By Dillon Yeh
Undergraduate Economics Student
Despite the recent rally across equities since early February, now is still the long winter of our discontent. And it will not be made glorious by a summer, or a spring, or a fall. Nor by a Bank of England, a Federal Reserve Bank or European Central Bank.
I write to you about the precipitous situation occurring currently across the world. We do not see it, but an earthquake has gone off deep below the ocean, and a tsunami is going to follow soon. Can you feel it? What I say may seem alarmist, but hear my reasoning out and you will understand.
I have been managing a personal investment portfolio since I was twelve. My focus is global macro strategy, with a concentration in volatility and commodities, the latter especially in precious metals. Having studied the market for many years, I have come to the belief that a major correction is on its way. The near future of the markets will not only be a volatile year like 2011, but rather a period of widespread decline similar to 2000-2002 and 2008-2009. Or even the Lost Decade of Japan.
Throughout this and following articles, I will expand on the potential risks that might factor into creating the next great downturn.
“It’s a Trap” & The Recent Rally
It is important to first disprove the recent rally as a sign of long-term market recovery and future stabilization. Alas, the markets are comparatively just as weak fundamentally as they were at the bottom of the January correction. The CBOE Volatility Index (VIX) has decreased significantly, while the major indexes have regained most if not all of their losses, as the DJIA and S&P scrape positive returns this quarter.
However, cloudy skies hover above the performance of junk bonds relative to quality corporate bonds, which finds itself still trapped under a quagmire. From observing the ratio between iShares IBoxx $ Investment Grade Corporate Bond Fd ETF (NYSEARCA:LQD) to that of iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA:HYG), it is possible to gain a sense of investors’ desire for risk, since risk-averse investors would favor the former security over the latter. And what is the indication? The result is not pretty. Though recovered from its February lows, the indicator still lags far below its 100-day moving average and downward regression line established since June 2015.
Still observing the behavior of bonds, the iShares Barclays 20+ Year Treasury Bond ETF (NASDAQ:TLT) is considered a safe haven in periods of market corrections, having jumped +60% and +45% in 2008 and 2011 respectively. And while the ETF has withdrawn from its February peak at the height of the equity bottom, on-balance volume (OBV) has yet to decline (Fig. 1). Which begs the question of, why are investors still accumulating this security? The obvious implication being that there is still more foreseeable turmoil further ahead.
Still don’t believe me? That’s okay because there’s already been precedent of this. Check this out. There is an eery precision in how similar the current environment of 2015 going into early 2016 is to the market behavior of 2007 going into early 2008. The resemblance between the two are undeniable. And that is not just a single company, but rather the movement of 2000 companies. I use the Russell 2000 Index here because it is the small-cap market index comprised of the bottom 2000 companies that make up the Russell 3000 Index. Because of this, it thus gives a better picture into the underlying of the market more so than the DJIA or Nasdaq. Returning to the charts; you can see that following a tumultuous second half and brutal early few weeks of the year, the index begins to stabilize and even rally. That is where we are, on the rally phase. But had I guess, it will not continue forever, and what the 2008 chart does not show is that the rally will be followed by an April-May decline and buoy over a few times until H2. Which turned straight ugly then.
Capital Consolidation & Tight Trading Range
Okay. Now given the above - why else do I think there will be a major correction? Again, technical analysis and worrying fundamentals.
Last year’s capital squeeze into large caps and the tight trading range are indications of general market instability. Recent performance of individual stocks have not been optimal. In February, the median stock was falling 12 percent from their all-time highs, a third of stocks were in individual bear markets and just slightly less than half of the S&P 500 traded below their 200-day moving average. Were it not for the infamous four “FANG” companies, Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Netflix (NASDAQ:NFLX) and “Alphabet Inc” Google (NASDAQ:GOOG), the Nasdaq would have declined 10 percent instead of its 2015 gain of 5 percent. What this implies is that the underlying components of the major indexes are deteriorating as investment capital is consolidating in the larger cap companies.
MKM Partners technical analyst Jonathan Krimsky notes that the only other times such a high proportion of stocks traded below 200-day moving averages with the S&P 500 trading within 2-percent of 52-week highs were in 1998-2000, October of 2007 and July-August of 2015. This behavior can be observed similarly with the poorer performance of our friend the Russell 2000 relative to the DJI, with the former beginning a much more dramatic decline after its June 2015 peak. Inflation-adjusted regressive trend lines imply that the S&P 500 is valued at 70%+ above annualized growth rates (since 1871).
As demonstrated by Figure 2, the 100, 200 and 400 day moving averages are echoing the behavior of 2006-2008 with almost terrifying exactness. While the occurrence of the “100 over 200 MVA death cross” occurs relatively frequently with little indication of a true market bottoming, the 400 over 200 cross has only occurred on a few instances. In fact, Eric Parnell, founding director of Gerring Capital Partners, points out: this behavior has only taken place 17 times over the past 90 years. But not all of the crossings have had the same parameters as we do today. Parnell expands noting that the most indicative previous crossings given today’s market characteristics of having a strong dramatic clean breakdown rather than a prolonged decline, an already flat to negative 400-day moving average, and rampant TTM earning report valuations and 10-year cyclically adjusted P/E ratios premiums are: 1929, 1937, 1940, 1973, 2000 and 2008.
The narrowest 180-day trading range in 65 years occurred in the first half of 2015, trading within a 5 percent ban. Looking at 12-month performances of the S&P 500 in terms of 6-month trading ranges, results are inconclusive. Greater market gains occurred over wider trading periods, but narrow 6-month trading ranges also led to modest market gains. Broadly put into their contemporary context, these narrow trading ranges occurred often because of a declining positive trading sentiment turning neutral but maintained for lack of negative news, or negative news met positive trading sentiment. EM Advisor Group’s Jonathan Anderson implies that the recent volatility has been due to investor confusion. With a rising Fed interest rates, perhaps heavy continued monetary pressures will support the deteriorating market.
Structural Warnings & Creaking Floorboards
Expanding on the last point, indications of overvaluation exist. The markets have been artificially inflated by company share buybacks, capital inflow from a strong US Dollar and geopolitical flight, as well as Fed monetary policies. Company share buybacks are at levels unseen since 2008, and now rival the 2007 highs. Rather than conventional spending on development, dividends or growth, free cash flow has now been used at extraordinary rates to buy shares outstanding, driving remaining shares higher, in order to appease shareholders. The dollar amount spent on share buybacks for the TTM ending in Q3 represented 64.6% of net income, the largest percentage since October 2009, when buybacks made up 74.8% of net income. There are 130 companies of the S&P 500 whose buyback spending exceeds earnings. This is an unsustainable behavior.
The ever strengthening US Dollar is hurting multinational companies earnings while also driving capital flight to the US markets. A majority of country ETFs and ETNs are down Y/Y by double digits as foreign investments shrink to multi-year lows. However, foreign exports continue to shrink despite the strong USD, with Japan declining the most since 2009 at a 2015 loss of Y/Y 12.9%. The Dollar Index has spiked at a rate unseen since before 2000 and 2008. In such a manner, the US Dollar and the American markets, being the most stable relative internationally, has become a bubble.
Gray Credit/Bond Market & Sentiment
Cloudy skies hover the credit and bond markets as well. Though subsided recently, Ted and LIBOR- OIS spreads rose dramatically in the latter half of 2015 and early 2016 in correlation to the market turmoil. While spikes of these natures do occur, such as in 2010 and 2011, the spreads decline dramatically shortly after. At the moment, they have not returned to normal levels since, maintaining an elevated rate. The increased spread imply a decline in banks’ willingness to lend, a decrease in liquidity as a result and a gloomier forecast of the general financial industry.
The collapse of the junk and high-yielding bonds, the possible defaults and bankruptcies by their issuers and ripple effect onto lenders is a major risk to the general markets. The BoA Merrill Lynch US High Yield Master II Option-Adjusted Spread has moved upwards past 7.5, a move that has only occurred during the 2000-2003, 2008-2009 and late 2011 market turmoil.
The value of high yield defaults from 2014 to 2015 increased by 52.4% to $48.3bn, while the numbers of companies increased from 37 to 74. The December 2015 TTM default rate of 3.4% is only expected to rise to 4.5% close of 2016 and that distressed debt exchanges will remain the prominent source of default, according to Fitch. UBS predicts an increase of junk-rated energy and natural resource company bond defaults of 15% in 2016.
Actions by the Fed have tried to curb contagion fears by suspending energy mark-to-market. Bank exposure is greater than expected, from JPMorgan and Wells Fargo to BOK Financial, who missed analysts’ expectation because of a loan-loss by a single energy-industry borrower. Goldman Sachs disclosed a $4.12bn exposure to non-investment grade oil and gas companies, with many other banks holding significant portfolios in similar products. In a fashion similar to the beginning of the subprime mortgage crisis; if revolvers are no longer being redetermined since issue terms in 2012/2013, or even 2014, then just as MBS payback schedules started to fall behind, at a certain point, interest payments will begin to collapse for the high-yield oil and natural gas bond.
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Featured image by OTA Photos
