US stock market propelled by QE, buybacks and margin debt since 2009

The US stock market has enjoyed a spectacular rally from its lows of 666 on the S&P 500 in March, 2009.  Since then the market has surged higher, surpassing 2,100 on that same index.  Stocks are credited with the ability to forecast the economic future of their respective country.  This is a pattern that explains why rallies may occur before substantive economic improvements are realized.

This time is different

Instead of fundamental economic improvement, the stock market has rallied largely because of cost cutting, earnings improvements, quantitative easing (QE) and share buybacks.  The latter two phenomenon are of particular concern because they offer a glimpse in to catalysts that are a complete departure from normal stock market rallies.  The economy itself has largely languished since the 2008 collapse.  As an indicator of that the workforce participation rate is at multi-decade lows while US debt is at an all time high.

Enter QE 1 through 3

During QE the stock market experienced the majority of its gains.  As you can see in the chart below QE 1 through 3 bolstered the US stock market from its lows to new highs.

qeThis unprecedented accommodative monetary policy, combined with a backdrop of enormous share buyback programs (see chart below), seems to account for the majority of gains that US equities have experienced since 2009.

Share buybacks surge to 2007 levels (from 2010 until now)

buybacks1Share buybacks engender an atmosphere where corporate earnings seem to be better than they really are delivering.  This is because with each share purchased the earnings per share reported increases.  That is to say, a corporate stock buyback takes the shares out of public circulation and by virtue of doing so makes price-to-earnings multiples appear to be healthier than they really are.

Margin speculation exceeds 2007 highs

nyse_margin_debtAs seen in the chart above, margin debt is now exceeding that of the previous bull market.  This is a disconcerting trend as all three indicators (QE, buybacks and margin debt) seem to illustrate a stock market that is thrusted higher more by debt than fundamental macroeconomic improvement or by improvements in company financials.   That isn’t to say that this is a universally applicable rule to every individual stock, but by and large it is having an enormous effect on US equity indices.

Where do we go from here?

Every investor would love a crystal ball that shows them tomorrow’s prices today.  If such a device existed there would be no uncertainty in investments.  Indeed, everyone would be a winner — and there would be no losing trades.

My personal take on these charts and the facts they bring to light is that we are currently in the midst of a bull market that has been driven more by debt than structural improvement.  A market where more of the gains eked out have been contingent on monetary stimulus, share buybacks and margin-based speculation than what this country truly needs: a stable, growing economy.

Burst bubbles lead to bigger and bigger bubbles

With that in mind I feel as though the lessons of bubbles past have been largely missed.  Each time there is a bubble (NASDAQ 1999, real estate and finance in 2007 and with just about every debt-based asset class now) the bubble itself becomes more dangerous due to the underlying amount of debt and leverage necessary to inflate it. This trend is made possible by ever increasing amounts of monetary stimulus, market intervention and debt-driven speculation being used as the remedy for each previous bubble bursting.

I do not believe we have ever been in a more dangerous bubble than we are now.  Real estate, stocks and bonds are largely at inflated values that rely on debt-based expansion rather than economic expansion.  As a result, it may be worth considering exiting from those asset classes that have benefited from outsized gains due to, at least in part, an incredibly unsustainable combination of supporting factors.

Once this current bubble pops, the very same one that financial media, talking heads and central bankers claim does not exist, we may see a return to 2008-like volatility — or worse — a total seize up of the financial system.  But one truth is certain: the rally we have experienced to date across multiple asset classes has been built on nothing more than a house of cards.  And when it tumbles, so too shall confidence in the financial system at large.

US dollar index rally stalling, long term trend still down

With all of the fervor over the US dollar index rallying close to 100, a reality check is in order.  According to financial media reports the Euro is collapsing, gold is a barbarous relic that’s lust its luster, oil is falling and the commodity complex itself is imploding.  Readers of this blog may remember that on November 1st of 2014 I wrote about the possibility that such a situation may play out in 2015.

Opportunities may exist in battered markets

Sentiment for other major currencies, energy, precious and non-precious metals could not be much worse than it is now.  Cautious contrarian investors may find opportunities in the extreme negative sentiment. Certainly many natural resources companies have much more attractive valuations now than they did several years ago.  Commodities themselves may also offer more value at these price levels than they did in previous years.  Both as a hedge against inflation and a bet that resource consumption will increase in years to come.

Meanwhile US dollar trend followers may pile on to what appears to be a massive multi-year rally in the US dollar index or short other currencies, commodities and similar assets.  There already exists an enormous amount of speculative betting on the dollar surging higher and other dollar priced commodities and foreign currencies tumbling.  This positioning leads me to believe that we may be closer to a high in the US dollar rally than a base to move higher from.

united-states-currencyThus far the US dollar index on a long term technical basis appears to have made a series of lower highs and lower lows stretching back to the rally in the mid-1980s (see above chart) which began as a result of massive interest rate increases by the US Federal Reserve.  In order to break this downtrend the index would have to rally beyond 120 and sustain itself there.  Only then would I feel that the US dollar has decisively entered an uptrend. That has not happened yet.

The range bound US dollar index

As of the last 10 years we find the US dollar index trading within a range between 72 and 100 (see chart below) which may continue for some time if there isn’t an outside catalyst.  Ultimately I believe the US dollar index is headed for a lower low when the current rally stalls further and then reverses lower.

10yUSD

One must remember that the US dollar index is a trade weighted currency basket that measures the dollar vs. the Euro, Yen, Pound Sterling and does not necessarily directly reflect the purchasing power of the US dollar other than when buying these currencies.  In addition, the US dollar index has enjoyed its current rally largely on expectations of a widening interest rate differential between the US Federal Reserve and other central banks.

Will the September hike come to fruition? Is it meaningful?

The Federal Reserve has repeatedly delayed its much anticipated interest rate hike, setting expectations that such an event may occur this September — and only if economic data fits their ever moving target.  Given the mix of economic data (both good and bad), combined with the backdrop of a significantly weaker Euro and the US dollar beginning to impact multinational companies earnings, I would be surprised if the Federal Reserve set its sights on a heightening cycle.  Perhaps a few increases to placate the financial media.  But a significant normalization of interest rates would likely have catastrophic effects on multiple asset markets, including mortgages, bonds, stocks and interbank financing.

Fed and interest rates thru 2009Up until 2008 the Federal Reserve largely followed the US Treasury 3 month bill rate — rather than vice versa. This meant that interest policy was apparently largely set by the 90-day Treasury Bill market.  See the chart above for a visualization of this trend.

Where there was once rate guidance there exists only volatility

Below you will find a chart of the 3 month Treasury bill rate graphed from 2000 to present.  In that chart one can see that the same dynamic may no longer exist. That is to say that the 3 month Treasury bill rate is extremely volatile and has been since 2008.  Is this an unintended consequence of quantitative easing and zero interest rate policy?  Is the Federal Reserve now without guidance from this critical interest rate setting market?  Or is the paradigm shift one where the Federal Reserve will now lead where the markets once did?

IRX-2000Much as the rate heightening cycle in 2004-2007 set off a powder keg of insolvencies related to highly leveraged speculative bets imploding, I believe any similar rate heightening cycle this time around will have equally disruptivbe, if not worse, consequences. But it’s anyone’s guess at this point.  As you can see we are largely in uncharted territory.

Crude head fake means lower prices ahead likely

Crude oil has had quite a slide since July of 2014.  Recently it appeared as though prices may be stabilizing, but recent price action may suggest that what seemed to be a double bottom may actually have lead to a head fake rally rather than a durable price support level.

crude oil pricing

US crude oil spot price chart from the last 6 months.

With a firm rejection at the 50 day moving average, and the bollinger bands widening, it seems that on a technical basis crude is poised to take out its lows.  Is a $30 even $20 in the cards?  Possibly.  Crude traded as low as the mid $30s back in early 2009.  We could see similar price action in a capitulation event or a slow grind down.  There is not enough conviction for a significant price breakout without increased demand or a geopolitical event threatening oil production.

 

What’s Yelp’s review service worth to investors?

Yelp illustrates just another social media bubble reverting to the mean. The premise of this company is that it unites people with great local businesses.  And maybe that actually happens on occasion.  But today investors are increasingly skeptical of this company’s value.

YELP stock

Yelp’s stock crashes 20% on earnings that exceeded expectations.

How does Yelp operate?

Yelp’s position is to try to offer reviews that help consumers make informed decisions about the companies they engage.

The problem is the 1-9-90 situation that Yelp currently finds itself within.  One percent of reviewers are active, 9 percent occasionally review and the rest are simply viewers.

Without any transparency, how can there be trust?

Adding validation of identity, a business transaction or a check-in at the location would likely impact those numbers negatively. And that, in turn, would potentially hurt site traffic and advertising revenue.

But doesn’t having some ability to say, yes, in fact this person did engage this company for this service, provide credibility?  As of this moment the only credibility Yelp has is built off the reputation of the site.  And that seems to be dwindling as more become aware of the ongoing shenanigans.

If Yelp is not willing to go beyond providing anonymous reviews about business relationships that may have never occurred, which then potentially cause real world pain to hard working companies, then I’m not certain that Yelp really provides any value to the local businesses it claims to serve.

Yelp’s ad-driven profit engine is questionable at best

After reviewing how the pay per click advertising system works on Yelp I’m quite disappointed to see that the majority of ad placement occurs in non-related categories or outside of key geographic regions.  Essentially it looks like ads are foisted wherever they can be without attention to applicability.

So what’s the the bottom line on Yelp?

What is a company that provides at least 20% (according to Yelp’s own numbers) false reviews really worth?  Is it net beneficial or harmful to the local business community?  Can it be readily replaced by a service with more credibility and a stronger emphasis on transparency?  Will users continue to utilize this service with Google and other more established companies providing alternative ratings services?

Apparently today investors in Yelp’s shares are asking themselves the same questions.  With a P/E of close to 100 one can reasonably guess that the path of least resistance is down.  My personal estimate is a reversion to the post-IPO pricing of about $20-25/share.

Quick thoughts on 2015

This is likely going to be a year of reckoning for overvalued equities and corporate bonds.  The credit markets have already begun their contraction, but equities hold on to the promise of earnings expansion, while only truly achieving multiple expansion.  Stocks are far too rich in price vs. the underlying economic global backdrop.  I expect a significant correction, and I expect it to occur during (or before) Summer.

Copper’s crash confirms global economic rout

Copper, the commodity often hailed as a prognosticator of future economic trends, is tumbling 8% today, after shedding more than 4% yesterday.  Prices have not seen these levels in over 5 years.  The weakness is attributed to a lack of conviction among speculators by reports circulating the media.  I hazard to guess that the real reason copper has been plunging has more to do with a lack of demand.

As goes copper, so goes the world?

copper

Copper is used in infrastructure projects, for electronics and a variety of industrial applications.  Weak demand is an indication that manufacturing is dwindling.  Such a slow down would be a confirmation that our earlier call for deflation is playing out and we may see further economic and financial market weakness to come.

In fact, it is becoming quite likely that the world realizes all of the recovery since 2009 has been predicated on stimulus and liquidity, rather than resolving the underlying economic and debt imbalances.

Higher stock market volatility may be persistent in 2015

A recurring theme in the bull market rally since 2012 has been minimal volatility.  The days of enormous whipsaws in price were seemingly behind us until late 2014.  The mood of the market has decidedly changed as of late.  What used to be a complacent, calm and somewhat orderly march in to parabolic territory has degenerated in to a much more unpredictable series of widening trading ranges.

Watch for a potential trend change

As volatility increases, there is the potential that fear will overwhelm greed and the bulls will become more concerned about securing profits than taking risk.  Margin levels are off the chart and short positioning is still historically low, so downside momentum may hasten quickly if it is perceived that an interim top is forming.

Volatility index (VIX)

If such a change occurs, it is likely that we will see a long overdue correction occur in the broader equity and lower tier credit markets.  It also may prompt an exit from the crowded long dollar trade if the risks are perceived to be domestic.  2015 holds plenty of promise for interesting global and financial market developments.  Stay close to the news feed and price ticker.

The crude contagion could cause chaos, crash

On the heels of another massive sell off in crude oil, the US stock market woke up from its slumber.  Instead of the discount in crude oil being priced in as a stimulus, it was seen (perhaps more accurately) as a risk. Crude touched prices that had not been seen since April, 2009.

US equities sold off on higher than average volume, with bonds, gold and silver catching a bid.  The VIX showed fear entering the market and spiked higher, but the rally faded as the day went on.  The US dollar strengthened modestly on the back of a weaker Euro and Yen.

Interest rates on the 10 year bond tested 2.00%, while gold has climbed above $1,200 and stabilized.  Tonight the Nikkei is selling off significantly in Tokyo.

crude oil

Greed may pause to give room for fear to take the reigns.

Markets are decidedly in a risk off mindset.  I suspect that this fear of risk will prevail over the leveraged and crowded long side bullishness that has pushed the US stock market up to record highs with few downdrafts over the last few years.

The fundamental improvements in the US economy have been sluggish, with many corporations buying back their own shares to boost EPS.  There is a dislocation between current perceived valuations and the global economy’s condition.

The crash in crude oil has brought about a serious challenge to many economies of energy producing nations, including the US.  Since 2008 many of the high paying new jobs have been in the energy sector.  Now that oil is down over 50% from its highs, many of these projects are no longer viable and drill rig operations are now at 10 month lows.

us oil and gas rigs jan 5 2015

Energy markets are an indication of economic health.

There is a certain amount of feedback from energy market prices that can be indicative of manufacturing activity, shipping and transportation.  To the extent that supply exceeds demand, prices should diminish until demand returns.  But even with a 50% cut in prices, there still seems to be room for more of a decline.  That is because while demand is diminishing, some oil producers are keeping or increasing supply rather than removing production.  This includes OPEC, Russia and Iraq, who stubbornly churn out more oil as prices lose support.

The perception becomes that a flood of oil is oversupplying the markets, but the reality is that demand has declined to such an extent that softening Chinese manufacturing demand has caused a ripple effect.  Most of the softening demand comes from Europe, China’s largest customer, coming to grips with a wave of economic headwinds.

This new normal, if we are to give it a name, is likely an indication of future global macroecnomic trends.

Global GDP 2015

Deflation strikes Japan and the EU.  Is the US next?

Persistent deflation is becoming a persistent theme.  Bond yields in Germany on 5 year notes hit negative yields.  Japanese bonds have fractional yields.  The US bonds seem to be ebbing lower and lower in interest rates in sympathy of the global deflationary pressures coming home to roost.

Are we going to experience a lost quarter century like Japan?  It seems ever more likely as the similarities are increasingly problematic.  A prescription of debt to solve debt-related problems.  Liquidity injections for structural economic problems show a lack of understanding from central authorities about what is wrong with our economy.

Nikkei stock index

Too much leverage, too many derivatives, too little transparency.

What the world needs now is more clarity about how far stretched the current system has become.  With over 700 trillion dollars of global derivatives, there is such an enormous amount of risk in opaque markets that a significant dislocation could cause another financial collapse.

None of the problems of 2008-2009’s Great Recession have been resolved at home or globally.  Instead the financial players that created the problem have now been given the reigns of the global economy and are leading us down a destructive path towards crisis.

The problems of the world will most likely come home to the US in 2015 and cause a profound impact on our economy and financial markets.  While it may not be apparent yet, I believe that the risks now are much greater than back in 2008-2009 and the ability of monetary authorities to mitigate those risks is impaired by the current and recent aggressive measures.

DerivMkt-BIS-Dec'87-Dec'10

Stay tuned in to the flow of news.  Interesting things may happen sooner than we expect.