September 12, 2016

When Will the ‘Run For Yield’ End?

And What are the Implications?

Last month, we asked:

So are we deteriorating into a period of lower rates, witness negative rates around the world, that will ultimately spell doom for economies and equities? Or might we transition to a period of more rapid economic growth that pulls us out of the downward rate spiral and into an environment where rising rates, due to economic growth and not run amok printing presses, are actually good for equities?

We noted the lackluster leadership of the credit markets as monitored by the ETFs HYG, JNK, VWOB and LQD. But we were more concerned with the lack of participation by the Dow Transportation and Russell 2000 Indexes. The reason being that IF we are to transition into a growth-supported, bull-market environment, the transportation and small-cap sectors will have to participate, if not even lead the charge. We note that the transports and small caps have made a decent showing post Labor day; a precursor of things to come?

Let’s back up a bit. There is no question that we are in a new world. The Bank of England (the UK’s central bank) recently lowered its key lending rate to the lowest in its 322 history. According to Bank of America, there are currently about $12.3 Trillion of negatively yielding bonds around the world and central banks own some $25 Trillion of financial assets. Talk about upside down! These last two stats alone describe the canvas that the entirety of financial asset valuation is based upon. Interest rates are the cost of money, and with negative interest rates it is next to impossible to calculate project returns; capital investment models used by corporations to project future cash flow returns are non-functional with negative interest rates. And just when did it become a ‘reasonable’ course of action for central banks to buy corporate stocks and bonds? Most importantly, negative interest rates are driving demand for yield assets for the sake of yield, not for the attractiveness of the underlying asset, the normal equity (stock) valuation methodology.

Yeah, this is some scary stuff! No question about it. So scary that a plethora of financial wizards are yelling from the mountain tops that investors should be running for the exits, including Bill Gross, Jeffrey Gundlach, Stanley Druckenmiller, George Soros, Carl Icahn, Jim Rodgers and Mohamed A. El-Erian. We note that Mark Cuban recently commented that to the extent that Donald Trump’s candidacy gains strength he’ll be effectively out of stocks and bonds entirely. And to be sure, there is evidence that investors have been increasingly defensive. But the entrails mostly suggest that investors worldwide have been searching for yield and passivity. In this new world, there is an abundance of evidence that investors have been chasing yield assets and shifting out of actively managed vehicles into passively managed ones. We note the corollary accolades given to John Bogel, the father of passively-managed, market-indexing mutual funds and the abundance of articles speaking to hedge funds struggling to justify their lofty fee schedules in a low-return world. The Leuthold Group points out, as reported in a recent Barron’s, that “safe stocks” are accounting for about 35 percent of the S&P 500’s sector weightings, levels seen only during market distress. Hmpnf …

While a glance at the market averages suggest a subdued, basically flat performance over the last 20-21 months, we note an interesting exercise using a simple and small change that paints a different picture. The Dow Jones Industrials average is a price-weighted index that is calculated by adding up the prices of the 30 stocks and dividing by 30. note: due to splits and other adjustments over the years, the divisor is now 0.146; so take any Dow 30 stock’s daily move and divide by 0.146 to find its contribution to the index’s change. The purveyors of the index decided to add Apple (APPL) to the index in March 2015 as a way to reflect the ‘new economy’ in which we live. But couldn’t we make an argument that Amazon might be a better reflection of the breadth of advances that technology is fostering? We note that IF Amazon were in the index instead of Apple, the Dow Jones Industrial average would be roughly 745 points higher thus far in 2016. And had the change been made during the fourth quarter of 2014, the Dow would be an astonishing 3,315 points higher. Wow! What a different look we’d have.

We think that the weight of the evidence is rapidly building toward a ‘trend ending’ scenario. So are we in the camp of the market intelligensia that is saying run for the hills? No. We acknowledge the risks, they are clear and present. But we also note that while many things are different in this ‘new world,’ human nature is never changing. And the clarion call for the exits evidences a collective fear suggesting to any good contrarian that there must be another way. Is the ‘exit sign’ the magician’s diversion?

But what alternatives are there?

While we’re certain Mark Cuban will be wrong, mapping the future is clearly more challenging.

Predicting what the Fed will do has been and is a fool’s errand. There is no question that the economy is mired in a sub-standard growth mode and the Fed has no business ‘engineering’ higher rates for the sake of maintaining some measure of credibility. But we repeat from last month’s issue, IF rates rise due to strengthening economic fundamentals, that is a good thing. And we note that the two Fed economic models that are strictly quantitatively based and unbiased by operator opinion are forecasting Q3 GDP growth of 3.5% and 2.8%, both rates capable of sparking a rise in rates.

We’d clearly suggest being wary of the yield-seek trade. (We note that as we write this on Friday, September 9 with the Dow 30 down over 300 points, the stock that is down the most is also 0the highest yielding). The high-yield trend is very long in the tooth and vulnerable t a reversion to the mean (meaning will go down). As we mentioned, the ‘safe-yield’ sector now makes up a disproportionately large portion of the S&P 500, levels that history suggests is ripe for reversal. We also observe that the bull market in bonds is some 35 years old, and we’ve recently finished what might prove to be an important reversal. The time to be loading up on yield assets might have passed.

Ten-Year Treasury Yield 1975-present

Yield Scale: 25.00 = 2.5%

Chart(s) courtesy of TC2000.com

While pointing out that so many who are calling for an end to the world are likely to be wrong, we’d add that the widespread pessimism creates an environment that will likely see ‘fear’ escalate so quickly on any market declines as to likely minimize the ‘actual’ damage. So prepare your psyche for ‘fear’ headlines to come. Amazon (AMZN) will likely break hard; we note that it fell nearly 29% in just a month at the outset of 2016. This is not a sell AMZN and stay away observation; we are only suggesting what the next market-buying opportunity might look like so as to be prepared and not scared.

In a corollary setup, we note another trend likely to be ending. Many a commentator has recently noted that general market volatility has reached historically low levels. The S&P 500 has not had a more than 1% daily move since July 8 (today, Sep 9 excepted). So IF stocks are more extended than what meets the eye (extended search-for-yield trade and AMZN-adjusted Dow Industrials) and with volatility normally increasing during market declines, let’s acknowledge the risks and confine new purchases to be made on weakness; let’s wait for a sidewalk sale. For those with existing portfolio constructions, you might look to scale back on any overweighting in high-yielding stocks.

For a bullish scenario watch for:

           Relative strength in transports; especially FDX and UPS

           Relative strength and stability in HYG, JNK, VWOW and LQD

           Relative strength in energy sector, including natural gas (UNG) holding $7-$7.5 zone

           Watch for XOM and CVX to hold at or near their August lows

           Selloffs to be quick and scary

           Yield-trade sectors to be relatively weak, utilities, consumer staple and discretionary

It would be problematic IF:

           Fed raises rates amidst weakening underlying economic fundamentals

           Rates for any reason move below recent lows: Ten-year 1.34% and Five-year 0.91%

So, have we answered our question? A bit perhaps; this is going to be a process. But the extreme negative sentiment suggests that any selloffs will likely be sharp but contained. The most vulnerable sector is the high-yield trade where investors have chased high-yield stocks too much for the sake of the yield and not underlying fundamental outlook. And we are “suspecting” that we’re making a turn toward higher rates; we’re hopeful that it is due to more rapid economic growth, but are wary that the Fed could raise rates for the wrong reason.

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