As 2014 draws to a close, providing hard asset investors with yet another desultory and depressing year of investment performance, we are hard-pressed to make a bullish case in the near term for nearly any commodity. Longer term, without a doubt, cash will still be trash, however for now the Central Banks have the upper hand and are firmly in control of the steering wheel guiding the markets. Gold remains in a trading range between 1240 and 1120, and does not appear to have the momentum or determination to break out meaningfully. Risks most likely remain to the downside. Gold stocks started the year on a bullish tone, only to once again savagely reverse course and dive downwards. Agricultural prices collapsed across the board, shadowed by weaker copper, silver, cotton and sugar. And then there’s oil.
Oil’s spectacular decline has been variously blamed on the Saudi’s trying to maintain market share and fend off the US shale oil drillers, on the US Government trying to put Russia and Putin out of business and more generally on the overall punk economic environment and the other persistent signs of deflation emanating from Europe and Asia.
Interest rates show no signs of life yet, and continue to forecast more of the same--global deflation…
This is not at all surprising, given the monstrous US debt pile which has barely come off its all-time highs versus GDP; and remember, this is only the “on balance sheet” debt, if you include the “off balance sheet” debt (e.g. government pensions, social security, Medicare, Medicaid, etc.) that adds another 60 trillion or so of debt.
Debt acts like a ‘sea anchor’ on the economy, and exerts an invisible drag on growth. The entire global Central Bank response to the 2008 crisis is predicated on stimulating already highly leveraged economies into adding incrementally more debt. Which begs the question; just how much debt can they support in the end? It looks like we are going to find out the hard way…..
Debt is also very deflationary. If the graph below, snatched off of Wikipedia, can be believed, the US has teetered back and forth for centuries between long bouts of inflation followed by long bouts of deflation…..
Since the US went off the gold standard around 1971, we haven’t had any deflation. Maybe cyclically, we are due. Certainly, with the mountainous debt load we are carrying, we should be due. If the US slides further into a debt induced deflationary spiral of downward prices, commodities, gold and we are in for a very nasty time indeed.
Moving right along to a more cheerful train of thought, it is certainly a truism that every price move in every asset class makes somebody happy, and that somebody this year has been US equity investors, particularly of the passive variety.
No Christmas for commodity investors……
In hindsight, the major beneficiaries of the massive globally coordinated Central Bank monetary expansion since 2008 have been bond, equity and real estate investors. Passive investment strategies with their lower fee drag have hammered active managers over this period, and all commodities have pretty much been smashed.
We fully expected another large correction to retest the lows put in after the crash in 2008-2009. We further expected that all the coordinated massive global Central Bank balance sheet and money supply expansion would lead eventually to some kind of price inflation, leading gold and other commodities higher. We have been flat out wrong about the macro environment and stocks for quite a spell now, and we find that fact fully as irritating as you must. We have been and remain in a Central Bank induced twilight zone, where traditional relationships do not apply and outcomes are not intuitive.
The UK, Japan, ECB and US central banks have massively expanded their balance sheets from 11% of combined GDP in 2007 to 24% of GDP in 2013.
As the world turns, we overlooked the fact that while the money printing presses were running flat out, the velocity, or turnover rate of that money kept falling, because everybody was too scared to keep doing business as usual-which greatly dampened the potential for global prices to reset to higher levels.
Interestingly, on the longer term velocity chart below, we can see that by historical precedent velocity could well continue contracting, as it did steadily between 2.15x in 1900 to its low of 1.2x in 1946, from which one could infer that the velocity problem and concomitant deflation could be here to stay for quite some time longer and even greater deflationary pressures for the Central Banks down the road.
Certainly, inflation expectations continue to collapse. The graph below shows the now infamous “5 yr /5yr forward swap” rate, made famous by Mario Draghi who runs the European Central Bank. For those not quite up to snuff on arcane finance lingo, herewith a definition from Investopedia…
“A swap agreement created through the synthesis of two swaps differing in duration for the purpose of fulfilling the specific time-frame needs of an investor. For example, if an investor wants to hedge for a five-year duration beginning five years from today, this investor can enter into both a five-year and ten-year swap, creating the forward swap that meets the needs of his or her portfolio.”
In sum, it is a real market price indication of what people today believe future interest rate levels will be 5-10 years out into the future. And the future, at least in Europe, is looking bleaker by the month……
So the Market is forecasting more Deflation, and if velocity keeps falling, that is exactly what will happen. The reason for the punk velocity numbers starting about the year 2000 is not hard to find. The banks, hampered by ever increasing regulation and punitive and mostly undeserved regulatory fines, simply shut off the taps and hunkered down in a highly risk averse mode. They refused to lend and the lending that they did tended to be low risk secured lending against fully collateralized and easily liquid securities. Consumer loans are still extremely weak and commercial and industrial loans barely show improvement in recent quarters. Bank lending growth has recently recovered into positive territory, and is starting to accelerate, but it still has a long way to go to be “normalized”.
So where does that leave us? We are still stuck in the topsy-turvy, Alice-in-Wonderland, artificial financial landscape crafted by the global Central Bank alliance. They have made it very clear, time after time, that rates will not be allowed to rise until unemployment is much lower and nominal inflation and GDP growth are well entrenched to the upside.
On the minus side, US stocks are getting pricey on some traditional metrics, and sentiment is flashing warning signals on numerous fronts. Margin debt as a percentage of total stock market value has blown past where it got to in 2000 and is flirting with the prior peak level achieved in 2007…
On an absolute basis, total outstanding margin debt now exceeds levels attained in both 2000 and 2007.
In addition to very high margin debt, another interesting metric in terms of relative valuations is the ratio of the total value of US stocks to US total income; income being a proxy for the raw material of savings, investment and consumption. This measure is also flashing in the red zone and approaching levels last seen in 2000…
In the more neutral camp, the rapid decline in global oil prices has potential pluses and minuses for the global economy, with some marked winners and losers….
The yellow circles are the “winners” and the maroon circles are the “losers”. With Japan, China, India, Turkey and the Eurozone effectively getting a big oil “tax cut” those economies should have a fresh wind at their backs. The situation in the US is more nuanced, however, as the surge in shale oil production in the Bakken and Eagleford regions have been one of the main drivers of incremental job and capital spending growth over the last several years. On the surface, one would think the fall in prices is a complete win, in the sense that prices will come down at the pump, people will have more money in their pockets and consumer spending will rise, creating more jobs and bolstering the economy. However, capital expenditures in the US oil patch for 2015 are estimated (Deutschbank research) to decline precipitously by over $ 500 billion, which is almost 20% of the entire amount spent on capex in the US in 2014. High yield debt, or “junk bond”, issuances to oil drillers is estimated to be 17% of all high yield bonds outstanding currently, spreads have recently blown out and this could lead to a “contagion” effect of rolling defaults, margin calls, more defaults etc. The jury is still out on this one, much will depend on where the oil price finally does settle.
On the positive side of the ledger, potentially offsetting some of those seemingly bearish omens, the total investible supply of equities outstanding continues to shrink from corporate buybacks and there simply are no other better alternative places to park funds. Anybody who is buying 30 year bonds at current yields ought to have their head examined. Anybody who is issuing 30 year bonds at current yields ought to get a big, fat bonus. As can be seen on the chart below, that is exactly what corporations are doing, issuing ever more debt and retiring shares. This is shrinking steadily the overall supply of stock, and is also helping to underpin the market.
Another interesting and to our minds potentially bullish indicator is (for lack of a better description) what we shall term the “Blow Off” factor. By this, we mean that most bull markets end with a big bang, and don’t just slink off with barely a whimper. Witness the chart below, showing the textbook final “Blow Off” in silver which occurred in 2011. Note the steady, slow grind upwards from the beginning of 2009 until mid 2010, and then the lift off into the stratosphere in 2010 – 2011. That’s a textbook case for how a bull market usually finishes.
Silver 2009 - 2013
If we move to look at the S&P 500 over the last five years, we see only the slow, steady incremental crawl, but we do not see signs of the asymptotic “Blow Off” top formation anywhere yet…
S&P 500 2010 - 2014
It is true, however, that on a longer term note, the rate of ascent in the last couple of years does look a bit steeper and much more extended than either of the run-ups to prior peaks in 2000 or 2007….
S&P 500 1995 - 2014
What is also intriguing to us is that the volume clearly increased during the bull market run-ups in both late 1990’s and mid 2000’s, but for the latest bull, from 2009 to present, volume has consistently been falling until very recently. What that ultimately implies, we don’t really know. Maybe there is less turnover because the total supply of stocks keeps shrinking through buybacks. We would expect volume to spike to the upside should the final “Blow Off” come. Obviously, the market has been a complete one way trade from 2009 to present, which is going on 5 years and counting. We wouldn’t be surprised either way, that it does have the usual upside blow off, or that it suddenly turns around and sells off inexplicably for reasons that will become apparent only much later. We remain on high alert, and ready to run for cover at the first sign of material weakness.
Another interesting valuation metric is the Price to Earnings ratio and Price to Ebitda ratio. The Chart below shows both, the green being P/E and the red being P/Ebitda.
S&P 500 P/E (green left scale) and P/Ebitda (red left scale) 1929-2014
Of note, on a P/E basis, at 18.3 x trailing, the market does not look horribly out of whack valuation wise. The P/Ebitda ratio at 9.4 x trailing is pushing up to the outer limits however, and will soon be really in the “Red Zone” where it got in 2000 before the ensuing crash. To sum this part all up: trend wise, we believe we should be long stocks and long US dollar, and short very little except other currencies. The run up in equities does look a bit long in the tooth however, so we as always are keeping our opinions on a very short leash and a wary eye on global conditions. We are prepared to shift from long to short very quickly, and will do so should it appear the market is beginning to run out of upside potential.
Moving right along, on another brighter side note, the US economy, relative to the EU, Japan and even China looks very positive.
GLOBAL ECONOMICS OUTLOOK
2014-12-15, 03.37 PM ALEJANDRA GRINDAL
Global economic expansion intact, with mixed trends by region.
We continue to maintain our view that the global economic expansion remains intact and is likely in its mid stages. Growth trends have been mixed by region, with North America a notable positive standout. Emerging economies are generally looking less bad compared to the beginning of the year. But trends in Europe have weakened, suggesting growth may moderate in the coming quarters. For 2015, we expect the global economy to expand 3.6%, up from 3.3% in 2014.
U.S.: We expect the economy to accelerate in 2015, with most GDP components growing at a robust pace. The positive performance in the U.S. should spillover to Mexico and Canada…
Eurozone: The economy has been showing signs of moderation, with unsettling weakness in Germany. Spain and Ireland are notable bright spots. The weaker euro, lower oil prices, and modestly improving lending environment should help support growth. But deflation and geopolitical risks remain threats.
Japan: The economy fell into a technical recession in Q2 and Q3 due to the April sales tax hike. We expect the economy to recover in Q4 and grow at a slightly faster pace in 2015 than in 2014, helped by accommodative monetary policy and the government's decision to postpone the second tranche of the sales tax increase to 2016. Minimal real wage growth and a persistent trade deficit remain longer-term concerns.
China: The current economic environment is mixed, as poor lending and real estate conditions weigh on growth. Nonetheless, the government will likely achieve its growth goal for the year of around 7.5%, using broad and/or targeted stimulus when needed. Annual growth targets will likely be lower and lower in the coming years as the government focuses on quality over quantity of growth.
So, with the US economy starting to finally pick up steam relative to the rest of the world, the US dollar should continue to rally, and in fact appears to have broken out of a long term downtrend into a long term uptrend. Historically, the dollar has traded in fairly long cycles, and the cycle has definitely turned again. The rest of the planet is trying to lower their currencies vis-à-vis the dollar in order to jump start their economies and the US does not appear to care. The path of least resistance for the dollar is higher, for the foreseeable future.
We are now long the US Dollar index, short the Euro, the Australian Dollar and the British pound. These currencies were chosen because they have deep and liquid futures markets.
We are also long Indian, China and US Equities and have lowered our short equity position considerably. We are preparing to re-engage with gold stocks yet once more, as sentiment is again as bad as we have ever seen on almost any asset class at any time. We stand by our original thesis on Gold, which can be reviewed here, http://www.tanocapital.com/ (under the news and research heading - Tano Capital Research: “Bullish Again on the Prospects for Gold…")
We thankfully avoided this year’s debacle in oil, and are now reviewing the oil patch from the long side as well, although we believe it is still too early to start buying. With oil cratering almost in half to under 60 dollars a barrel, the price cuts should show up soon at the pump and leave more cash in people’s wallets, which we believe could then show up in retailers’ pockets this Christmas. As a result, we are now long several retailing plays.
We have been following the lift off in the domestic China “A” share equity market with interest, and believe that that market is still in the early innings of a very large up move. Retail investors in China have not participated in the domestic stock market for a generation now, and we believe they now are finally becoming aware of stocks and a monstrous upside bubble is in the early stages of forming as more and more retail investors get active in stocks. We are analyzing the best way to participate there.
India is one of the hugest beneficiaries of the decline in oil, as they import virtually 100% of their oil from elsewhere. Lower oil prices will help stabilize their current account, and should enable the central bank to start lowering interest rates, which are very high by global standards at the moment. Indian stocks have already had a nice run, but we believe it is still early innings. We are in the process of setting up the legal and regulatory pipeline to enable us to buy domestic Indian Equities directly.
The Central Banks have made it extremely difficult to predict when things are going to happen globally. Our goal is not to make 5-10% a year by closet indexing to some benchmark, and then throwing our hands in the air and riding the market to hell like everybody else when it does inevitably correct violently, like it did in 2008. Our objective is to steadily increase our capital by making smart expected value bets, and being very nimble to get out and preserve capital when we are wrong. We could be in for a prolonged period of continued deflation, central bank muddling and interference and slow growth. The implications of that are difficult to discern, other than if money velocity continues to decline it will keep gold and other commodities pinned down for quite some more time.
There are also quite a lot of bad things happening globally, which bear watching.
Putin has been emboldened by our weak and vacillating leadership, and he is unlikely to stop where he is now. He has instituted a domestic draft and continues to build a very large army. He will need to put it to use, and clearly has plans to do so.
ISIS has been unleashed in the Middle East, again due to weak and vacillating leadership in the west and to our minds it is only a matter of time before they get nukes and god help us then. They have money, sophistication, organization and an agenda that is totally inimical to the rest of the civilized world.
Ebola has left the press, but it has not left Africa and further future outbreaks outside Africa are a virtual certainty.
China and Europe continue to parse through the Snowden revelations on US spying abroad, and this will have a very chilling effect on U.S. centric global technology companies who are trying to peddle their wares in those markets. Our once globally powerful technology companies will increasingly face fragmented markets and locally grown competition with government support behind them.
China will continue to slow. The massive infrastructure build out that began in the 80’s has effectively reached its limits, and the leadership knows it must transition the domestic economy from Investment lead to Consumer lead GDP growth. This will not be easy or smooth.
Iran and Israel have not yet reached any kind of stasis over Iran’s continuing nuclear development. The Israeli government is turning increasingly hawkish. The situation is not stable and could blow up at any time.
Saudi Arabia is a tinderbox demographically. The population has exploded over the past 20 years, and half of the population is under 29 years old. There is virtually no domestic economy and no jobs for all those new young kids. With oil prices cratering, the usual subsidies going to that sector of the population will be impacted and who knows what they will do.
Europe’s bad debt problems and currency strains have not disappeared. All the countries that joined the Euro gave up the ability to devalue their currencies as a tool of last resort to reboot their economies, and the strains are starting to show again. Germany is blocking the ECB so far from making any material progress in following the path of the other central banks globally, which is causing deflation, high sticky unemployment and high dissatisfaction with the status quo. Recent elections throughout the Eurozone point to nationalist and hard line parties continuing to gain in power and influence, and most of those would back and support some form of exiting from the Euro currency. Something will have to give.
The good news is that all the global bad news just keeps making the dollar look better and better. Money will continue to move globally into the US, as our economy relatively speaking is starting to shows signs of life and rebooting. As those funds flow in, they are likely to wind up in the equity market, since effectively there is nowhere else to put it other than real estate.
Some further thoughts on Russia’s meltdown, from a Wall St Journal Blog 12/16/2014:
Reasons For Investors to Care About Russia’s Market Turmoil
It might be tempting to think in realpolitik terms about Russia’s financial woes right now — the idea that a weakened Russia has less weight to throw around in conflicts such as the Ukraine and Syria. But the reality is that a plummeting ruble and the disarray in that country’s markets pose real threats to the global economy.
Here are five major reasons why outside investors should care about a financial crisis in Russia.
- Debt market contagion. Having never resolved a lasting mistrust in the ruble or created the right governance rules to attract investors, Russia has no large, functioning market in ruble-denominated debt. Its biggest corporations continued to borrow heavily in dollars, which means they are now at risk of defaulting on those bonds as their ruble-based earnings plunge in line with the currency’ slide. That poses risks for the rest of the world. Holders of those bonds will face losses and – much as they did during the Russian crisis of 1998 – will dump other risky bonds to cover those losses, widening the market fallout. Those in line for contagion include the sovereign bonds of emerging-market countries from Africa to Eastern Europe that had until recently exploited a voracious appetite for yield among global investors and junk bonds in the U.S. that are already reeling from falling oil prices. If a few major hedge funds or, even a big bank, were to run into trouble, this mushrooming effect could become even more severe.
- Currency market contagion. A currency doesn’t fall in isolation. Its effects are felt far and wide by the competitive challenge it creates for other countries. To offset that, currencies of Russia’s trading partners are falling in “sympathy.” That’s all very well if it’s contained and helps offset the blow to their exporters’ fortunes. But if it goes too far, too fast, it can foment the same reinforcing spiral that has forced the Russian central bank into desperate actions and led investors to rush for the exits. A few currencies in particular are in line to become the next domino. One is Turkey’s lira, which is also hitting record lows and where a combative relationship between the government of Prime Minister Recep Tayyip Erdogan and the central bank has undermined market confidence. Another is Indonesia’s rupiah, which is suffering from a slowdown in Chinese demand for its commodity exports and because the central bank is grappling with an inflation threat after the government ended fuel subsidies. The more currencies get dragged into this contagion, the wider the matrix of affected trading partners becomes, which means that the dollar will simply rise further and further. Eventually that itself becomes a problem for U.S. producers.
- Further declines in oil prices. Economists originally viewed the collapse in oil prices as a net positive for the global economy, on the grounds that it puts more money in consumers’ and businessmen’s pockets. But a chaotic decline of more than 45% in less than six months is now showing its negative side – in part via the financial stress felt by oil producers, which will struggle to meet debt payments, and in part because investors in commodities and high-yield bonds are hurting and selling other junk debt and other commodities in response. Russia’s economic woes could make the imbalance in crude markets even more extreme. On the one hand, its oil producers will be under political pressure to maintain supply and keep revenue flowing, even if it is unprofitable to do so at these prices, while on the other, the blow to Russia’s economy from this financial meltdown will undermine its internal demand there, ensuring an even bigger excess supply for world markets. That will put the international crude price under yet more pressure and so worsen the financial impact for producers and commodity investors in the U.S. and elsewhere.
- An escalating military conflict? Like a wounded bear, a weakened Russia could be more dangerous than a strong one. President Vladimir Putin got a powerful message from poll numbers that put his approval rating as high as 80% in response to Russia’s incursions in Ukraine. Sensing that he has nothing to lose, Mr. Putin might opt for a similarly belligerent response as he seeks to extract concessions from the West and bring relief to the Russian economy. Russia has been hurt economically by the U.S. and E.U. sanctions that were first imposed after it annexed Crimea and strengthened in response to its support for separatists in Eastern Ukraine. But with Russia’s unstable state posing an economic and political risk to its neighbors, the Kremlin might deduce that this time it can use the threat of more conflict as leverage.
- A cold winter for Europe? In its battle with the West, Russia’s “nuclear option” – not literally – would be to follow through on threats to curtail natural gas supplies to Europe. That’s a serious problem for countries like Germany, which gets more than a third of its gas supplies from Russia, and an even bigger one for Poland and other Eastern European countries, where the dependence is almost total. Natural gas, which arrives via fixed infrastructure such as pipelines, can’t quickly be replaced with other fuels or tapped from other sources – not until expensive projects to convert U.S. shale gas into exportable liquid natural gas come online. Gas in those countries is used to heat homes and keep critical industries running. A blow of this kind would be economically devastating to a giant economic region that’s already suffering from stagnation and deflationary pressures. As with the euro crisis of two years ago, an event like that would quick spill over into U.S. and other markets.
In sum, the macro picture, while always shifting among the variables listed above, and many others, appears to us a bit less cloudy than it has in a very long time. The US economy is rebooting, interest rates are in process to be normalized, and the dollar has broken out to the upside in what should be a fairly long appreciation phase. While the US stock market has pretty much gone straight up since its bottom in early 2009, it has not had the asymptotic ‘blow off’ yet to the upside that usually accompanies long bull market runs. The advance so far has been deliberate, orderly and relatively staid. It is very possible, given the paucity of decent other alternatives, that stocks continue their upside march, that P/E ratios continue to expand, that the strong dollar acts as a magnet for global capital and becomes a self-reinforcing theme. This could lead to a massive upside blow off in equities. We are watching closely as always. We optimistically enter 2015 very long stocks, with almost no shorts, very long dollar, and long China and India equities. We are neutral in commodities, and as referenced will be evaluating bombed out gold and oil equities in search of a good future entry point.
Charles E. Johnson