US Economy and Stock Markets Overview

Both the US economy and stock market has been on a roller coaster since 2000.

First there was the technology bubble that burst in 2000-2002, leaving investors with losses of over $6 trillion (NASDAQ technology sector fell 70%). From that period on, Federal Reserve Chairman Greenspan at the time aggressively brought down interest rates to stimulate the economy. It worked, the economy began to expand and the US became the initiator the next major bubble, real estate. We also saw a period of derivative expansion at unprecedented levels within major US and European banks. Financial institutions were lending out money, especially for mortgages if you had a pulse. The brokerage firms were securitizing all these mortgages, packaging and selling them off to unsuspecting investors. They knew that many of the mortgages were likely to fail and some of the firms actually shorted (sold the mortgage backed securities market while not owning it) making hundreds of millions while selling the same type of investments to their customers.

The next major meltdown started in 2007 and bottomed in the first quarter 2009. It brought the markets down more than 50% bringing the financial industry to its knees. If the Federal Reserve did not lend and put trillions of dollars into the system, there would have been great depression 2, with a significant number of financial firms and corporations going bankrupt. Governments also put hundreds of billions into saving corporations from bankruptcy and implementing stimulus programs to try to get the economy back on its feet.  All leads to…..

Bonds and Stocks Are Reflecting Completely Different Scenarios – Which One Will Play Out?

Interest rates are now at all-time record lows while US stocks are reaching record highs.  Both scenarios are what we have been looking for, but the former is too early in the cycle.  What we mean by this is that when stock markets reach peaks, interest rates are usually rising…but they are falling today.  The reality is, stocks or bond prices should fall soon.  Which one will it be?

Interest rates have already taken out the lows not seen since the Great Depression.  This is telling us that the prospects for the economy are very poor.  Low-interest rates usually occur during a recession/depression to try to stimulate the economy.  But they are falling to historical lows during a period of growth, all be it, weak growth.  At the same time, stocks are hitting highs.  Something is not making sense.

10YrTreasury_1962toJuly2016

Remember, when economies are healthy, interest rates tend to move up to control inflation and prevent too much growth.  If interest rates are falling, it tells us that an economy is weak, there is no risk of inflation, and the economic forces are falling or recessionary.

So then let’s have a look at stocks. When they are rising, you either have a market with low valuations (opposite today); rising earnings (again, the opposite today); and sound economies (we are in a low growth environment that is not strong or weak right now).  The key is valuations, and the median stock has never been more highly valued than today other than in the late 1990’s to 2000 (massive tech bubble).  With stocks so strong, it is telling us that economic growth will be very strong, leading corporate earnings up.

Here is a chart of the S&P500, the best gauge to assess US stock performance:

SP500_1995toJuly2016

But let’s have a look at how earnings have fallen four straight quarters and struggled since 2014:

EPS_10YRs_toJuly2016_vsMarket

What is critical to note is that earnings were ahead of the stock market from 2010 to 2013.  Since then, things have reversed as earnings are falling as the stock market rises.  This is not a sustainable environment long term.

Look at the record gap we see between the stock market that has hit record levels and earnings that have fallen steadily.  The only way that this is sustainable is for earnings to rise (not happening) or the stock market to be at a low valuation.

Let’s have a look at how the market is valued and compare it to how it was at the peak in 2007:

SP500_TrailingPE_10Yrs_toJuly2016

This is a chart of actual trailing price-earnings multiple.  This means the real earnings, not those forecasted by Wall Street.  Before the crash in 2007-08, the peak of the trailing PE ratio was 17.  Today we are just below 19.  The market is much more overvalued today than it was in 2007, just prior to the massive financial crash.

Now if the macro situation was favourable, we might say that there is a chance that earnings can offset the significant overvaluation.  But we have talked numerous times about how weak Europe and Japan are.   China continues to contract down, and North America is in a world of low growth and falling.  This is not a situation conducive of rising stocks, but they are.

The reasons are simple:

  1. Overvalued markets can become very overvalued, which is where we are today
  2. We use Elliott Wave analysis, and it was looking for one more all-time high.
  3. We see that today interest rates are low and in some parts of the world negative – good in that alternative fixed income investments are unattractive, BUT it also tells us how bad things are below the surface
  4. It is perceived that Central Banks will just keep printing money when problems occur – problem here is that their balance sheets are so ugly now, and there is a limit how bad they can get
  5. Trigger event has not happened, yet.   Saying that Brexit may be the event we look back at as starting the next phase down

It is very possible that we are very close to the final all-time high we have been looking for, and the reversal may begin soon.  We would not be buying into this market except for select sectors like precious metals. This is advice for investors.  We feel that traders can play the bounce but keep tight stops.  Investors should be very cautious here.  Look at this as a window to take some money off the table by selling some lower quality equities.

Given interest rate levels, inflation needs to tank hard.  With regards to stock prices, economic growth and earnings need to soar to justify current stock market valuations.  One of these occurring is possible but both, nearly impossible.   Our belief is that the former will occur, and interest rates will stay down and likely fall further.  Stocks are another story, with a correction or crash needed.  If we see breadth and volume in the market improve, we will look at adding some long positions but this may prove, like other times, that false breakouts are not to buy into.

 

 

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