Be A Contrarian, Or Be A Victim

Be A Contrarian, Or Be A Victim

By David Hunter of Casey Research

Historically, stocks have performed better between Halloween and May Day. Thus the old saw, “Sell in May and go away.”

“Unlike most other seasonal patterns that capture Wall Street’s attention,” writes Mark Hulbert, “this one has a very strong statistical foundation. It’s been discovered in the stock markets of 36 of 37 countries that were studied, and as far back as 1694 in the case of the United Kingdom.”

No one has gone away this year. The stock market continues to grind onward and upward to all-time highs. Interest rates and gold are sinking. First-quarter GDP did the same.

Everything must be hunky dory with the 1%—after all, luxury retailer Tiffany says its first-quarter revenues were up 9%. But where middle-class Americans shop, Walmart, Q1 revenues were down 5%. Where the downtrodden look for bargains, Dollar Tree, saw its first-quarter sales jump 7.2%.

That’s not a good sign.

The trillion-dollar student debt overhang continues to stifle the hopes and dreams of millions of young people, not to mention central bank Keynesians. Half of the just graduated are jobless or underemployed, and 11% are in default on their school loans.

For older folks, a glut of home equity lines of credit (HELOC) are resetting from interest-only payments to 15-year amortizations over the next five years. “The giant sucking sound is all of that money being taken out of consumer spending,” Richard Redmond, a mortgage banker in Larkspur, CA, told the Wall Street Journal.

And while the US Bureau of Economic Analysis (BEA) had Q1 profits up 5.3% year over year, after adjusting depreciation to an economic rather than tax basis, profits were down 6.8%, the biggest drop since Lehman collapsed.  

So other than the Fed’s rocket fuel, there is nothing propelling the market to what Deutsche Bank’s David Bianco describes as mania level. He measures it this way: Take an elevated market price/earnings ratio divided by market complacency as measured by the VIX, and the market is at a place it hasn’t been in recent memory. The PE/VIX ratio hit 1.66 on June 6. In the 2007 boom, the ratio stopped just short of 1.5. In the tech bubble of 2000, the ratio reached 1.3.

A month ago, David Hunter reminded us of how the last five stock market cycles ended and made the case that the current bull market is out of gas. He’s back by popular demand to give us his contrarian’s update.

Enjoy.

Doug French

Where We Are Now: A Contrarian’s Perspective

So the beat goes on. We get shallow corrections in the equity markets, followed by rallies to new highs. We haven’t had so much as a ten-percent correction in two years. More and more investors are jumping on the bandwagon, and more and more pundits are proclaiming that we are in the middle of a secular bull market that has a long way to run.

Fundamentals may not justify such bullishness, but when the tape is strong, fundamentals take a backseat to investor psychology. Imagine if we had the exact same economic and fundamental backdrop, but with a negative tape. In that case, investors would likely be singing a much different tune—a far more bearish one.

Underneath the surface, there are some troubling technical signs. The parabolic-momentum stocks that were leading the market have suffered reversals in the past two months. In previous market cycles, when these momentum stocks broke, it was almost always a sign that a market peak was near, and that a bear market would soon follow.

What's more, fewer and fewer stocks are making new highs, even though the indexes continue to do so. The newest highs occurred on low volume, indicating a lack of conviction. In fact, trading volume is at six-year lows. All of these are signs that this market is long in the tooth and should be approached with a healthy degree of skepticism.

There are plenty of fundamental reasons for concern as well. But as of right now, most investors are choosing to focus on the positives. It is not that investors are unaware of the risks. They just don’t believe the conditions are in place for a big decline any time soon.

Bulls argue that rates would have to climb substantially, at least two to three hundred basis points, to threaten to the equity market. As the argument goes, higher rates would likely coincide with a stronger economy and even stronger corporate profits, particularly among cyclical companies. Thus even in a rising-rate environment, stocks could continue to trade higher for a while.

I understand the argument. We have witnessed this in many previous cycles. There is no question that interest rates are historically low and credit spreads are historically narrow. We are not yet getting the kind of warning signals that normally precede a major cycle turn. But this cycle may be different.

I know it is dangerous to suggest that this time is different, but I do think there are reasons why this cycle may not follow the typical post-WWII prescription. In previous cycles, the economy overheated and then the Fed attempted to cool the economy by draining liquidity and raising rates. The combination of strong loan demand and restrictive monetary policy would drive rates substantially higher and that would then trigger a sell-off in the stock market and ultimately a bear market.

Obviously, we have not seen either the overheating or Fed tightening thus far in this cycle, and we're not likely to see it any time soon. This is why so many on Wall Street believe that stocks are in a secular bull market that has a long way to run.

The Difference Is Deflation

What is different this time, however, is that we are dangerously close to entering a deflationary cycle, something we haven’t experienced in almost eighty years. With inflation hovering between one and two percent this late in a recovery and with nominal GDP growth so low, it would not take much of an economic downturn to push us into deflation.

If deflation is as close as I believe it is, then real interest rates are much higher than is generally assumed. I argue that the point-and-a-half rise in ten-year rates last summer, following Bernanke’s taper comments, represented a far more significant tightening than is generally understood.

This is why housing activity peaked back then and why it has been softening ever since. Last summer’s rate rise is also why mortgage refinancing activity has been so anemic, which in turn is one of the primary reasons why retail sales have fallen so short of expectations this year.

Throughout the past year, we heard how rates were still so historically low even with the point-and-a-half increase, and that the increase would not impact housing or the economy all that much. However, it definitely has negatively impacted housing and the economy. Analysts are still struggling to understand why.

Essentially, we have already had a stealth tightening. Those arguing that rates would have to move substantially higher before they would impact the economy or stock market in any meaningful way are not recognizing the deflationary forces that are already impacting this economy. With consumer balance sheets as fragile as they are, it takes a far smaller rate increase to negatively impact demand than has been the case historically.

I think this failure to grasp the immediacy of the deflation risk is the root cause of the widespread complacency among investors, particularly institutional investors.

If one looks at the current cycle in the context of the previous post-WWII cycles where deflation wasn’t an issue, one can understand why a majority of investors are bullish. After all, corporate profits are at record highs, interest rates historically low, and the stock market at all-time highs. Investors are behaving rationally if one uses the last sixty years of market history as a basis.

However, deflation is a game-changer, and I do not think the majority of investors are focused on it. While pundits give a good deal of lip service to deflation, I see little indication of a true understanding of the tremendous impact deflation would have on the economy, the capital markets, and the financial system. Additionally, there is a widespread belief that the Fed can and will prevent deflation at all costs. Putting this kind of faith in the Fed seems rather misplaced, given the Fed’s long history of reacting to events after the fact, rather than anticipating them and heading them off.

Wall Street's Struggles

Both the buy and sell sides of the Street are struggling to understand this cycle. Even with the stock market at all-time highs, we are not seeing the normal exuberance that usually characterizes bull markets. Instead, we hear how challenging the environment is.

For example, many of the large banks and brokers are expected to post big drops in their trading revenue for the second quarter. Traders in these firms have admitted that they are finding the current environment a difficult one in which to trade. Long-time hedge fund manager Paul Tudor Jones recently said this was as difficult a trading environment as any he has experienced in his 25 years in the business.

Certainly a lack of volatility is one big reason why traders are finding the environment so challenging. But it's more than that. Neither the economy nor the bond market is behaving in the way that Wall Street expected coming into this year. 2014 was supposed to be the year the economy finally got back on a more normalized growth path with housing, autos, and capital investment all expected to show major improvement. Instead, we started the year with a negative first quarter.

The housing market is looking much weaker than expected, and corporations are remaining far more cautious with their capital spending plans than was projected. At the beginning of the year, there was virtual unanimity on the Street regarding the expectation that interest rates would rise, and rise quite substantially. Here again, the consensus was wrong. Rates not only didn’t rise, but actually declined quite dramatically. We have seen similar miscalculations regarding currencies, precious metals, and various sectors of the equity market. Yes, the equity market is at all-time highs, but most portfolio managers are finding it a challenging environment in which to perform.

Thus far, most pundits are sticking with their forecasts despite the disappointing start to the year. They view the first quarter as an aberration, both with regard to the economy and interest rates. They continue to believe this is the year we return to more normalized growth, and they continue to expect interest rates to rise substantially.

I think the consensus is wrong on both counts. We are getting some bounce back in the economy in the second quarter now that the harsh winter is behind us, but I expect weakness to return in the second half. A global recession is a real likelihood, despite the Street’s expectation of strong growth. I continue to forecast that interest rates will fall to dramatically lower lows, with long-duration Treasuries doing especially well. My forecast is definitely an outlier on the Street, calling for the long bond yield to fall to 1% by year-end and the ten-year to ½ of 1%.

It will take a global deflationary contraction to get rates to those extreme levels, but that is precisely what I think is coming. Most bond managers are still very short duration. They are choosing to trade down the risk curve to pick up yield, rather than extend duration. I think they should be doing the exact opposite, limiting credit risk and extending maturities.

Central Banks Are Reining in Liquidity

It is interesting to note that while policymakers in the US, Europe, Japan, and China are all becoming increasingly concerned about the risks of deflation, the Fed, the Bank of Japan, and the People’s Bank of China are at the same time becoming less accommodative, and quite significantly so.

If things proceed according to plan, the Fed will have completed the taper by fall, putting an end to QE3. The Bank of Japan has already halted its asset-buying program after dramatically ramping up QE in the past year. The People’s Bank of China is also attempting to rein in liquidity, in an effort to slow down the rapid expansion of shadow banking credit in China.

The European Central Bank, which has been the least accommodative of the four central banks in the past year, has indicated it will now begin providing more liquidity. However, that increase will pale by comparison to the amount of liquidity that is being removed by the other three central banks. The net result is that the global economy will experience a period of substantially reduced liquidity just when it may need it most.

Normally, under these circumstances, we might be hearing calls for a more stimulative monetary policy. However, Wall Street remains fixated on the idea that the Fed has pursued a far too expansive monetary policy that risks igniting an inflation cycle that will be difficult to contain once it starts. As a result, most investors are cheering on the taper and are anxious to see QE3 come to an end. There seems to be little recognition that this reining in of global liquidity and credit could lead to a deflationary contraction. Policymakers, in the US and abroad, may be committing a historic policy misstep, one that could trigger a steep and swift global decline.

I believe the financial and economic risks today are higher than at any other time in the post-WWII era. Yet it is clear that investors are quite bullish and willing to take on significant risk in the hopes of earning a higher rate of return. We see this in the junk bond market where rates are near historic lows and spreads to Treasuries are very narrow. We see this in the most recent Investors Intelligence sentiment survey showing bullish sentiment among investment letter writers at its highest level in many years.

It is clear that a significant majority of investors have bought into the secular bull argument and are not particularly concerned about the risks today. As a contrarian, this is the kind of investor behavior I would expect to see at a cycle top, which is where I think we are today. I continue to forecast a likely unwinding of the cycle in the second half of 2014 that could be steeper and deeper than that which we experienced in 2008/9.

History suggests that this is not likely to end well.