Is the Bear Market Priced In?

From NYC/CT to California to Chicago, Keith and I have been on the road facilitating discussions with clients and prospective clients for much of the ~3 weeks since our Q4 Macro Themes Call. As always, the discussions were candid and brimming with thoughtful analysis on both sides of the bull-bear debate. In terms of aggregating sentiment, I find that gauging buyside consensus is substantially easier now than it has been at any point over the past few years:

 

  • Equity and fixed income investors alike are fairly bearish – at least rhetorically. Much of that bearishness is a function of the now-obvious global industrial recession and domestic earnings recession we’ve been calling for at Hedgeye.
  • Relative to the amount of pushback we received 3-6 months ago, investors are at least willing to entertain the thought that we may be proven right in our assertion that the U.S. economy is indeed #LateCycle.
  • Still, most investors ultimately disagree with the aforementioned conclusion and don’t view the U.S. economy has having enough “speculative excesses” to support recessionary-like declines in economic and capital markets activity. Moreover, there exists a near-universal degree of consensus regarding the [overwhelmingly positive] outlook for the U.S. consumer.
  • With respect to the Fed, many investors place higher odds on QE4 than they do on eventual “liftoff”, which ultimately supports a generally sanguine outlook for “risk assets”.

 

Hopefully this synopsis is helpful, but to the extent you view these summaries as known-knowns, you may find additional value in our responses to what our team viewed as the key points of contention to our existing views:

 

  1. Great call nailing the domestic and global growth slowdown, but with the S&P 500 now down only a few percent from its all-time high, was everything you called for priced in at the August lows?
  2. Why won’t bad news continue to be good news for risk assets?
  3. In the U.S. household balance sheets are healthy, house prices are accelerating and gas prices are falling. Why won’t the U.S. economy and the domestic equity market weather the storm of international growth and earnings headwinds – much like they did in 1998?
  4. When citing your economic cycle timing indicators, how do you know that current signals aren’t false positives, rather than soundly in support of your view that the probability of a U.S. recession commencing by mid-2016 is high and rising?

 

See below for our detailed responses to each question. As always, feel free to reach out with any follow-up questions.

 

Best of luck out there,

 

DD

 

Darius Dale

Director

 

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Q: Great call nailing the domestic and global growth slowdown, but with the S&P 500 now down only a few percent from its all-time high, was everything you called for priced in at the August lows?

 

A: Fair question, but we continue to think we are in the early innings of a series of lower-highs for the U.S. equity market.

 

Moreover, it’s a mischaracterization to cite the S&P 500’s minimal draw-down as indicative of the pain being felt by the preponderance of investors. For example, the HFRX Equity Hedge Fund Index is down nearly -6% from its YTD high in April. Moreover, 62% of stocks in the Russell 3000 Index (~98% of investable public equity market cap) are below their 200-day moving average (CHART). Worse, the mean and median YTD-peak-to-present drawdown of these 3,015 tickers is -25.2% and -20.2%, respectively (CHART). Recall that we initially warned of the dour implications of declining breadth in our 7/20 note titled, “Dangerous New Highs for the Market?”.

 

All told, we think it’s risky for investors to assume the coast is clear as a result of navel-gazing at the S&P 500, DOW or NASDAQ when the preponderance of single names are resoundingly signaling incremental deterioration of both top-down and bottom-up fundamentals.

 

Like Rome, this bear [market] wasn’t built in a [trading] day…

 

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Q: Why won’t bad news continue to be good news for risk assets?

 

A: Given the pervasive level of bearishness I mentioned at the onset of this note (largely perpetuated by the terrible SEP Jobs Report), “risk assets” are once again trading inversely to policy rate expectations after a lengthy hiatus (CHART). Investors are clearly betting that their returns will be spared by a continuation of dovish policy and/or guidance out of the Federal Reserve.

 

But is the “don’t-fight-the-Fed” mantra an appropriate risk management overlay in every scenario? Historically speaking, the Fed has proven to be impotent at arresting #Quad4 deflationary pressures and/or the general credit risk associated with slowing economic growth (CHART, CHART). Moreover, the ECB and BoJ’s entry into the global currency war has made it much harder for the Fed to sustain #DownDollar asset price reflation (CHART, CHART). Lastly, the Fed has yet to prove it can suspend gravity during an actual economic downturn (CHART, CHART).

 

Importantly, our work continues to point to a rising, not falling, probability of the aforementioned bearish catalysts materializing:

 

  1. After moving to neutral from a ~15 month-long short/underweight bias on reflation assets, we now think another bout of #GlobalDeflation is just around the corner. Click on the following links to review the supporting analysis: “Risk Managing the Shift to #Quad3 – Especially in Energy” (10/8) and “Are You Prepared for a Deepening of the Global Earnings and Industrial Recessions?” (10/22).
  2. We think there is a greater than two-thirds probability the U.S. economy enters recession over the NTM. This compares the preponderance of investors pegging those odds at only 22% per a recent CNBC survey. Click on the following link to review the supporting analysis: http://docs3.hedgeye.com/macroria/Hedgeye_Economic_Cycle_Indicators.pdf.

 

All told, we think the economic cycle ultimately wins out. While betting on QE to carry “risk assets” to new highs has proven to be a profoundly profitable exercise for investors during an economic expansion, we don’t recommend holding the bag when the growth music stops during what are now precariously illiquid securities markets (CHART). Most investors failed to forsee the 2000 and 2007 market tops and we expect most investors will continue to miss their opportunity to risk manage the 2015 vintage.

 

Tops are processes, not points. It’s never obvious to the crowd until it’s far too late…

 

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Q: In the U.S. household balance sheets are healthy, house prices are accelerating and gas prices are falling. Why won’t the U.S. economy and the domestic equity market weather the storm of international growth and earnings headwinds – much like they did in 1998?

 

A: First and foremost, we would be remiss to do anything other than concede the aforementioned premises:

 

  1. Household balance sheets are indeed healthy (CHART);
  2. Home prices are indeed accelerating (CHART); and
  3. Gas prices are indeed falling (CHART).

 

That said, however, the U.S. economy had something working for it in 1998 that is now decidedly a headwind to consumption growth surmounting a demonstrable acceleration to cycle-peak base effects in the four quarters ending in 2Q16 (CHART) – demographics.

 

Specifically, U.S. consumption growth (and ultimately the U.S. economy) was able to remain resilient in 1998 largely due to rising demand from baby boomers “graduating” up the life-cycle consumption and income curves (CHART, CHART). Now the U.S. consumer at large is decidedly scaling down the backside of that curve with no reprieve from the millennial generation until 2019.

 

Perpetual 2.0-3.5% population growth in the 35-54 year-old cohort during the 1980s and 1990s might just be the greatest demographic dividend ever experienced in the western hemisphere. From the longest of long-term perspectives, “comping” that “comp” might just be the most damning component to Consensus Macro’s perpetual expectations of 3-4% U.S. GDP growth.

 

Now with employment growth slowing on a trending basis (CHART), investors have no choice but to wonder how where incremental [sub-prime] auto loan demand is going to come from. The risk to investors is that many failed to realize just how good the current cycle has been amid perpetually misguided expectations of a return to prior peaks.

 

All told, real household consumption growth has already negatively inflected (CHART) from its cycle-peak growth rate and growth in the [much-larger] services side of the U.S. economy appears likely to follow the manufacturing and export sectors lower in the coming months (CHART, CHART, CHART, CHART, CHART, CHART).

 

Lastly, let us not forget the inconvenient truth this is the S&P 500 experiencing a near -20% crash during 1998 (CHART). The SPY would have to drop roughly -17% from today’s closing price for the “it’s 1998, not 2000 or 2007” bullish narrative to get fully priced in…

 

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Q: When citing your economic cycle timing indicators, how do you know that current signals aren’t false positives, rather than soundly in support of your view that the probability of a U.S. recession commencing by mid-2016 is high and rising?

 

A: We don’t. The entire point of investing would appear to be betting on what one’s analysis labels as a probable outcome becoming increasingly probable and ultimately getting priced into the market by other investors who subsequently arrive at a similar conclusion(s). It would seem silly for a bottom-up analyst to do a ton of work on a name only to take the other side of his/her own analysis. Macro investing isn’t any different…

 

This we do know:

 

  1. Most investors and the Fed do not expect a recession next summer.
  2. Most investors and the Fed are beyond terrible at forecasting GDP. Review our 9/2 note titled, “Early Look: Do You QoQ?” for more details.
  3. The signals suggest the probability of recession commencing at some point over the NTM is rising, not falling.
  4. The preponderance of high-frequency economic data continues to slow on a trending basis (CHART), as well as consistently surprise consensus expectations to the downside (CHART) – thereby increasing the aforementioned probability at every interval.
  5. Various read-throughs from capital markets activity – including peak M&A and buyback announcements, widening credit spreads (CHART), etc. – are confirming the rising probability of recession as well.

 

The confluence of the factors listed above support maintaining our current defensive posture with respect to our active Macro Themes and preferred factor exposures on the long and short side. When the fundamental, quantitative and behavioral inputs are no longer supportive, we will adjust accordingly.

 

Longs:

 

  • Long-term Treasury Bonds (TLT*, EDV, ZROZ)
  • Municipal Bonds (MUB*)
  • Utilities (XLU*)
  • REITS (VNQ)

 

Shorts:

 

  • High Yield Credit (HYG, JNK)
  • Financials (XLF*)
  • Retailers (XRT*)
  • Small Caps (IWM)

***An asterisk denotes current Macro Playbook exposure. Long Housing (ITB), Short S&P 500 (SPY) and Short Spain (EWP) round out the list.*** 

 

All told, we aren’t raging bears. We aren’t calling for Lehman-style a collapse in asset markets. We are simply calling for a run-of-the-mill #LateCycle Slowdown in which inflation and capital expenditures peak and roll first, followed by employment growth and ultimately by consumer spending.

 

Textbook macroeconomics…


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