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Monday Monetary Madness – G20 Promises to “Fix” the Markets

What a World, what a world

Unlike the wicked witch, who uttered that phrase during the previous Global Depression, liquidity has been good for the markets so far as the World is swimming in it and, even this week, more is expected from the Bank of Japan on Friday.  The entire G20 got together this weekend and promised to use "all policy tools" to lift global growth.

While the weekend's signals from the G20 meeting in China were welcome, investors were bracing for a hectic week that includes a U.S. Federal Reserve meeting, European bank stress tests and what could be another super-sized slug of stimulus from Japan. "The Bank of Japan is really the one that is front and centre this time with the all talk around 'helicopter money," said TD's Richard Kelly, "if they disappoint, which I think is probably more likely, then we are likely to see risk assets coming off."

I've been calling for CASH!!! all summer and so far, so wrong on that one as we make fresh record highs pretty much every day since the Brexit but now Goldman Sachs (GS) has decided to agree with me, putting out their own 5-point warning to clients:

  1. Valuations are already at historical extremes. The S&P 500 trades at a forward P/E of 17.6x, ranking in the 89th percentile since 1976. At 18.4x, the median constituent ranks in the 99th percentile. Most other metrics such as P/B, EV/EBITDA, and EV/Sales paint a similar picture. These valuations are only justifiable because of the historically low interest rate environment.
  2. Zero profit growth is not consistent with high stock valuations. Sluggish global growth and low inflation along with negative interest rate policies in Europe and Asia have led to record low US bond yields. Consistent with this backdrop, 2Q results will show the seventh consecutive quarter of declining year/year operating EPS (-3%, but +1% ex-Energy). Despite near-record margins, adjusted S&P 500 EPS have been flat for three straight years.
  3. Many Financials will have lower profits if low interest rates persist. Historically low yields squeeze the net interest income of banks and make liabilities harder to meet for insurance companies. Our Bank equity research team this week cut their EPS forecasts by 5%-7%. The fall in Treasury yields explains most of the cut. For the aggregate S&P 500, a 50 bp drop in the 10- year yield cuts EPS by $0.25. The headwind consists of a $0.50/share cut to Financials sector EPS partially offset by a boost to the rest of the index.
  4. Low rates will also detract from earnings by increasing the value of current pension liabilities through lower discount rates. The impact of pensions on S&P 500 earnings was last felt in 2012, when the pensions of three firms – T, VZ, and UPS – combined to subtract nearly $2 from S&P 500 EPS at the end of the year. We estimate that pensions could cause a $2 hit on S&P 500 operating EPS this year if rates remain low. Although many analysts and investors will “look through” these charges, they are yet another wedge in the growing rift between GAAP and non-GAAP EPS.
  5. The fall in US unemployment hints at wage inflation. The GS wage tracker is now at 2.9%. Higher labor costs suggests lower margins and equity valuations. As inflation expectations climb, the risk exists that the Fed tightens sooner than the market expects and bond yields may also rise. Higher bond yields and a narrowing ERP are consistent with our 2100 target.

Note GS now has our target (S&P 1,850 for the expected low) and our year-end target (2,100) as well.  While it makes me very uncomfortable to be on the same side as GS, at this point I'm happy to have the company as I've been starting to feel silly for being so cautious in the midst of this huge rally

While going to cash is not the same as getting bearish, it feels like we're bearish when we sit on the sidelines and watch a rally pass us by.  Yes, we have plenty of long positions, but our hedges are getting crushed so we're treading water in our portfolios while we wait for the other shoe (or any shoe) to drop.

May Retail Sales fell by 3.9% and it was across the board with department stores: down 4%, teen/young adult stores down 4.6%, home goods down 3.6% and electronics down 3%.  Tony Sagami of Mauldin Economics notes that "Americans are becoming too poor to shop" and Retail Sales are expected to drag the S&P 500 to a 5.6% (y/y) decline in Q2 profits.

As you can see from the chart above, last week's Economic Confidence Index (through July 17th) is at the low's of the year and miles below where we were last summer, right before China imploded and took everything down with it.  Even worse, it's "Future Conditions" that are dragging us down, with a -27 reading in polls that include a broad base of the American people (the ones who are voting in November).  

As noted by Gallup:

Indeed, consumers don’t live in the Wall Street economy. Their double-digit credit-card interest rates don’t necessarily reflect the Fed’s zero-interest-rate policy. Mortgage rates are low, but home prices have soared, and mortgage payments, taxes, and insurance have soared along with them. Car loans are cheap, but cars have gotten a lot more expensive, and despite record low interest rates and over-stretched loan terms, payments are pushing the envelope of the possible.

Health-care expenses have soared. As have rents. Over the past few months, gas prices have started to tick up. And if you’re going to send your kids to college, you’re in for some rude surprises.

Real household incomes have languished for the lower 80%, which most likely includes the 61% in the Future Conditions Index above that expect the economy they live in to get worse for them, regardless of how perfect those conditions will be for corporate CEOs.

And real incomes have declined for the bottom third, if they even have jobs. This includes most likely those 31% in the index above who found that the current conditions of the economy they live in are “poor” for them, regardless of how beneficial they might be for those Fed-coddled folks that are holding a lot of inflated assets. For them, it’s immensely tough out there, and asset bubbles just aren’t helpful. On the contrary.

Yes, this is nothing I haven't been saying all year but it's nice to know I'm not the only person who sees this gaping hole on our economy that the MSM seems to be extremely adept at glossing right over.  I don't know when it will begin to matter or IF it will ever matter but I can't, in good conscience, deploy a lot of capital ahead of the Fed (Weds, 2pm) or the BOJ (Friday am) or ahead of at least half the S&P 500 reporting (end of next week).  

There is a 100% expectation that Kuroda and the BOJ will fire off another round of stimulus and any disappointment, even with the size of it, will not be market-friendly into the weekend.  Our Fed has already lined up two doves (Williams and Kaplan) to speak on Friday – just in case you get any funny ideas about selling equities on some bad news (and our own GDP comes out at 8:30 that morning).

I know it's boring but please – let's be careful out there!

Indulge me for another 2 weeks and then we'll have plenty of things to buy – no matter which way the market goes…


Provided courtesy of Phil's Stock World.

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