesses from being purged). Note that the above-referenced paper was written 13 years after the bubble began to burst!

And, yes, that can-kicking indeed managed to keep a 1930’s-style depression at bay.

Japan’s unemployment rate (orange) vs the U.S.’s (white) from 1990 to present:


Successfully averting depression notwithstanding, Japan’s policymakers -- having no stomach for the pain that would result from failed enterprises meeting their market fates -- have left their economy constrained by "zombie" companies.

Short and sweet, from a 2017 Bloomberg article on productivity issues in Japan’s manufacturing space:

"“Some Japanese companies keep unprofitable businesses alive to maintain employment,” says Yasuhiro Kiuchi, senior researcher at the Japan Productivity Center in Tokyo."

Unprofitable businesses that require constant capital infusions to stay afloat (zombies) are drags on an economy, as they consume resources that could've otherwise been used in productive endeavors. 

You'll recall how Japan was once the word's innovation leader, well, Bloomberg's Innovation Index now has them in 12th place.

As for the U.S., not so good, we're 9th. We were #1 in 2013.    Hmm....

Note how Japan’s GDP growth rate (orange) has essentially hugged the zero line all these years (until recently [although that’s bouncing off of the Covid low]): (U.S. GDP in white)

Here’s a look at Japan’s GDP (orange) in nominal terms. Note the utter stagnation these past 25 years. (US nominal GDP in white):



And note the incredible rise in Japan’s government debt (bottom panel) -- now 264% of GDP -- while the economy has done essentially nothing:



I.e., Pain-aversion (and, thus, stagnation) comes with a very high price tag!

Yes, Professor Friedman was spot on:

“Let government succor failures, and we shall be headed for stagnation...”

There’s much more we could dissect with regard to Japan’s post-80s economy -- ~zero interest rates in perpetuity, central bank balance sheet, lousy demographics, waning productivity, etc. -- but suffice to say that virtually all of it, even to some degree lousy demographics (read immigration policies, and the correlation between wage growth/standard of living and population growth), results from government’s unwillingness to allow markets to clean up the messes government creates.

And, lastly, before we tackle today’s debt bubble, while the above may sound dire, understanding what policymakers will have to bring to bear in their attempts to avert a worse-than-2008 financial market scenario brings clarity (read opportunity) to the portfolio management process…

As a picture can speak a thousand words -- and since we’ve been relentlessly pounding on this topic for well over the past year -- I’ll be succinct with the rest, and enlist the aid of a few charts to once again make our point.

Here’s that BBB-rated (one notch above junk) U.S. corporate debt chart that I featured multiple times late last year, updated:



Remarkable!

And how about U.S. companies (within the S&P 500) with literally upside down balance sheets:



And to really drive home the surrealness of the day, note the head-scratching divergence between the growth in corporate debt and its cost:



Like I said above:

“...a surreality that could only occur at the end of a debt supercycle, amid epic asset price bubbles, and while panicky policymakers who -- in the willful abandonment of capitalism -- are desperate to keep asset markets and failed companies afloat.”

So, cutting to the chase, here’s from our October 9 blog post:

“...I would not have expected -- because it was illegal at the time (well, technically still is) -- that the Fed would be able to buy corporate bonds, junk-rated ones no less, and, thus, leave people with legitimate reason to believe that there's absolutely no place they ultimately won't go to keep markets from clearing (Federal Reserve Act constraints be damned!) -- which given the debt mess we came into this recession with (before I could even spell coronavirus) would ultimately be destined to exacerbate the worst recession since the Great Depression.

Well, we indeed have the latter, but, thus far, we haven't remotely experienced the clearing necessary to allow markets to emerge in any semblance of decent shape.

So why might I have previously proclaimed that the next recession would be the worst since the Great Depression? Well, among other things, charts like the following two:

My black arrows point to how after the past several recessions (grey shaded areas) total corporate debt cleared only to a point that left more on the books than the bottom of the one prior. My red arrows point to how interest rates peaked at a lower spot than they did at the peak of each prior expansion. My red circles point to how interest rates rested at zero when debt peaked during the 2008 worst recession since the Great Depression, which is where they essentially sit currently, while debt, alas, ramps ever higher:

And here's the proverbial icing on the cake.

My red circles are where debt peaked during the Great Depression and where interest rates were at the time; where it peaked in 2008 and where interest rates were at the time; and, alas, where interest rates currently sit -- the level where debt will peak this time is yet to be determined:

”

Of course this is not just a U.S. phenomenon.




Bottom line folks, great financial crises tend to come at the end of great private-sector debt cycles. A history that the powers-that-be are all too aware of. Hence their willingness to risk (accept/strive for) long-term stagnation to avoid the short(er)-term painful consequences of, frankly, conditions of their own making.

Whether or not they’ll “succeed” of course remains to be seen. Which is a risk we absolutely must hedge against as we otherwise work to exploit the opportunities inherent in an environment where policymakers will remain hellbent on, among other things, keeping interest rates, as well as the dollar, pinned to the floor…


In parts four and five we’ll explore some of those opportunities, as well as the risks, presented by today’s equity, commodity and currency markets' setups...

Morning Note: "Profit Takes Care of Itself if"

With markets closing early today and equities (and our core portfolio) basically flat as I type (although the Russell 2000's down half a percent), I'll keep this morning's note short and sweet.

A Telling Internal Conversation

From our internal research thread this morning...
This is telling...

Morning Note: The Dollar is Key -- AND -- The Speculative Mood

Dow futures -- responding to the President's push back against the stimulus bill -- were at one point down ~200 points overnight.

This morning, however, is seeing the opposite, with the Dow up triple digits as I type.

The headline says the market's bouncing back despite the threat to the stimulus bill. While that's of course true by definition, it leaves out the likely catalyst for this morning's rally.

And, no, it's not the fact that weekly jobless claims -- still north of 800k -- came in lower than expected. 

I'm thinking we can credit much of this morning's optimism to weakness in the dollar (strength in the euro and the pound) in response to news that a Brexit trade deal is close at hand.

Here's from Monday's morning note:

"Recall also in last week's video that, while I'm generally bearish on the dollar longer-term, the technicals have been pointing to a bottom, and I thus warned of a bounce that would "play havoc with stocks." We'll see if today isn't the beginning of something. Although a Brexit trade deal would I suspect quell the dollar's upside, at least momentarily."

Well, we've seen a bit of a bounce since last Tuesday's video, and it did play a bit of havoc with stocks.

White = the US Dollar Index, Blue = the Dow (note the near perfect negative correlation), through yesterday:


And here's adding on this morning:

Yes! The dollar will be key going forward...

Asian equities rallied overnight, with all but 2 of the 16 markets we track closing higher.

Same for Europe this morning, with all but 3 of the 19 bourses we track presently in the green.

U.S. major averages (save for the Nasdaq Comp) are nicely green as well: Dow up 179 points (0.59%), SP500 up 0.39%, Nasdaq down 0.04%, Russell 2000 up 0.44%.

The VIX (SP500 implied volatility) is down 5.57%. VXN (Nasdaq vol) is down 2.97%.

Oil futures are up 1.98%, gold's up 0.79%, silver's up 1.63%, copper futures are up 0.84% and the ag complex is up 0.83%.

The 10-year treasury's down (yield's up) and per the above the dollar's taking a hit this morning, down 0.37%.

In that our core mix expresses our longer-term weak-dollar thesis, our core portfolio, up 0.79%, is besting the overall stock market so far this morning.

Leading the way is energy, banks, silver, financials and base metals. Our only decliners on the morning are tech and Verizon.

We indeed see opportunities to exploit in a world where the central bank has managed its way into the proverbial corner; the narrowness of the path out (money printing, interest rate and dollar suppression) gives us unusual clarity (amid what are certain to be unusually volatile times) in terms of where probabilities lie sector by sector.

That said, sentiment, valuations, IPO fever, etc., (not to mention a corporate credit bubble) scream bubbly conditions that demand that we hedge in a manner that would mitigate the damage from a major market blowup.

I.e., the mood is speculative, to put it mildly:

"It is another feature of the speculative mood that, as time passes, the tendency to look beyond the simple fact of increasing values to the reasons on which it depends greatly diminishes. And there is no reason why anyone should do so as long as the supply of people who buy with the expectation of selling at a profit continues to be augmented at a sufficiently rapid rate to keep prices rising." 

--Galbraith, John Kenneth. The Great Crash 1929 

Have a nice day!
Marty

PWA 2020 Year-End Letter Part Two: The "Momentum" We're Concerned With

Of all the things I might attest to, the notion that there’s much more to investing than passively riding the market wave would be one in which I'd have high conviction. 

Quote of the Day: "A Bird in the Bush Is Worth Two in the Hand"

Financial reporter Michael Santoli speaks to the bubbly nature of today's stock market:

Morning Note: "Pork", That Wonderful Time of the Year, and Beware the Contagion of the Crowd

Imagine being handed a 5,600-page proposal and told you have to vote on its passing in just a few hours. 

Well, welcome to Washington.

No, speed reading is not a requisite to public office. And, no, those who voted on the stimulus bill did not remotely know all that it contains.

Morning Note: The Bull/Bear Boat

With, as we've been reporting, standing room only on the bull side of the boat, and only crickets over on the bear side, it would make sense that a good news ("stimulus" coming [big in the U.S. and Japan])/bad news (more contagious COVID strain hitting Europe, plus Brexit trade talks still in turmoil) morning setup would see the market yielding to the downside.

PWA 2020 Year-End Letter, Part One: The Eagle, The Ice, and The Basketball

2020, a year to forget, but one we never will, is coming to a close…

Being that folks come here for insight into markets and economies, we’ll only touch on politics and pandemics in the context of markets and economies.

This year’s final message will come to you in several parts. Part One will focus on how we here at PWA metaphorically view the investing process.

Macro Update: Will This "End Well" For the Stock Market?

Since this is your weekly "macro" update, I should probably mention jobless claims, which, at 885k last week would typically provoke visions of utterly desperate equity markets. But, as you've noticed, equity markets are presently not interested in anything fundamental...

Morning Note: Fundamental Knowledge vs Perception

Tesla's inclusion in the S&P 500 on Monday will stir up a flurry of volume -- and potentially volatility -- near the market close today. 

The utter enormity of the shuffling within the equity and derivatives markets that's about to occur... well... let's just say that the timing -- heading into a low-volume/liquidity time of year, and on a day when options and futures contracts on indexes, and on stocks themselves expire (so-called "quadruple witching") -- for making the biggest add to the S&P 500 Index ever was perhaps not all that well thought out...

Quote of the Day: Surreal...

"The interest in participating in a bubble in something that precious few understand is truly disturbing. Then again, these are the same markets that saw investors buy Hertz after it declared bankruptcy, and the same markets gobbling up a century bond from Peru at 170 basis points over Treasuries. Dare I say, a world of negative bond yields in places like Italy, Spain, Portugal and now Greece."

Morning Note: Fantasy...

For reasons we'll explore in our year-end letter(s) (it'll come in several parts), the Federal Reserve has, over many years, manipulated itself -- well, the economy and the markets -- into a corner that leaves it (in the minds of its governors) left with no choice but to continue to inflate asset bubbles and, well, pray...

This Week's Message: Our Latest Messaging...

Since I'll be devoting much of my writing time over the next several days to our year-end letter, this week's main message will be some highlights of our recent messaging:

Morning Note: Coaxed

Asian stocks followed yesterday's U.S. rally into the night, with 14 of the 16 markets we track closing higher.

Europe's leaning green this morning, with 13 of the 19 bourses we track trading higher as I type.

U.S. major averages (save for the Russell) are barely off to start the day: Dow down 22 points (0.07%), SP500 down 0.01%, Nasdaq down 0.12%, Russell 2000 down 0.52%.

'Technical' Market Update (video)

IF VIEWING FROM YOUR MOBILE PHONE, CLICK "VIEW WEB VERSION" AT THE BOTTOM OF YOUR SCREEN.

Note: While I point to the setup for a technical bounce in the dollar, potentially playing havoc (if not provoked by) the stock market, I'm first looking at the potential for a leg lower off of Euro, and pound, strength in the event of a signed trade deal with the UK in the coming days.

Shortly thereafter is where I expect the short-term bullish technical setup for the dollar to play out...

Once playing, click the icon in the lower right corner for full screen. Focus should occur after a few seconds; if not, click the wheel to the left of the YouTube icon to adjust:

Morning Note: Why Patience Right Here?

While we've made some notable sector shifts over the past few months (with more on the horizon) -- gaining a more cyclical, and international, tilt to the overall mix -- we've yet to reduce our target fixed income exposure. 

And for those of you who've recently either added capital to your existing portfolios, or are new clients to the firm, you've noticed that we're taking our time getting you to 100% of your personal target to our core portfolio.

Quotes of the Day: Bedeviling thinking pattern...

While establishing the format for our lengthy year-end client letter, I've decided to kick things off with 3 analogies I've offered up over the past 3 years to help folks understand what inspires and drives our disciplined approach to markets.

As I searched for blogposts that featured the ones I'm after, I stumbled across the following from a past "Quote of the Day." 

"A Growing Insolvency Crisis"

As I suggested in this morning's note, markets these days are moved by a most myopic force. 

By definition, that suggests that they may not be properly discounting longer-term reality.

And while, as we've stressed herein, there are clear opportunities to exploit in this world of top-down market manipulation, there are huge risks that prudent, thoughtful investors simply must hedge -- as we've been preaching since well before the pandemic hit...

Morning Note: Acute Myopia

The EU and the UK hard deadline to ink a trade deal, well, wasn't so hard after all. Yesterday's news that they'll go the extra mile has global stocks in celebration mode this morning -- although the breadth among U.S. sectors is suspect (financials, industrials, materials and energy are actually down as I type).

Also helping equities (well, save for the key sectors mentioned above) this morning is optimism over U.S. budget talks, and more hints that global central banks will stay in the mood to print as far as the eye can see. Of course the latest vaccine news is notably bullish as well...

Macro Update: Back in the Red...

As our macro index has been climbing its way out of virtually unfathomable depths of late, I suspect you've noticed an air of skepticism in my commentaries. 

That largely stems from my awareness of the sheer enormity of support the powers-that-be have brought to bear in their efforts to avoid what seemed destined to be a deep, protracted recession and historic bear market in asset prices.

Morning Note: How Bubbles Form

Asian stocks traded mostly higher overnight, with 12 of the 16 markets we track closing in the green.

European equities, with a possible no-trade-deal Brexit on traders minds, is trading mostly lower so far this morning, with 14 of the 19 bourses we follow in the red.

U.S. major averages are (save for the Russell) leaning lower to start the day: Dow down 44 points (0.15%), SP500 down 0.33%, Nasdaq down 0.47%, Russell 2000 up 0.17%.

Morning Note: "Awesome Stories" and The Dangers of Artificial Sweeteners

Asian equities leaned red overnight, with 9 of the 16 markets we track closing lower.

Europe's following suit so far this morning, with 15 of the 19 bourses we track down as I type.

U.S. major averages are mixed to start the day: Dow down 46 points (0.15%), SP500 down 0.07%, Nasdaq up 0.12%, Russell 2000 down 0.03%.

This Week's Message: Beating the Proverbial Dead Horse...

Well, as I begin to pen this week's main message I'm wondering how many ways I can spin my commentary around a setup that has stocks trading far removed from fundamental reality -- although our technical assessment has improved markedly. 

I mean, from how many different angles can I continue to beat the proverbial dead horse?

Morning Note: Easy Peasy?

Asian equities continue their ascent; 11 of the 16 markets we track closed in the green overnight.

Europe's up as well so far this morning, with 14 of the 19 bourses we track trading higher.

U.S. Major averages are mixed, as I type: Dow down 62 points (0.20%), SP500 down 0.15%, Nasdaq down 0.16%, Russell 2000 up 0.29%.

Morning Note: Consumer Caution...

Asia once again leaned green overnight, with 9 of the 16 markets we track closing higher.

Europe, riding rising sentiment and vaccine prospects, while ignoring rising risk of a no-trade-deal Brexit come 12/31 (I'll be surprised if there's ultimately no deal), is mostly higher -- 13 of the 19 bourses we follow are in the green -- so far this morning.

US major averages, save for the Nasdaq Comp, continue to -- albeit slowly this morning -- climb a wall of extreme (dangerously extreme) optimism: Dow up 57 points (0.19%), S&P 500 up 0.11%, Nasdaq down 0.08%, Russell 2000 up 0.53%.

Morning Note: All Else Equal...

Asian equities traded mostly higher overnight, with 10 of the 16 markets we track closing in the green.

Europe's mixed as Brexit trade negotiations have hit an 11th-hour snag: 10 of the 19 bourses we track trading lower as I type.

U.S. major averages, save for the Nasdaq, are leaning lower: Dow down 160 points (0.53%), S&P 500 down 0.11%, Nasdaq up 0.43%, Russell 2000 down 0.21%.

Potentially Problematic Complacency, Except in Futures...

Like I said last week, the bull side of the boat is presently a standing room only affair, and -- contrarianly-speaking -- that's not necessarily a good thing...

Macro Update: We May Be Onto Something...

Our proprietary macro index remains, for the second consecutive week, out of the red, although still not in the green either. Its overall score rested at 0 this week.

Morning Note: One Common Theme to Crises

Just the numbers this morning... well, I'll probably throw in a quote... then our weekly macro update later today (tomorrow at the latest).

Morning Note: The Torment 😎

Asian equities traded mostly higher overnight, with 12 of the 16 markets we track closing in the green.

Europe, well, not so much. 10 of the 19 bourses we follow are in the red so far this morning.

U.S. major averages are solidly in the green early in the session: Dow up 142 points (0.47%), S&P 500 up 0.17%, Nasdaq up 0.35%, Russell 2000 up 0.99%.

This Week's Message: What We Know - And - What's Not To Like?

This week's main message will be short and sweet. It'll essentially be me doing a little thinking out loud...

Morning Note: "To consort with the crowd is harmful"

Asian equities traded mostly green overnight, with 10 of the 16 markets we track closing higher. 

Morning Note: Never Content With "Discoveries Already Made"

Allow me to offer up the opposite to yesterday's metaphor, as asset prices, the world over, are swimming in a sea of green to start the month of December.