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- Perception versus reality. Facts do not cease to exist simply because they are ignored (Aldous Huxley). Performance dispersion within and amongst equity indices tells the ‘true’ story about U.S. equity performance. Unlike the S&P 500 and Nasdaq Composite, many broad indices and non-technology sectors remain well below previous highs, some of which were marked in mid-2018. Since then, it’s been a bear market for the Russell 2000 and NYSE Composite.
- Overvaluation. Even when considering that many stocks have performed negatively for the year (or even since mid-2018), equities generally remain expensive relative to where they sit in the business credit cycle. Large cap technology companies, which are benefiting from the pandemic (almost as if they were countercyclical), are now excessively overvalued and poised to drag down other sectors on a correlation event, which could be related to a number of risks.
- Risk-Reward. As I’ve suggested for some time, risk-reward remains generally unfavorable to U.S. equity ownership as equity markets are underappreciating risks to the following:
- Valuation – Molodovsky misapplied: the business cycle’s credit contraction isn’t over. It’s just starting. This context for growth and inflation make forward multiples excessive for many sectors.
- Fiscal policy – The DC gridlock around Heros and HEALs will continue as the election approaches. More importantly, because of massive deficits, higher taxes are coming, especially if a Democratic President takes office;
- Election outcome – The risk to a less business friendly Biden Presidency (perceived or real) is far higher than corporate credit and equity valuations suggest;
- Trade – the trade war with China is back in full swing again, and it’s a bipartisan problem. It will weigh on global economic activity.
- Monetary policy – For the Fed, there’s basically no policy space left but a move to negative rates across the curve; they are inefficacious at best and harmful at worst.
- Growth – At the end of 2019, the U.S. economy was already fragile. The risk of a double dip is far greater than risk-asset markets (temporarily propped up by fiscal and monetary policy) are suggesting.
- The virus – Vaccine efficacy and distribution are unpredictable at best… making the pace of the economic reopening equally as uncertain.
- Conclusion. It may be a brave new world, but it’s not enough to convince yours truly to drink the soma. To me, markets feel as if they are on the cusp of yet another significant risk-off correlation event.
Facts do not cease to exist simply because they are ignored. –Aldous Huxley
Huxley’s most famous work was A Brave New World, which was written during the Great Depression. This quote comes from his complete essays and predates the novel, which is set in the futuristic, dystopic ‘World State.” (Now that I’m on my own time, I’ve been able to revisit some of the classics.) The State’s citizens are genetically and socially engineered in hatcheries and conditioning centers, respectively, for placement within an intelligence-based social hierarchy. The protagonist, Bernard, studies sleep-learning, which is one of the conditioning techniques used to influence the moral choices and behaviors of its citizenry. In addition, the Alpha controlling caste both uses and administers a mind numbing drug called soma to suppress whatever base, natural instincts might still remain. It is especially useful for control of the working class “Gammas.”
The Brave New World’s existential condition seems uncomfortably familiar. Consider some of Huxley’s descriptions:
“The mind that judges and desires and decides [is] made up of these suggestions. But all these suggestions are our suggestions… suggestions from the State.”
Don’t fight the Fed. Use the Fed Model.
“The Nine Years’ War, the great Economic Collapse. There was a choice between World Control and destruction. Between stability and…”
Must I explain?
“Soma had raised a quite impenetrable wall between the actual universe and their minds.”
The Fed’s SOMA (System Open Market Account) is now, too, an integral part of how it controls the markets’ gammas. What was extraordinary has become ordinary. The unthinkable is being slowly accepted as necessary to the preservation of order and stability. Unfortunately, the gammas have become somewhat tolerant of the SOMA, and it has forced the State to act directly with massive fiscal stimulus. Stability achieved at the expense of democratic capitalism? It ends up being a societal choice. We are making it… one crisis, one ‘extraordinary circumstance’ at a time.
While philosophy can be useful, this comment ought to bring to light more pragmatic truths that might lead one to conclude the following: 1) equities as an asset class (excluding its largest technology constituents) have broadly been in a bear market since 2018, and 2) risk-reward to equities is awful because market breadth is unhealthy, valuations are extreme, and risks to fiscal policy are elevated into the election.
Ignorance Is Bliss
On August 17th, I wrote:
“While I’m on the wrong side of history [relative to the most-widely followed indices] at the moment, I continue to believe [my skepticism] will prove justified in the context of what’s to come. The expansion of breadth into small caps is likely to pan out as a short-lived rotation that continued weakness in earnings and higher levels of defaults will derail.”
Indeed, the rotation into small caps has so far failed to endure. While a touch above the June 8th local high, around which I wrote The Portnoy Top, I continue to believe upside is extremely limited. The true condition of U.S. stocks has been masked by the construction of the most widely followed indices, but that construction will not ultimately save them… unless a vaccine is found and distributed far faster than appears possible.
When one drops the veil, it becomes clear that stocks have not performed well overall. While Huxley was correct – ignorance of facts does not deny their existence – it can lend itself to an impenetrable wall between people’s minds and the reality of the world around them. As I wrote in The Narrative Matrix, perception becomes reality, but the truth ultimately prevails. I haven’t conducted a formal survey, but I’d guess the average investor perceives that ‘stocks’ are doing well. My doorman certainly seems to think so. In fact, since 2018, the majority of stocks have been in a bear market. Performance dispersion within and amongst equity indices tells the ‘true’ story about U.S. equity performance.
Unlike the S&P 500 and Nasdaq Composite, many broad indices and non-technology sectors remain below or well below previous highs, some of which were marked in mid-2018. It’s essentially been a bear market for the Russell 2000 and NYSE Composite since then. The NYSE Composite is down 7.5% YTD (down 4.6% from its 2018 high) and Russell 2000 is down 9.6% YTD (down ~11.5% from 2018 high). The S&P Equal Weighted Index, which is roughly 6.5% below its January high, shows the importance of large cap technology company performance to the capitalization weighted S&P 500. Only a handful of stocks have driven returns for the broader tech-heavy indices like the S&P and the Nasdaq. This is not a unique insight, but it bears emphasis because narrow breadth typically means markets are fragile.
Sector dispersion and breadth indicators within the NYSE and S&P 500 further tell the story. Financials tend to be important to the sustainability of market moves. Large cap banks (XLF ETF) are still roughly 20% off their 2020 high and~18% off their 2018 high; regional banks (KRE ETF) are roughly 35% off their 2020 high and 40% off their 2018 all-time high. Financials (and particularly regional banks) are struggling. Not since mid-2018 has it generally paid to be overweight economically sensitive stocks. The Dow Jones industrial average still remains down almost 5% from its 2020 high, despite the very recent addition of a wholly un-industrial company: Salesforce. Whoever said the benchmark indices weren’t actively managed?
Index breadth has been narrowing. According to Bloomberg data, the percentage of NYSE stocks above their 200-day moving average has certainly rebounded, but it has failed to rebound quickly above the 60% level that typically characterizes the beginning of a new bull market advance. See Exhibit 1 of the Appendix. The NYSE cumulative advance-decline line tells the same story. It looks quite a bit like it did in mid-2015 just prior to the significant hiccup in energy and industrials. See Exhibit 2 of the Appendix. Like 2015, when healthcare and retail drove the entirety of the S&P’s advance, now there is even narrower leadership from technology. New highs minus new lows on the NYSE now hovers around zero and has been quite weak as market bounces typically go. See Exhibit 3 of the Appendix. The media narrative, which tends to focus on tech, masks this reality.
Telling a story and creating a feeling around what it means to day trade has certainly help change the nature of market participation. The Robinhood app has brought the promiscuity of Bumble to investing. Sexy is as sexy does. From numerous anecdotes, it would appear that little thought is given before getting in or getting out.  (For those who’ve read Brave, we can agree I’m really stretching the analogy here, but why not try to have some fun with it?) Market participants are part of society, so this behavior should come as no surprise. With the numbing effects of SOMA at work, and with the continued assurances that The State will provide prophylaxis for its citizenry’s misjudgments, it’s no surprise that there’s little fear. No morals. No moral hazard. Pretty simple.
Because of performance dispersion within the S&P and negative earnings within the Russell 2000, talking about valuation is far more difficult than it’s ever been. While it does not tell the story for most stocks, or even for most stocks in the S&P, it does help inform how much risk there is to the narrow band of S&P leaders. Technology companies within the S&P 500 trade on a capitalization weighted basis at ~31x year-end estimates; the remainder of the index trades around 20x. There is so little visibility around Russell 2000 earnings, and so many companies have negative earnings, that the P/E based on the 2020 estimate for earnings is 93x. The estimate for companies with positive earnings is 17.4x. It’s a laughable disparity. Nearly 1/3 of small caps lost money over the last twelve months (according to FactSet) and, based on my rough estimates, at least 25% will lose money over the coming twelve months. Index valuation has always been tricky, but it is now even more so for both large cap and small cap indices.
Of late, I’ve seen every manner of justification for a year-end 2020 forward S&P 500 P/E of almost 26x. One obvious justification is an expectation for a rapid recovery in earnings. Even a recovery in S&P earnings to $150 by this time next year would make the forward twelve month P/E a still eye-popping 21x. I’ve recently seen some good analysts try to make a case that a fair value forward multiple for the S&P 500 is just that (21x). This ludicrous assertion is typically reliant on some variation of the Fed model (i.e. – equity yields are favorable relative to Treasury yields). It also routinely points to tight corporate spreads and equity risk premium relative to those spreads. The latter, at least, is more sensible. The Fed model justification is just rubbish. It does not take into account the normal equity risk premium required above a risk-free asset. It also doesn’t it take into account inflation or the reason rates are so low in the first place!
Rates began falling in 2019 for a reason – there was a global slowdown that began in 2018. In 2019, earnings for U.S. large caps were flat year-over-year, and for corporate America (more broadly), they were down over 5%, despite the tax cuts. Russell 2000 earnings were down over 15%! Few seem to recall this fact. The 2019 curve inversion caused lower loan volume growth, which eventually turned negative in December 2109. This probably would have aggravated the already weak earnings picture in 2020, but we’ll never know. The earnings slowdown was followed by an unprecedented pandemic shock. In sum, corporate cash flows were already challenged and then collapsed on the pandemic’s impact. This resulted in unprecedented and unsustainable stimulus from both monetary and fiscal policy makers. Given this backdrop, why should we expect cash flows to rebound quickly above 2019 levels? Soma anyone?
This is likely a distorted and prolonged cycle downturn. The already fragile backdrop for corporate earnings makes a quick recovery unlikely, so the Molodovsky effect does not yet apply. Molodovsky’s 1953 article “A Theory of Price Earnings Ratios” observed that at the bottom of the business cycle, earnings were depressed to the point that P/E ratios were often much higher than when earnings were strong at the top of the cycle – even though share prices were higher. First, this is actually not always the case, as additional empirical observation since then have revealed. Second, if one is to make the case that valuations are ‘distorted’ by the recession, then one must believe the recession has ended and that earnings will bounce back as they would after the end of other cycle downturns. It is a flawed and tautological argument to assume that valuations are elevated because of the earnings downturn. If the downturn hasn’t ended, then price rather than earnings could just as easily correct for the overvaluation.
Alongside and related to poor cash flow growth, inflation has been well below target for some time. Inflation is a key variable when assessing earnings risk premium (ERP) and P/E. Central banks have failed to produce it for over a decade. Last month, PPI excluding food and energy printed at 60bps, up from just above zero the prior month. The proprietary ERP model I’ve previously presented in detail uses a forward inflation rate of 1.5%; it suggests that the ‘fair value’ forward P/E multiple for the S&P 500 is closer to 17.5x twelve-month forward earnings. Even if one assumed an EPS recovery to $150 by this time next year, using this fair value multiple, the S&P should be closer to 2,625. The traditional Fed model is rubbish, but the State has programmed many to believe it.
At current valuations, it’s almost a ‘no win’ for large cap tech here. If the economy improves, enthusiasm for many of the tech giants should wane. If the economy double-dips, which is likely, even these tech giants are likely to suffer. The growth in cash flow and earnings just isn’t there to justify the valuations of these mature, large cap tech companies. The reversion will come as these go-go names suffer a mean reversion to the rest of the market and as market participants realize they are impacted by the same risks as the rest of the market. Moreover, relative value assessments to corporate spreads are misplaced; the default cycle is just getting started and pandemic policy response won’t prevent it for lower-rated borrowers. High yield credit spreads implying 3% to 4% default rates with defaults already on pace to rise above 5% makes little sense. Investment grade (IG) spreads may not budge, but the risk premium of equities over IG should widen instead. In sum, valuation risk is extreme.
Policy and Growth
Except after the Great Depression, U.S. markets have never been so reliant on policy – especially fiscal policy. Despite Treasury-funded Fed lending, the most recent loan officer survey (released on July 31st), shows that standards have tightened across the board. This will have a feedback effect on growth. Importantly, and as I’ve written ad nauseam of late, fiscal policy is now far more important that monetary policy. Without a coordinated effort between the Treasury and the Fed, the Fed would not be able to lend under Section 13(3) to buy corporate debt. Companies would not have received the (Paycheck Protection Program) PPP loans, which have prevented even deeper layoffs. PPP expired on August 8th, and the pace of the recovery has not been quick enough that PPP borrowers will be able to afford keeping on workers. These layoffs will keep PPP loans on company books and, unfortunately, the pace of improvement in unemployment may slow.
We’ve already seen the beginnings of those postponed layoffs with airlines, big banks and automakers making announcements. What will small businesses do? It appears that many of the beneficiaries of PPP or other companies that took more of a ‘wait-and-see’ approach, began to read the writing on the wall in mid-September. According to news reports, on September 14th, Citigroup continued laying off roughly 1% of its global workforce. The cuts end a previous commitment to pause layoffs amid the pandemic. United Airlines announced on September 2 that it will furlough 16,370 employees once federal aid expires on October 1. On August 25, American Airlines, which previously announced cutting 20% of the company’s workforce, said that it would cut 19,000 employees in October when federal aid ends. In late August, Delta Airlines announced it plans to furlough 1,941 pilots in October following the expiration of federal aid. In April, Boeing announced plans to cut its staff of roughly 160,000 by 10%. In an August 17 memo, Boeing told employees it was starting a second round of buyout offers that would extend beyond the original expected numbers.
It’s not just airlines and aerospace, which are clearly industries most impacted by Covid-19’s progression. Ford is offering buyouts to 1,400 workers eligible for retirement this year in the US. The September 2 cuts make up just under 5% of the company’s US workforce. MGM Resorts is laying off 18,000 previously furloughed employees, and that began August 28. Coca-Cola said it plans to offer voluntary-separation packages to 4,000 employees in North America beginning on August 28. It did not specify the total number of employees it plans to lay off. Salesforce started to lay off 1,000 of 54,000 employees on August 26In March, CEO Marc Benioff pledged a 90-day freeze on layoffs. These layoffs demonstrate that corporate America is being forced to respond to a slower-than-expected emergence from the pandemic. Balance sheets were already levered, with leverage ratios at all-time highs and even with coverage ratios beginning to start to deteriorate – even with ultra-low rates.
While extraordinary fiscal policy action has been effective, once the initial stimulus ends, credit to businesses and consumers is still generally transmitted through banks. Given 1) high corporate leverage levels, 2) anecdotal evidence that large firms will begin to lay off workers in October, and 3) initial claims still hovering just below a million (with continuing claims falling to just over 13 million), it’s unlikely banks will become more excited to lend in the near future. The higher frequency payrolls data seems to confirm what ISM’s payroll component reflected on September 1st when it printed at 46.4. It also seems to confirm the deceleration in private payrolls growth to just over 1 million. Figure 1 shows that standards tightened considerably in the second quarter despite stabilization in credit and equity markets due to implementation of a plethora of policy responses. With credit this tight, it will be difficult for growth to immediately rebound in the way markets seem to be expecting.
The truth of the matter is that, since 2018, most U.S. equities have had a rough time of it. Most seem blissfully unaware of this condition, as the headline indices are dominated by what have turned out to be somewhat countercyclical (at least relative to the pandemic) technology stocks. While these stocks are wildly overvalued and subject to correction, even the more ‘reasonably’ valued remainder of the S&P 500 is still too expensive. Yes, this is true even when taking into account rates and the so-called Molodovsky effect. I believe it’s almost impossible to argue that high yield credit and U.S. equities (and I’ll throw a blanket around all of them) are priced at fair value. The kind of recovery in corporate cash flows that’s needed just isn’t in the cards. The backdrop coming into the pandemic was just too fragile and the foundation simply too weak.
Perhaps I’m just plain wrong. Maybe the new breed of market Bumblers has changed markets from price discounting and discovery mechanisms to a new form of entertainment. But I’m just not willing to concede that ‘truth’ is no longer relevant. Future corporate and personal taxation increases are an almost inevitable consequence of the current fiscal policy response, which the Fed has (for now) been monetizing. In my view, the risk that these tax increases come in January 2021 is now far greater than it was prior to the pandemic. Given the perceived effectiveness of the Trump administration’s pandemic response, a Biden victory is not out of the question. All in all, the risks are severely skewed the wrong way for equity investors given current valuations. It may be a brave new world, but it’s not enough to convince yours truly to start drinking the soma. Markets feel as if they are on the cusp of yet another significant risk off correlation event. Maybe I can fix that feeling with a half hour on the heavy bag. Whatever floats your boat, I guess.
 The NYSE Composite is down 7.5% YTD and Russell 2000 down 9.6% YTD. The S&P Equal Weighted Index, which is roughly 6.5% below its January high, shows the importance of large cap tech’s outperformance to the S&P 500.
 Large cap technology companies within the S&P 500 now trade at about 31x 2020 forward earnings. These are mature technology companies whose earnings growth does not justify this elevated multiple.
 I’m also in the midst of rereading James Fenimore Cooper’s Last of the Mohicans. It would be a stretch to try to draw market analogies from that masterwork, but I may yet try!
 SOMA is the acronym for the Fed’s System Open Market Account, where it houses securities it now buys with Treasury’s able assistance under Section 13(3) of the Federal Reserve Act. Gamma just so happens to be the option Greek that that describes the ‘leverage’ an option gives the underlying asset. The higher the gamma, the greater the change on the rate of change and ultimately the more pronounced and option’s price move will be. Take out the gamma and stability returns… or something like that!
 Despite this underperformance, at an average of 1.2x price to tangible book, large regional banks are far from cheap. I have been particularly bearish of small cap banks since 2018, as they tend to be sensitive to the slowdown in loan growth that began then.
 Transports, for example, are down just under 2% since mid-2018 at their most recent peak. REITs are down slightly from their mid-2018 peak and down over 17% from their early 2020 high. Energy (XOP ETF) is down almost 58% from its mid-2018 peak. Metals and mining companies have suffered an almost 37% decline (XME ETF). Consumer discretionary (XRT ETF) is down about 4% form mid-2018. Discretionary stands in stark contrast to staples, which are up considerably because many of those companies benefit from stay-at-home trends along the homebuilders, which are also at new highs.
 Please see Exhibit 4 of the Appendix.
 As the WSJ authors of Everyone’s a Day Trader Now wrote: “it appears even bigger—and broader—this time around, amplified by digital communities on Twitter and Discord, a popular online chat hangout. Investors have transformed those social-media platforms into virtual trading desks, a place to swap tips, hype stocks and talk trash as they attempt to trade their way to a quick fortune.” My favorite quote from the story is a woman who proclaims that her trading style is aggressive because ‘scared money makes no money.’ According to the Journal, “she read ‘Trading for Dummies,’ watched YouTube videos, opened an E*Trade account and dove in.” That sounds about right. https://www.wsj.com/articles/everyones-a-day-trader-now-11595649609
 As global growth slowed, U.S. long rates continued to rise – until they hit just over 3%. The economy, as well as equity and rates markets, all had hissy fits. The yield curve inversion and equity markets selloff forced the Fed to cut and to stop balance sheet normalization.
 Intuitively, when inflation is low, nominal earnings growth will also be lower; thus, P/Es should be lower all else equal. Importantly, capital costs have little room to move lower, as rates/loneger-yields been so close to zero for some time and spreads have been so tight. That is the ‘all else equal.’
 “To bolster the effectiveness of the Small Business Administration’s Paycheck Protection Program (PPP), the Federal Reserve is supplying liquidity to participating financial institutions through term financing backed by PPP loans to small businesses. The PPP provides loans to small businesses so that they can keep their workers on the payroll. The Paycheck Protection Program Liquidity Facility (PPPLF) will extend credit to eligible financial institutions that originate PPP loans, taking the loans as collateral at face value.” – The Fed