YIELDING TO HIGH YIELD

Last Friday’s New$ & View$ ended with a brief paragraph downgrading equities to 2 stars. More explanations:

The Rule of 20 has been excellent in providing unbiased readings on the risk/reward equation throughout this long cycle. Since the March 6, 2009 lows, the S&P 500 Index has bounced off the “20” fair P/E several times, always refusing to cross into the more dangerous “Rising Risk” (yellow) range where valuation downside risk begins to exceed valuation upside potential. Each time, this triggered a correction back to safer metrics even though history clearly shows that valuations tend to extend into overvaluation levels before retreating to safer ground.

Measured by the Rule of 20, this has always happened in the 9 up cycles since 1958, except in the 1963-65 period when the Rule of 20 P/E kept bouncing off the “20” level and oscillate between 19 and 20 for 3 years before declining to 17.5 in mid-1966 as the S&P 500 Index dropped 16% even though earnings kept rising. The trigger was rising inflation from 1.7% in the fall of 1965 to 3.6% one year later.

In February 2015, valuation began to test the darker side, reaching 21 on the Rule of 20 in mid-May, a first indication that risk tolerance might be rising and that the we could finally reach the 22-23 levels on the Rule of 20 scale, culminating the “normal” valuation cycle.

I now believe that economic and financial conditions will not allow valuations to climax in the yellow zone, let alone reach the “Extreme Risk” area. In fact, investors are much more likely to seek safer grounds in coming months and downside to the 17.5 range on the Rule of 20 is quite possible as a result. At current earnings and inflation levels, this would take the S&P 500 Index down to 1825, 9% below current levels. Lower if inflation rises, and/or if earnings drop.

• Earnings have stalled and even though they are holding ex-Energy, investors are no longer willing to discriminate.
• To wit, nearly 50% of the stocks of operating companies on the NYSE are down 20% or more from their 52-week highs. Ex-energy, the ratio is 44% according to Lowry’s Research. The bear has clearly reached out and communicating vases are likely to keep working on the downside rather than on the upside.
• Another proof of that is found in the high yield market where fear is spreading out. Given on-going weaknesses throughout the commodity space, a rapid turn of fortunes is a low probability event at this time.

• The commodity rout is so violent following a decade of rising prices and leverage that the final episodes could be pretty nasty with many potential known and unknown unknowns. Who can confidently predict when and where oil prices will bottom? And China? In such leveraged environments, groundhogs can surface anywhere, anytime. The year 2016 could well become groundhog year.
• True, lower commodity prices benefit consumers. However, demographics and long lasting scars from the financial crisis seem to be keeping consumers cautious.
• While many fear deflation, inflation is the bigger risk at this time. Core inflation is already at 2.0% and rising in the U.S. (in Europe +1.1% YoY but +2.4% a.r. in last 4 months). Core Services (59% of total CPI) are +2.9% YoY with essential items such as shelter +3.2%, medical care +3.1% and car insurance +5.5%. Energy is –14.7% YoY (gasoline –24.1%), holding overall CPI at +0.5%.
• The longer the depression in the energy sector, the nastier things will get in credit markets.
• A sudden turn in oil prices would rapidly feed into the CPI number. In November, deflating energy prices subtracted 1.1% to YoY CPI. Energy inflation cratered between July 2014 and January 2015, holding fairly steady in the past 10 months. Unless energy prices decline much more, their YoY impact on total CPI will seriously recede starting with the January 2016 reading. November energy prices were only 1.0% lower than in January. Assuming no change in prices from their November levels, total CPI will be +1.9% in the U.S. next month. Last time I looked, 2-year rates were 1.0% and 5-years were 1.7%.

• Mrs. Yellen talks smoothly with her “gradual” hikes and the market believes her if the futures market pricing 2 rate hikes in 2016 is any guide. But the FOMC tells us 4 hikes and a median Fed funds rate of 1.375% for 2016. The press release even openly says that “underutilization of labor resources has diminished appreciably since early this year”, and that “labor market indicators will continue to strengthen”. Fed’s labor job: check.
• The FOMC expects inflation “to rise to 2% over the medium term as the transitory effect of declines in energy import prices dissipate and the labor market strengthens further”. Medium term? The Fed has zero control on oil or other commodity prices, in fact it has almost zero forecasting ability on these prices, like everybody else. What it can influence is already at its 2.0% target. How can it reasonably forecast total CPI at 2.0% “over the medium term”? If nothing new happen, we could well be there by springtime. This is not a dovish Fed, rather a Fed hopeful that oil prices do not spike back up too quickly. Shorter term, the bet looks good, but it could reverse rapidly. Still, the base effect should result in a lesser drag on the CPI from energy prices in coming months.

• And there are the knowns: recessions in Brazil and Russia, maybe Canada if energy prices stay as low for a while. Significant slowdowns in the Middle East economies and most other emerging markets. This leaves the U.S. (ex-energy country, 15% of GDP) and Europe as far as what is measurable and foggy China, the huge known unknown. The Fed is done pushing and is now hoping. Can Draghi walk the talk? Is Beijing too cautious, too late? It sure looks like Q4 in China is as slow as it is foggy.
• Corporate profits ex-energy have held up in Q3 and seem to be doing the same in Q4. However, the recent Markit flash PMIs were rather disconcerting looking forward, especially the all-important Services PMI which abruptly dropped from 56.1 to 53.7, the lowest reading in 12 months:

(…) some service providers noted a more subdued willingness to spend among clients. Reflecting this, latest data indicated that incoming new work expanded at the slowest pace since January. Weaker growth of new business contributed to a decrease in backlogs of work across the service sector for the fifth month running in December.

(…) businesses such as transport, accounting, financial services and consulting citing reduced demand for many services from the goods-producing sector, as well as signs of some increased reluctance to spend among consumers. (…)

Inflows of new orders to the two sectors showed one of the smallest increases seen this side of the global financial crisis, slowing sharply in services and almost stalling in manufacturing.

(…) the degree of positive sentiment dipped to its lowest recorded for just over five years.

At the composite level, Markit concludes:

The survey data are consistent with gross domestic product rising at an annualised rate of 1.8% in the fourth quarter. That’s down only slightly from the 2.1% pace observed in the third quarter, but the survey shows a more severe slowing towards the end of the fourth quarter, with an annualised GDP growth rate of just 1.4% indicated for December alone.

As of December 16, the Atlanta Fed’s GDPNow model forecast for real GDP growth (seasonally adjusted annual rate) in the fourth quarter of 2015 is 1.9%. The Blue Chip consensus, wider than ever, is +2.2% (median). Its low forecasts may even prove too high if Markit is right. What would the Fed do in a stagflation environment?

This is clearly a risk-off financial market with declining long-term moving averages on equities. Not friendly and rather dangerous. And I fail to see any chance of a credible Fed put around the corner.