The charts you’ll see throughout this post were tweeted by several people who I follow on twitter, including @tradefast, @ritholtz, @RonnieSpence, @EquityNYC, @ukarlewitz, @DavidSchawel, & @JacobWolinsky.
As always, thanks for being a part of my stream and sharing your thoughts, work, & insights! #FF
I think we are getting real close to a major inflection point. It seems like every macro-economic data point I come across is saying one thing – the same thing. There is an extremely high correlation between all the varying data points and indicators. Data like the 10yr treasury yields, PMI manufacturing, durable goods orders, copper prices, international (ex Japan) stock markets, inflation expectation, margin levels etc – are all saying that the (global &) US economy is slowing, and that the risks of deflation/contraction/recession are growing.
The only thing diverging from this pattern in all of the charts below is the US equity markets.
It is highly unlikely that all of the different macro indicators are wrong – there are too many of them & most are driven by different drivers & variables. It’s only sensible that it is the US equity markets that is diverging from everything else.
So what’s driving equities higher? Back in September, after QE3 was announced, I wrote What QE3 means for your portfolio, and predicted the following:
The “hunt for yield” caused by #ZIRPforever should bring continued demand to high yielding junk bonds, REITs, & high yielding blue chips (Staples & Utilities), while the sub-par growth in the economy should cause cyclical names to underperform.
As you can see from the next set of charts (it might have taken a few months, but) this was precisely what has occurred.
In market weighted indexes, these defensive blue chip high dividend paying stocks have a disproportionate effect (as they are typically larger in size), which has led the broader markets higher.
In the long run, many believe that the “Bernanke Put” allows you to be invested at all times. Their thinking is that if the economy improves, although you might lose QE, but it’ll only be because of an improving economy, so you’ll be in a real bull market. In this scenario, cyclical companies should lead the way.
If the economy doesn’t improve, Bernanke’s Put is in place and QEforever will drive the hunt for yield causing higher equity markets. In this scenario leadership would come from these defensive/high yielding names.
So theoretically the Bernanke Put makes sense. The markets should/will always go up, if it’s led by cyclicals, that means the markets believe we’re getting somewhere and QE will end sooner rather than later, but at least growth is gaining some traction. If it’s led by defensives, that’s telling us that deflation/recession/contraction etc is all back on the table, but the markets are still going up because of Bernanke’s ZIRP.
So at least we understand why the divergence is taking place. The economic data is bad – we all know that. Look at copper, bonds, inflation breakevens, everything. Nobody will/can argue otherwise. Even the US equity markets are not saying otherwise. Look at cyclicals etc. It’s only the Bernanke Put – QE – causing the hunt (and now almost the fight) for yield – that is pushing up the indexes (hence led my defensive high yielding names), and not because of growth.
The Bernanke Put in all its glory:
Another reason why defensive names have done so well, is that investors that are aware of the above and are afraid to invest in the market because of the above economic data etc are “tiptoeing” into the markets and “playing it safe”. By buying these defensive healthcare/staple/utilities names, they figure even in a correction, they wont get hurt as bad as if investing in higher beta/more aggressive names. (more on this in a bit)
This is all fine, up until a certain extent, and here is where I believe we are approaching an inflection point. There has to be a price point where investors will realize that the risks of buying a typical 12x p/e stock – a stock where you’ll normally be thrilled to earn 10% a year (when you include their dividend) – are greater than the reward. Some of these stocks are trading at a high teens multiple, others over 20x. There are some that just rallied 20%… in 3 months! The risk vs reward, yield or not, just isn’t there. I think we are close to that level where investors will “fight the Fed”. Not because they want to, but because the alternatives are worse.
The same goes with high yield bonds, and most other investments (REITS, MLPs etc) buoyed by the hunt for yield. This is especially the case when the economic data is coming in so much worse than expected.
There are two extreme scenarios that can “correct” the above divergence, although I believe it will be a combination of the two.
1 – We could see a correction of 15-20% that would put the US equity markets back in line with most of the charts above. It would then be priced closer to fair value based on most of the recent economic data.
2 – The economic data can pop back up. Whether it was because of the payroll tax increase, sequestration, or some other seasonal event(s)… maybe this is/was just a blip on the radar these last few months, and the economic data will “catch up” to the US equity markets.
If these scenarios were mutually exclusive, I would bet the farm on #1. A realistic base case assumption though, is a combination of the two. I am anticipating a good 10% correction combined with a small pickup in some of the macro data.
Either way, something’s gotta give. The level of divergence here is bordering historic, and the relative and absolute over-valuation of some of these high-yield names are frightening.
One last point… Although during a correction defensive names typically correct less and are known as the place to hide… I think this time it will be different. Because of the historical nature of their increase, and the way they were leading the market on the way up – which is also non-typical – I believe they will lead to the downside and decline more. They have become a bubble of sorts, as they are probably the most over-owned & chased sub-asset class around.
In conclusion: stay safe, raise some cash, buy protection, & don’t chase!
To the investors chasing these yields, it might not be as bad as picking up a nickel in front of a steamroller, but it’s pretty darn close. Think of the risk vs. reward here – long term.
And to those “smart” investors (who must have only skimmed through the first set of charts of this post…) “tiptoeing” into these names because you’re trying to be prudent and take less risk. You might only be tiptoeing, and doing so ever so carefully & quietly, but you might have just tiptoed yourself onto a train that is about to derail.
UPDATE: 5/3/2013 11:42AM.
Today’s NFP data came in stronger than expected, with really good revisions higher for the last two months. As I type this, copper is trading up around 6%, and the broad equity markets are up around 1.25%. The key however is that today’s run-up is being led by cyclicals.
So as I tweeted this morning “bad news = good news for defensives, while good news = good news for cyclicals.” “This Bernanke Put however – at least on the bad news = good news front – is getting ridiculous. Either way defensives should underperform.”
In other words, even if the above 2nd scenario – better econ data – is the one that will close the divergence, (again, i think this is less likely,) defensives will still underperform.