Wednesday, March 8, 2017

Topping Phase

Let's look at the big picture.  Over the last 5 years, SPX has gone from 1370 to 2370.  It is up 1000 points.  Over that same time period, the 10 year yield has gone from 2.00% to 2.57% right now.  If you had told anyone in March 2012 that the S&P 500 would be at 2370, they would first, think you were crazy.  Next, they would probably guess that the 10 year yield was probably at 4% or higher.  Not 2.57%.  On December 2013, the Fed announced tapering, the 10 year yield was at 2.92%.  The SPX was at 1810.  Most people would think that if the SPX 3 years later was at 2370, they would be shocked to know that the 10 year yield was actually lower at 2.57%.

So if a long equity bull market can't make bond yields go higher, I can't possibly imagine what would happen if we actually had a bear market.  New all time lows in 10 year yields is likely in that case.

Bond yields have stayed stubbornly low despite the huge rally in the S&P.  The Treasury market correlates with other bond markets.  There are a lot of foreign buyers of Treasuries, and they buy because they don't want to hold negative interest rates bonds.  Europe has been Japanized.  They are stuck in low rates now.  Their economy can't get much better, like Japan, because the population isn't growing.  It is extremely hard to grow a developed economy when the population is stagnant.  There is no productivity growth.  Smart phones and flat screen TVs don't enhance productivity.  Robots do, but they replace workers, reducing wage growth, increasing unemployment, and hurting demand.  

The ADP number came out at 298K today, and the financial media is going nuts over that number, but the trend since 2008 has been an increase in lower paying jobs, keeping wage growth low.  You have had a boom in server and bartender jobs.  Not much has changed over the past 5 years.  Economy is still stuck around 2% growth, but the big difference is that the S&P is much higher, and global debt levels are much higher.  That is a bad combination for future S&P returns.  

High debt levels cannot sustain a high interest.  National debt of $20 trillion paying 2% interest is much different than $20 trillion paying 5% interest.  If the US government had to pay 5% interest on its debt, there would be an extra $600 billion per year required just for interest payment.  And the US debt is growing about $500 billion per year.  

You are already seeing a slowing in stock buybacks, because of higher interest rates.  Trump's tax plan is going to do very little for economic growth, since most of the benefits go to the top 1% who will just save more, and put it in stocks, bonds, and some real estate.  But the higher interest rates hurts a broader group, undoing most of the tax cut benefits. 

And it's still not certain how much the taxes will be cut.  If they cut the taxes too much, the budget deficit will balloon, and the amount of Treasury supply will be overwhelming, causing the 10 year yield to go artificially high.  That will put pressure on stocks, and then the economy, and force the Fed to cut rates and do another QE.  It will be similar to the 2000 to 2008 experience under George W. Bush.  Except the debt is much bigger this time and growth even slower.  

The SPX has been weak the past few days even as the VIX has been trading lower.  This not very common, but historically it usually means there is little downside short term.  Longer term, it just means there is a lot of complacency.  I stick with my view that we are forming a long term top this year.  Some of it is due to overpricing benefits from Trump policies, but most of it just the natural animal spirits forming after 8 years of a bull market.  Investors have been conditioned to buy, and eventually, it goes higher.  Now that the valuations are even more stretched, with low growth, and interest rates rising, it makes this market that much more fragile.  

I have gotten long some bonds today, seeing good risk/reward from here with the Fed hike priced in for March, and with the French elections coming up in less than 2 months.   I also expect the S&P to pullback going into April, so any rally towards 2400 this month will be a time to short.    

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