Updated 11/28/17 – Notwithstanding extreme bullish sentiment (usually a contrarian indicator), the stock market continues to power higher but again it’s been mostly led by the mega cap tech stocks. Since October 11th when Bulls in the weekly II data reached 60, the Value Line equal weighted geometric index is up about 1%. I like this index as it consists of 1700 stocks and isn’t overwhelmed by a few big cap name.
The US market over the past few weeks also has been an island unto itself. European markets have become much more choppy as the Euro Stoxx 600 is no higher than it was during the summer. The Shanghai index last week had its worst day in a year and closed at a 2 month low. German politics has been an influence with the DAX but I have to wonder if there is some cautious trading ahead of ECB QE getting cut in half in just over a month. European bank stocks also do not trade well. Chinese stocks finally got weighed down by the persistent rise in interest rates that is resulting from government attempts at cracking down on the shadow side of lending and the need to slow the rise of what’s been excessive credit growth.
How we trade in the last month of the year is anyone’s guess but with each passing day we get closer to a major tightening of liquidity in 2018. The Fed alone will remove $420b of liquidity next year and the ECB will buy about $500b less of assets versus its current run rate. Even the BoJ is talking about letting its yield curve steepen by buying less longer term assets.
This week the Senate will vote on tax reform, if they have the votes, and that of course has been a major driver of bullish sentiment. I applaud the corporate tax changes that will likely come our way but Congress is mangling the individual side (via ending the SALT deduction) as they are desperate for ways of paying for the corporate cuts.
Either way, considering the dramatic rally in equities after the Presidential election it is clear that it’s already been priced in.
“It’s an earnings driven market” I’m sure you’ve heard many times this year but to say again, this has been a P/E multiple expansion market which is normal in a bull market. Over the past 5 years, earnings are up about 30% and the S&P 500 is up 80%.
I’ve said high valuations don’t matter until they do and I’ll repeat my belief that now they really matter. With the tax reform catalyst played out and monetary tightening intensifying next year there is no room for error, there is no margin of safety for stocks.
I’m a broken record so I’m sorry here. With respect to your US equity exposure, it’s time to be taking chips off the table or at least putting in stops depending on one’s time horizon. A longer-term time horizon is an investors best friend but a short one is now fraught with risk. Is this the end of the bull market? I’ve been burned before trying to predict and I know it’s a fool’s game but I will say again, central bank largesse is turning the other way. Don’t forget what got us here. Bottom line, monetary tightening will be the big story in 2018 and historically it’s what ends the party.
I’m going to repeat my commentary on EM which thankfully has been a great investment over the past 2 years. While I completely understand that emerging markets will not be immune to any selloff in developed markets driven by central bank tightening, I remain a bull on many of these markets such as Brazil (EWZ) and India (INDA). I also like Vietnam (VNM). Emerging markets have had a great run this year, better than US markets but I expect outperformance for years to come both from a growth and valuation perspective. US stock markets have just pulled forward so much in terms of future returns.
India remains an exciting long term story as the benefits of Modinomics takes hold. There was big news a few weeks ago that took the Sensex to a record high and that was India announced its own version of TARP where $32b will be injected into the state banks as a recap of their balance sheets which suffer from high levels of non performing loans. India’s stock market is not cheap so still consider this a long term hold.
I remain bullish on Brazil and EWZ but it did sell off a few weeks ago on reduced hopes for pension reform. This was a key part of Temer’s reform plan and I’d be disappointed if it doesn’t get done. I’ll be monitoring this situation closely but it does look that Temer is trying to do anything he can to get something passed, even if its watered down. That said Michel Temer has successfully passed two of the important three key legislative goals when he took office. The first one was limiting government spending to the rate of inflation in order to slow the excessive rises in debts and deficits. Just two weeks ago labor market reform passed and this is a major step in liberalizing the Brazilian labor market. Within the bill, companies would be able to more freely negotiate with employees directly instead of thru collective bargaining. Also, union members would not be forced to pay union dues which instead would be voluntary. Having the ability to more freely fire an employee for cause without major repercussions makes companies more inclined to hire which results in a net improvement in job creation. The third key piece of needed change is reform to the pension system by extending out retirement ages. The country is coming out of its two worst recession years since the Great Depression in the early 1930’s and many are still down on the Brazilian market. The Brazilian economy in Q2 grew on a y/o/y basis for the first time since Q1 2014.
I think we are beginning to witness a major change in gold stocks and something that has been prevalent in equity markets in general. That is buying on the dip. Gold traded back below $1300 the last few weeks as the US dollar got a bid on the very dovish stance of the ECB but the dollar continues to trade like crap. I do though believe there is a new bull market underway here people and it’s time to get on board if you are not. If you have ridden thru a tough couple of years, the worst is now over. I expect gold prices to resume its upward path because of low real rates and continued poor performance of the US dollar. I’m hoping we are on the cusp of the next leg higher in the precious metals because it seems that the fundamentals are coming together. I remain very bullish on gold and silver.
Keep in mind, central bankers will tighten us right into the next recession and bear market and will quickly halt and then reverse the process. That is when gold and silver really explode higher. In the last 13 rate hike cycles by the Fed since WWII, 10 put us into a recession. The gold idea can be played via PHYS, SLV and the miner etf GDX. As for the individual miners, I like GG, AEM and NGD in particular. All three reported good Q3 earnings reports a few weeks ago. If I am correct that a bull market in precious metals is now getting into gear, I expect them to take out the 2011 highs in the few years to come. That’s what bull markets do. Of note, we are seeing a bunch of insider buying in gold stocks and that is encouraging to see.
I continue to like agriculture and am playing it via POT, MOS and the broader MOO. Crop prices have stabilized after a pretty volatile few months. I still believe we are potentially seeing the beginning of the next bull market after 6 years of a bear as pieces are falling into place. The global demand for food is on a perpetual rise so it’s always the supply side that helps to drive prices. Also, ending stocks for corn and soybeans have fallen recently as demand is beginning to ‘eat’ into the supply of robust harvests seen over the past 5 years. The 2017/2018 harvest may result in the first fall in ending stocks for corn since 2010 and 2011.
Oil has broken out above its multi month $45-55 price range. Geopolitics with what’s going on in Saudi Arabia and the Kurdish area of Iraq has filtered into the markets along with inventories that keep on dropping. OPEC seems dedicated to keeping a lid on production growth too. We also have seen pretty solid demand globally. Conventional wisdom believes shale turns on the spigot with oil above $60 and thus caps the rally. Maybe but maybe conventional wisdom will be wrong and oil keeps going higher as it absorbs that supply. We’ll soon see. I still like COP and HP and both have had a nice rebound over their lows. Both pay good dividends. I still like Williams (WMB), the large natural gas pipeline, gathering, processing and storage company last month. They own a large stake in the MLP Williams Partners which generates almost all of its revenues from fee based, toll booth type activity. Natural gas continues to take market share from coal and exports of LNG are becoming a large business.
As for individual industry themes, I continue to like the cruise line stocks as a play on an aging population globally and an emerging market (particularly in China) that is getting wealthier and who want to see the world. CCL and RCL are the best way to play this.
I remain positive on Las Vegas Sands (LVS) and Wynn Resorts (WYNN) as a great way to play the rebound in Macau and the rise of the Las Vegas of Asia.
I still like Cameco and even more so now with the news two weeks ago. Cameco (CCJ) is the world’s largest private miner of uranium. They reported a weak earnings report and cut their dividend sharply but countered that by closing two of their huge mines which would cut global production capacity by around 10%. This is a major move by a big producer to more quickly right size the supply/demand imbalance that plagues the industry and the price of uranium jumped 10% in response. Cameco is hunkering down but they will have huge upside leverage when this cycle turns, which it will. The uranium market has been in a tailspin since Japan shut down every single one of their reactors after the Fukushima disaster a few years ago but some Japanese plants are coming back online with about 9 expected to be operating by year end with 5 currently open. Why like this stock now? The entire industry is underwater in that it costs more to dig it out of the ground than it can be sold for. Production is being cut and very slowly Japan is beginning to bring on more reactors online. At the same time, China and India are voracious builders of nuclear power because it’s safe, clean and a great source of stable power in big size. In total worldwide there are 57 plants under construction on top of about 450 on line.
General Electric reported an earnings report that dramatically reset expectations lower and they put on the block up to $20b of assets including their transportation business (locomotives, rail). This company remains very challenged and the new CEO seems very intent on right sizing this conglomerate to further focus its businesses. The earnings bar has been lowered sharply, the dividend has been cut in half and the terrible action in the stock certainly reflects this. I remain positive on GE for those with a long term time horizon. They have dominant positions in aviation, oil and gas, power (natural gas turbines and wind), and healthcare equipment. The new CEO recently bought 60,000 shares and Director Jon Tisch bought 3,000,000 shares for Lowes. I would be buying on this drop but keep in mind the long term time horizon that is needed for this recovery to play itself out.
I added a new recommendation not long ago, Johnson Controls (JCI). It is an industrial company that is mostly focused on commercial building management. They provide everything from HVAC products and services, to fire, safety and security. The stock trades at 15x earnings with a 2.5% dividend yield. An earlier than expected CEO change helped to boost the stock over the past few weeks but the potential cash flow turnaround is large and the new CEO is the man to deliver. We also have the higher likelihood that the company spins out its Power Solutions business which is a division that produces car batteries. This is a very consistent business but doesn’t fit strategically with building management. They reported an in line quarter this past week but some were disappointed with the guidance and the stock fell about 10%. Stick with the name.
I added AES, the global utility company, to my buy list in September. It is global because they currently do business in 17 different countries via regulated units and independent power producers. They have revenue of $15b and back in February announced the acquisition of sPower, the largest independent owner, operator and developer of utility scale solar assets in the US. The US utility group is trading a historical high P/E ratios near 20x. AES instead is trading at about 11x with a 4% dividend yield. It is a value play for a company that is shifting its focus on natural gas, wind and solar as the predominant forms of energy production. They have and will continue to cut debt in hopes of achieving investment grade status in the next 3 years. They also have an exciting division which stores battery power and that will be its fastest growing business.
I recently said I like Hewlett Packard (HPQ). What attracts me to this story is their growing 3D printing and graphics printing business. 3D is a potentially transformational technology in so many different ways that could literally upend manufacturing techniques. I expect HPQ to be a major player here. The PC business is challenged from a secular standpoint but as the biggest manufacture, it generates a large amount of cash as does the conventional printing business. The stock trades at just 12x earnings and pays a dividend yield of about 2.5%. They reported last week a big upside surprise to revenue growth but in line eps as margins fell. In coming years, the printing business, particularly 3D will become the dominant focus of investors.
Updated 11/28/17 – After an extremely persistent rise in short term interest rates, the 2 yr note yield backed off its near decade of 1.77% and settled this past week around 1.73-1.74% after the FOMC minutes this week revealed many in the committee still obsessed with missing their made up 2% inflation target. But, because long rates fell as well, the 2s/10s spread remains pretty narrow at just under 60 bps, the lowest in a decade.
I’ve talked about the anecdotal stories that seem to be percolating on inflation, particularly in Europe and even Japan. A nine month high in commodity prices with oil at a 2 ½ yr high is a contributing factor. In the PMI’s from Europe and Japan this past week we saw more commentary on this.
This was from the Japanese report, “a cheaper yen and higher material prices have intensified cost pressures, as input price inflation increased to a 35 month high in November.”
From the European Markit report, Markit said “The faster pace of growth signaled by the surveys was accompanied by price pressures hitting the highest since mid 2011. Average input costs were pushed higher by the combination of rising global prices for key commodities, such as oil, as well as greater pricing power amid improved demand conditions. Input prices showed the largest monthly jump since May 2011 while average selling prices for goods and services rose to the greatest extent since June 2011.”
Also of note two weeks ago, regular base pay in Japan in September jumped .7% y/o/y. It doesn’t sound like much but it does match the fastest pace since March 2000. There was also a sharp 11.6% y/o/y increase in bonus’ payments. Is inflation percolating? Very possibly.
As I’ve said many times, the European bond market, both sovereign and corporates, are in an epic bubble and as goes European yields, as might go US yields. Throw in of course Japanese JGB’s and we’re all in this bubble together. I’ll call right here AGAIN that the next Big Short is the European bond market. European bonds rallied after Mario Draghi’s dovish tapering announcement but gave back some of those gains this past week.
With respect to the Fed, QT is underway. As stated before, the sucking sound of liquidity leaving the financial system will be modest at first but will get louder as the quarters progress. The Fed seems to believe that QT will be a smooth, boring, ‘watching paint dry’ type process. I think they are delusional but it’s that belief that will cause them to move forward. I want to be clear, this process must take place. The Fed must remove themselves from bullying and manipulating our markets but this will be highly disruptive to asset prices and the economy. A recession will most likely follow. As for when the next rate hike might come, it’s looking highly likely to be in December. The Fed still expects another 3 in 2018 but the fed funds futures is only pricing in about 1 ½ more (which happens to be an increase from ½ of one).
To quantify the sucking sound, another $420b of liquidity will be taken out by the Fed in 2018 while the ECB will buy assets at a pace $500b less than the current run rate. Also, even the BoJ seems intent on steepening its yield curve. This all will be on top of another Fed rate hike in a few weeks and a few more next year as well.
Sovereign bonds, particularly in Europe should be sold. This is where I’m the most bearish as stated and have been as I believe European sovereigns are a train wreck waiting to happen. Corporate bonds are also vulnerable in the Euro Zone. The yields on European junk bonds are about the same as the US 5 yr Treasury note. Let that sink in for a moment. US corporates are very expensive with corporate debt levels relative to cash flow at historic highs. Spreads are very tight with little room for error. Stay short HYG. HYG has weakened significantly over the past month and stick with this short notwithstanding the modest bounce last week. Further monetary tightening on top of a slowing US economy is not a good combination for high yield. As for investment grade, the yield spread to Treasuries got down to 100 bps but has since backed off.
Stay short BNDX. It’s the Vanguard Total International Bond ETF. I reiterate my call a month ago to get short TLT or buy TBT or TBF.
Updated 11/28/17 – The CRB index is at a 9 month high with the most recent rally driven by oil prices as they broke above its $45-55 WTI range. Industrial metals have held their gains this year and ag prices have stabilized after a pretty volatile few months.
I want to emphasize that I think the predominant backdrop for the rise in energy and industrial metals prices has been the multi year set up of a large cut in mining investment. It has not been due to a major lift in demand, which however has held pretty steady.
As stated before, I remain a bull on some commodities. I’ve recently been on the sidelines with industrial metals until we get better clarity on the economic situation in China. I did catch much of the industrial metal move off the 2015. I’m particularly intrigued by copper again as demand is now coming from new emerging sources. I do think there is progress being made on the supply side and One Belt, One Road initiative will result in voracious buying of industrial metals in coming decades.
Oil has now broken above it multi month range of $45-55. See above for more comments. Longer term, I’m no fan of oil as the rate of growth in its global usage should continue to slow as alternatives gain greater share. In the median term (1-3 years) however, there is a lot of long term supply that is being taken out of the market and I believe oil has one last bull run left in it in coming years. In previous notes I expressed the desire to buy oil at $40 and sell it at $60. I’ll stick to that for now but wouldn’t be surprised to see a breakout above $60.
Gold and silver are currencies not commodities but I’ll refer to them in this section again (see equities for more color). I continue to remain a huge bull and you can see my arguments above. Gold and silver prices were awoken from their stupor and gold is now at a one year high. It was nice to see gold back above $1300 earlier this month which again put it above its 50, 100 and 200 day moving averages but has since dropped back below mostly due to the rise in US interest rates. The US dollar though has begun to roll over again. I believe the gold/silver bear market ended in December 2015.
Agriculture has lagged badly over the past 5 years on robust harvests but the demand side has been strong. As stated above, wheat, corn and soybean prices spiked a few months ago and have since moved lower again. I still believe though that a trend change might be upon us. I like DBA and added CORN, the etf to my buy a few months ago. In July I added SOYB, the soybean etf. China has recently ramped up their imports of soybeans and demand for soybeans are at a record. The global demand for food is on a one way trip higher. This is a bombed out space and I therefore believe the risk is very low at current levels.
With my bull case for Cameco listed in the equity section, I also like uranium but that is just easier to play via CCJ. Stated above, uranium prices jumped 10% this past week after Cameco announced a 10% production cut by closing two of their major mines.
Updated 11/28/17 – The US dollar bounce that started a few weeks ago, mostly vs the euro after Mario Draghi’s press conference when they announced a 50% cut in its QE purchases to begin in January, has flattened out. The euro definitely has its challenges, especially in light of a more tenuous state of political standing for Angela Merkel. We also have the issue of policy divergence where the Fed is shrinking its balance sheet and will be still hiking rates while the ECB clings to NIRP and is still buying assets, albeit much less next year. I’ve been bullish on FXE for a while but has pulled back this week. Let’s stick with the $110 stop on it to lock in a profit if it gets there. That said, after what seemed to be just a contra trend bounce in the US dollar, that seems to have ended and the dollar traded weak again this past week.
We’ve also had 4 rate hikes from the Fed, a 5th one likely in December and quantitative tightening is underway and even this can’t boost the US dollar much as REAL rates are still subdued. I too believe the market is getting worried about US economic mediocrity at the same time we are seeing this tightening along with the uncertain political situation. If growth accelerates due to tax reform and Fed tightening speeds up, I’ll reevaluate. But, while the BoJ and ECB are still dovish, they are a less so with a subtle tapering going on with the former and the announcement from the ECB that QE will be cut in half. I expect the US dollar to trade much lower from here against a broad basket in coming years.
I still like Asian currencies, and have been a particular bull on the South Korean Won which has traded well this year. With my recommendation a few months ago to sell EWY, I’ll also say to sell the Won and take profits. I still like the Singapore dollar (FXSG). The yuan is particularly tricky here as while I’m hugely bullish long term on China, I still am worried about the short term implications of their large debt build up that they are so desperately trying to deal with but at the same time not wanting it to impact growth. The 19th Party Congress ended with leaving no doubt as to who is in charge. The high wire act of trying to slow excessive credit growth with the desire for strong economic growth will be hugely put to the test in 2018.
I still like the Canadian dollar (FXC) as its benefiting from the rise in commodity prices and the BoC had the guts to at least take back the two emergency rate cuts they implemented after oil prices collapsed in 2014 and 2015. Also, the BoC never fell for the drug that was QE. Kudos to them. The Canadian dollar did lose momentum after the BoC expectedly did not hike again and basically said they are on hold for now but the rise in commodity prices which I think will continue, will be a boost.