MorningWord 7/13/16: You Better Check Yourself Before You Wreck Yourself

by Dan July 13, 2016 10:06 am • Commentary

New all time highs in the S&P 500 (SPX) and the Dow Jones Industrial Average (INDU) have done the financial world the pleasure of anointing a whole new generation of market wizards. Myself? I have been skeptical until we saw a new high. Now that we have? I’ll just bask in your glow 🙂

But as long as we are keeping it real, realize that the dramatic change in sentiment since late June following the Brexit vote in the UK is stunning. The post vote sell off in almost every risk asset in the world felt like a disorderly panic, but the snap-back shares an equally panicky feel, albeit a tad more oderly.

And now that we’ve finally seen a breakout of a year long (plus) consolidation does this confirm the dawn of a new leg of the seven year bull market? That still could be wishful thinking. I am not sure how the fear of a Brexit induced slowdown in Europe somehow dissipated in 2 weeks. Or how a European banking crisis has been averted without any action. Or how one outlier June jobs report in the U.S. propels the U.S. economy to some sort of escape velocity. Or how the rebound in industrial commodities confirms a soft landing in China. Or how $13 trillion in negative sovereign yielding debt is bullish for anything.

I am not sure what changed in the last couple weeks aside from what appears to be a weak at best argument that capital needs to go somewhere while interest rates are at historical lows and while the Fed sits on its hands. So why not put it in U.S. stocks? That’s fine for a trade on the breakout. But investors piling in new money at all time highs for the next bull run might do well to check themselves before they wreck themselves.

It’s been my view that the U.S. Federal Reserve’s inability to normalize interest rates is NOT bullish for risk assets long term, regardless of the desperate search for yield and return.  The last two bull markets in the late 1990s, and the mid aughts were born of the same desires by investors, and were spurred by a U.S. Fed that failed to normalize interest rates, erring on the side of caution. Risk asset bubbles inflated, went on longer than most would have expected, but wreaked massive financial havoc in their aftermath, with the last implosion bringing the financial world to its knees.

I fear the next unwind brings much greater risk as central banks will have exhausted most of their traditional (read rational) ammo. And even bigger issues are possible. The divide between the haves and the have nots seems to expand with each unwind. The next one could mean massive political and social unrest globally.

The issue for the U.S. Fed for the next unwind is their lack of policy options given the Fed Funds rate at 25 bps and the 10 year Treasury yield just above record lows at 1.47%. You have heard this from me before, and to be frank it is not that original from my cadre, but I think it is important to consider as you weigh the risk reward of committing new capital to U.S. stocks simply for the fear of missing out.

The SPX’s 220% gains from its March 2009 lows has more than doubled the gains from the index’s 105% gain from its March 2003 (post dotcom bubble implosion) low to its October 2007 highs:

SPX since 1995 from Bloomberg
SPX since 1995 from Bloomberg

That’s impressive. And maybe the bulls are right that the SPX’s consolidation over the last 18 months is setting the stage for a blow off rally, or better yet one that is sustainable and just waiting for an earnings recovery here in the U.S.  That is a distinct possibility. But look at that chart again and then consider the massive rally arguments from here.

Just as the U.S. Fed orchestrated one of the most amazing financial backstops the world has ever seen, to the tune of trillions of dollars since 2008, this crisis policy has spread like a virus around the world, turning the tables on rational economic theory and pushed out what will eventually be a mandatory deleveraging. And just as the rebound in the SPX has more than doubled its gains from the prior recovery, the next decline (possibly from much higher levels) could make the 50% declines (March 2000 to March 2003 & Oct 2007 to March 2009) look like a walk in the park.

When the cracks in the artificial state of the global economy turn into a breach, it’s likely to result in the sort of protracted bear market we saw in the early 2000s as opposed to the V reversal we got in 2009. The major reason can be found in the very thing that has kept equities bid, interest rates.

Remember, at the highs in 2000 the Fed Funds rate was above 6%, and at the highs in 2007 the Fed Funds rate was above 5%. And now? After a 7 year bull market and stocks at new all time highs? The Fed Funds rate is just above zero:

SPX vs Fed Funds Rate since 2000 from Bloomberg
SPX vs Fed Funds Rate since 2000 from Bloomberg

Yeah, Zero.