The rally off of the almost bear market correction of late 2018, has led to a near euphoric take by many investors as 2019 had a large gain. In reality, the stock market moved up about 20% over the past 2 years, or about 10% on average per year. Exactly in line with historical averages.
The historic oil crash of late 2019 into early 2020 was damaging for us as I had an overweight in oil stocks. This correction was the largest in history for the oil patch.
The price of oil is rising again and certain oil stocks are inching up. Although I have cut oil holdings, we still have some of the best positioned for what is likely a rally off the bottom - much like the rest of the stock market had off their bottoms in late 2018.
If you suffered a loss in the past year, it is due mostly to the oil crash. Since May, all of our accounts have drifted upwards. I have maintained a large position in cash for the reasons I describe below. That cash position has been a bit of a drag. I expect it to be a source of strength as we invest it when better opportunities present.
Our best bet as investors is to understand the most important economic and financial factors, then control our emotions and be willing to adjust as markets move. Here's my summary look at 2020. I try to explain some of the most important parts of the economy and markets.
Of note, please take a look at the Core Bluemound Investment Strategies. After returning from New York last February and being able to talk to some very bright financial minds at the Investors Expo, I remade our portfolio strategies in order to build a larger margin of safety into what we do, without giving up opportunity. Set up a time to talk about your investment strategy.
Will Euphoria Finally Signal A Stock Market Top?
As I have discussed with subscribers and clients for several months now, I expect a rally into early 2020 as a result of the mini China trade deal and seasonality. I think it's very likely we see the final "euphoria" before a cyclical bear market greets us later in the year. This is the culmination of a prediction I made two summers ago and mentioned in a "tweet-versation" with Mark Yusko.
The underlying problem with many statements that euphoria was already in markets is the desire of many of those folks to want to call the next bubble.
Is There A Stock Market Bubble?
There's a huge group of prognosticators who want the fame that goes with saying "I called the bubble." Since the last financial bubbles burst over a decade ago, people have been calling the next bubbles. I talked about this in a piece two years ago called "A Bubble In Bubble Calling."
That's not to say there aren't bubbles today. The bubbles are just different that what most people think. Hence, the black swan theory.
The idea of euphoria today does not take into account a couple important factors, including that the bubbles probably aren't where we are looking. The circumstances in the markets have changed and a lot is unknowable.
One extremely important factor though, is that, just like after the Great Depression, there's an entire generation, the Baby Boomers, who will never feel financial euphoria again. Why is that? It's a perpetual feeling of financial uncertainty that most of the Boomers rightfully have.
For certain, there are some Baby Boomers who will still chase markets, but they do it in weird ways. There's a passive aggressive nature that's interesting to watch in their investing, simultaneously asking for higher returns and lower risk.
In general, the Baby Boomers, who control most of the money in the stock market, are trickling out of stocks as they retire (in about a decade we will have to face the fire hose). This puts an enormous strain on markets over time. There's no euphoria to ever be had from them again.
Euphoria from younger generations is not to be found in general either. While Millennials and Xers make more than the Boomers did, it's only just barely and has not moved up in current dollars. That is, most wage increases have barely covered inflation the past 40 years according to Pew Research.
Why would anyone have euphoria with that equation?
Continuing with the generational look, the perpetually ignored Xers are a small group without enough firepower to cause euphoria. By the time they have more money, they will want to start spending it. They can't create euphoria on their own now and probably never will get around to it.
The Millennials, though actually saving a larger part of their income to retirement than Boomers ever did, simply aren't making enough money yet. They can't create euphoria on their own either - not yet anyway.
If a combination of the Millennials and Xers can't create euphoria given the developing Boomer offset, what can? It would appear some combination of easy money and corporate buybacks is the answer. And that's just what we are getting into the seasonally strong part of the calendar.
The calendar plays a vital role in a euphoric hot minute. Early in the year, retirement plan money flows in through funds found in 401(K) and other plans. That gets spread around. Breadth expands. And then it ends in the spring. The new meaning of sell in May and go away.
Let's Borrow A Lot Of Money
There's an idea that the Federal Reserve is "printing money" and has been for a decade. Programs like QE and the current repo market bailout are mischaracterized over and over. Alan Greenspan just did it (if you listen to him, he's a contrary indicator).
The reality is that the United States, Japan, Europe and China - the four biggest economies representing about 80% of global GDP - are borrowing a lot of money. That money finds its way into the economy, but also the other side of the balance sheet as debt.
This is an important distinction vs. actual printing of money. The debt offset is deflationary. Given so much has been borrowed from the future, deflation is the real long-term bogeyman, not inflation - as Greenspan wrongly mumbled recently.
In theory, the immediate impact of borrowing is to be stimulative to the economy. Yet, growth is stuck. Why?
The answer is fairly simple. We are running into so much existing debt, on top of aging demographics issues, that the easy monetary policy of low, zero and negative interest rates can't do what Keynes said it would.
That of course gets blamed on Keynesianism and is a false criticism. Keynes also suggested paying down debt in good times, which no government has done in the 40 years except for a hot minute in the late 1990s in the U.S. Are we not in good times?
The Federal Reserve and other major central banks though continue to try to throw money at the economic growth problem. It doesn't solve anything, but it pushes asset prices up. Why? Because more money in the system today pushes asset prices up today. Milton Friedman told us about this in the 1960s:
Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output...
And there's the rub. Output is not increasing enough. So, we have monetary inflation, but without the corresponding boost to output, or GDP. That's a recipe for stagflation if we do not change fiscal policies, in particular regulatory and taxes, to create a more level playing field and collect more revenue to pay the Boomer retirement bill that's coming due.
In the short term however, easy money finds its way into the stock and bond markets, pumping up prices.
The Buyback Bubble Really Will End Badly
In early 2018, right after I correctly called the volatility spike that year, I suggested that "the buyback bubble will end badly." I stand by that prediction and believe the bubble in buybacks starts to unwind in 2020.
Goldman Sachs (GS) already warned us that buyback spending is falling. According to them, second quarter buybacks fell 18% compared to 2018. For the full year, buybacks are set to decline 6%. Why is this important? Buybacks represent all, that is 100%, of all net buying of stocks this year.
For 2020, economic and political uncertainty already is taking a toll on corporate spending. We can see it in quarterly report after quarterly report and in financial presentations everywhere. Yet, the stock market keeps inching out new highs. Those new highs are getting harder and harder to get.
The buybacks cannot continue at current levels unless economic growth picks up. My screening shows that about half of companies with buybacks have been borrowing to finance their buybacks. That bill will have to be paid soon as there is a wave of corporate debt refinancing coming. Companies will continue to adjust their buyback plans in anticipation. (Many low growth, high debt companies will be included in my coming series on stocks to sell in 2020.)
The Federal Reserve and other central banks are not in the business of being tight anymore, so monetary policy will remain accommodative. However, this is the year that more zombies start to run amok. We are already seeing it in Europe, China and the U.S. energy sector. Pretty soon, the zombies will need to die and that will have a knock on effect in the economy and markets.
Ultimately, slower economic growth will lead to zombie deaths and lower profits. Smaller corporate share buybacks will be a result of the lower profits.
The Trade Deals Really Don't Matter
There's a lot of hot air breathed out about the trade deals. And there's quite a lot to talk about. The main point that most people are missing is that the trade wars are fighting yesterday's battles.
As I've discussed with subscribers, the China trade deal is minor, weak and unlikely to ever be really implemented. China will continue to take what they need and mostly pay lip service to things they don't want to do regardless of agreements.
Back in college I had a Chinese dissident professor tell me that China would string America along for as long as the Communists ran the country. That proved very true. Why would it change now?
The only thing that can more profoundly deal with China is a united front with allies. The TPP, a flawed deal for sure, was a good first step to moving in a unified direction for keeping China at bay. It certainly would have needed constant improving, but walking away from it, has proven to be a mistake.
Ultimately, the whole "they took our jobs" mantra is false in general and very outdated now anyway. Study after study shows that job losses in America were around three quarters due to technology transformation. We should accept that because it's about to happen in again.
AI and machine learning are far more important to manufacturing and supply chain movement that almost anything that government can do with tariffs. What government should be doing is creating a playing field where innovation thrives and capital flows into R&D so that the supply chains move to America.
I will have several pieces at least on these topics in 2020, including stocks to win as the "smart everything world" continues to emerge.
Political Uncertainty And Misperceptions On A Democratic President
We already know that CEOs are adjusting their plans based on political uncertainty. The main issues for them are economic growth and taxes.
Slowing growth is happening for a host of reasons as touched upon in different sections of this piece:
- Aging demographics
- Trade wars
The tax issue also is very important to corporations and the wealthy.
Corporations go where their money is treated best. The U.S. is often the place. Our corporate tax code is now more accommodating than it has ever been for them.
What I am about to say people will find strange because I'm not a President Trump fan, but the corporate tax code is almost right currently. Why is that? In my opinion, corporations pass through almost all tax costs to consumers anyway. So, what's the point of raising their taxes other than ideological perception.
A more complex corporate tax code or higher corporate tax rates is not what we need. We ought to do away with most loopholes, but the current tax rates seem about right. Like I said, raising corporate taxes will just get passed onto consumers anyway. There are other mechanisms for raising revenues.
With that in mind, corporations are concerned that they will in fact see a more complex and expensive corporate tax code in 2021. That's impacting short-term spending plans at a time we need them to invest in things like R&D and modern manufacturing.
Family offices, the domain of eight, nine and ten figure wealth, have been dialing back equity exposure recently. Institutional Investor tracks this fairly well, albeit with a lag to the public.
The core catalyst for family offices to dial back equity exposure is a belief that equity returns will be lower in the 2020s. A recent study State Street Global Advisors suggested returns in the 2020s would come down due to valuations.
That's all on top of fear that taxes could go up in 2021 for the 1%.
If President Trump looks like he's going to lose, equity outflows from the wealthy will accelerate. If he does lose, the wealthy will lock in lower capital gains, then the traders will pile on and the retail side will eventually panic. This is the scenario that could drive the S&P 500 (SPY) (VOO) down to the 2200 level I outlined in a piece titled: How Low Can The Stock Market Go?
As investors, we should be concerned with the President Trump losing scenario. As I mentioned in a Seeking Alpha article, I have seen private polling which shows about 10% of Republicans are going to sit on their ballot (or maybe vote for Biden, which could turn into a maybe vote for Bloomberg). The takeaway is that the Never Trumpers are back and that will make it far more difficult for President Trump to win again.
In addition, the recent rift with some Evangelicals, after an editorial in Christianity Today calling for President Trump's removal from office on legal and moral grounds, underlies another group that is unlikely to turn out as in force for President Trump. That publication reported 3x as many new subscriptions as cancellations after the editorial.
This is just data. And, the data suggests the President Trump has a far greater challenge in threading an electoral college needle this time, than last time.
What else we should know as investors, is that the economy and stock market tend to do better under a Democratic President. Why is that? You decide. But, I suspect it has to do with cycles and building from the middle out versus top down. In any case, we shouldn't fear whoever wins, because, frankly, this is America and our advantages far supercede any politician who goes away in time.
Stock Market Valuations Are Very High
Various measures of stock valuation can be employed by equity investors. I prefer the measure that Peter Lynch used, which was PEG, or Price/Earnings divided by Growth.
As you see, the PEG ratio for the S&P 500 (SPY, VOO) is historically high. The forward P/E ratio is also approaching significant overvaluation. Either growth needs to pick up or prices need to come down a bit to bring these valuations closer to normal.
Brian Gilmartin of Trinity Asset Management points out that "Earnings Yield" is at its lowest point in the post-financial crisis era. He does point out that the forward estimates are about to become current year. That means we need to keep a close eye on what corporate chieftains say at earnings in a few weeks about their outlook. What if earnings don't meet expectations this year?
Multiple other valuation measures are also testing levels only seen a few other times in the past century:
The Q ratio is Warren Buffett's favorite indicator. It is the market cap of all publicly traded companies to the U.S. GDP. Its extreme valuation may explain why Berkshire Hathaway (BRK.B) continues to raise cash levels.
The Two Most Likely Scenarios For 2020 Are A Repeat Of 2015 or 2018
2015 was a choppy year that produced no gains:
2018 started rough, rallied and ended rougher:
Of course, we could always get "to the moon." If you are more concerned with chasing returns than managing risk, you can position yourself for that scenario. Contact me if you want to be more aggressive instead of waiting for a correction.
The "January Effect"
I am a big proponent of following the money flow into and out of markets. Chaikin Money Flow is one of my favorite easy to follow indicators. Followed across daily, weekly and monthly charts, we can find gigantic clues as to the demand for financial assets. Price equals supply and demand, after all.
What we know about the stock market is that there is considerable seasonality to it absent events or black swans. The January Effect is one of those seasonal periods where we normally expect a rally. Why is this?
One theory for the January effect is that people who sell for tax losses in December reinvest in January. I believe there is some reality to this. Another factor is very likely that retirement plan contributions peak in January as employers make matches and people make IRA contributions ahead of tax filing.
Although there was little tax-loss selling in 2018, save for energy assets, the economy is strong with low unemployment, meaning retirement plan contributions should be significant.
An Early Bout Of Volatility Akin To Early 2018
The new highs becoming harder to get achieve should be a harbinger to intelligent investors. It will not take much of a black swan to set off a spike in volatility. Could the China trade deal be not as good as advertised? I think so. Could Q1 GDP growth disappoint? I think it could.
There's likely to be at least one bout of volatility early in the year as many people are in the business of "shorting vol" and whatever black swan pops up won't have to be a really big black swan.
The "short vol" side of the boat gets overfilled once in a while. The perceived catalyst will get the attention for the surge in volatility, however, the reality is that it will simply be too many people selling volatility futures and the iPath S&P 500 VIX ETN (VXX) for the market to handle.
It appears that the trader "50 Cent" is back at it, betting on a rise in volatility in early 2020. I tend to agree with him, but think he might be a month early.
I have made a few successful VIX trades in recent years and a breakeven trade. My fear in betting on VIX is that it's a tough bet for retail accounts because it deteriorates quickly. Timing has to be almost perfect to use it effectively for a short swing trade (or day trades for those inclined).
For most investors, raising cash into and early in the New Year is a smarter approach to hedging. I had that discussion with Bob Savage (formerly Track Research, not head of FX Sales Americas at BNY Mellon) at the Traders Expo in NYC back in January. Simply put, hedging is hard, expensive and requires quite a bit of luck on timing. Most people should "just sell what they think might go down" according to Savage. I agree.
Pensions and Boomers Will Continue To Sell In 2020
Over the course of the year, however, we know that pensions and retirees will continue to take money out of the stock market. Pensions are now perpetual net sellers due to few young contributors and more Boomers reaching retirement.
I included life insurance net purchases of equities here because those companies are more tactical in their purchases. That is, they try to buy low and sell high. Notice their selling the past few years. Certainly, some of that can be attributed to more death claims with an aging population and the massive move towards term life insurance versus whole life. It's interesting nonetheless and does have a long-term downward bias, at least reducing another source for demand of corporate equities.
We also know another year's worth of Boomers are hitting the age for Required Minimum Distributions, or RMDs, from their IRAs and other retirement plans. Over 300,000 people will take their first RMDs in 2020.
Those demographically driven withdrawals from stocks are the leading reason that, on net, there is virtually no new demand for stocks other than corporate share buybacks.
Share Buybacks Are Now Slowing
As I covered in "The Buyback Bubble Will End Badly," the marginal buyer of stocks has become corporations themselves. That is, there is no net demand for stocks other than companies buying back their own shares. Consider that for a moment longer, it's extremely important.
Without a surge in stock buying from demographic drivers or foreign buyers, stock prices are even more tied to corporate earnings. We know that about half of stock buybacks are funded by debt. If earnings falls, then debt becomes harder to finance and cash flow for buybacks falls.
Goldman Sachs just projected buybacks for 2020 as falling by about 5-6% in 2020. That is on top of the roughly 15% decrease in buybacks from the highs attained in 2018.
With a wave of corporate debt refinancing coming, there are multiple worries that investors should have about buybacks persisting at such high levels for much longer. Slower economic and earnings growth would be a harbinger for a deeper decline in share buybacks and net demand for stocks.
Is China Trade Deal A "Sell The News" Event?
I have discussed with subscribers and in my webinars on YouTube that I believed the trade war as executed was a mistake. My initial read in early 2018 was that China would string out negotiations, give little and only agree to deals that gave them what they needed.
It was just announced that the Phase 1 trade deal would be signed on January 15th. But what does that really mean? It basically means that China gave little after a prolonged negotiation and is getting the food and resources they need. Essentially what I said would happen.
A new Federal Reserve report further backs my skepticism of the trade war and deal. The conclusion: “We find that the 2018 tariffs are associated with relative reductions in manufacturing employment and relative increases in producer prices...”
So, is there anything in the trade deal that really moves the needle going forward? Probably not. Here's most of what we know is happening:
- The U.S. will cut in half its 15% tariffs on about $120 billion of Chinese goods and suspend new tariffs.
- $250 billion of Chinese goods will still be taxes at 25%.
- China agreed to increase purchases of U.S. goods and services by at least $200 billion over the next two years. Nearly half of that is in agriculture. China purchases will not reach pre-trade war levels though.
- Difficult to define or enforce IP and forced technology transfer commitments.
- A dispute resolution process.
In other words, the trade war moved from full-on to take a step back and pause. Most observers and traders recognize this. I think the trade deal is a "sell the news" event come mid-January.
First Half Of 2020 Investing Strategy
Because I believe that 2020 is not shaping up to be as bullish as many are forecasting, I am inclined to raise cash further if the stock market rises in early 2020. Most of our portfolio strategies are already indicating to raise cash to around 50%.
If the broad S&P rises to another new high by mid-January, I would be inclined to raise cash as high as 75% by the third Friday in January. What does that represent? The third Friday is, of course, an options expiration.
While options expiration does not always suggest volatility, I believe it will this time. Many traders will be apt to trade a rally for a small correction after the trade deal, with the added expectation that corporate earnings will not be particularly bullish.
If we get a correction in the the first quarter, I do not expect it to be terrible. Rather, I would expect it to be a set-up for the completion of a first-half 2020 rally, and should be bought at least for a swing trade to mid-year.
If we get more fully invested and participate in a rally, I would expect to be very cautious entering the high political season.
All trading strategy depends on your risk tolerance and trading style. I am typically a position trader, i.e., looking for assets I can hold for at least a year. Until valuations come down and economic uncertainty declines, I do not think I will find many position trades soon.
As such, I am positioning myself for wading into a long swing trade if there is a small correction soon. The easiest asset to buy on a short shallow correction is the Invesco QQQ ETF (QQQ).
Quicktake On QQQ
The QQQ is is composed of the Nasdaq 100, which contains many of the "new economy" blue chips. Companies such as dividend payers Microsoft (MSFT) Apple (AAPL) as well as growth stalwarts Amazon (AMZN) and Google (GOOG) lead that index.
The QQQ has far outperformed SPY over multiple time frames, even inclusive of the "dot-com" bust, for total return.
That simple way to understand the differences between QQQ and SPY is this:
- QQQ is full of capital-lite disruptors with stronger growth and balance sheets.
- SPY/VOO has a large cache of disrupted capital-intensive businesses with lower or no growth and many weaker balance sheets composed of legacy obligations.
That is, of course, a generalization but carries a lot of merit. My research shows that about one-third of companies in the S&P 500 are at risk of massive business declines in the coming decade. Many higher-debt and lower- or no-growth dividend stocks are at particular risk - as discussed in this MarketPlace Roundtable discussion with other analysts.
In short, I prefer QQQ and cherry-picking the best out of the S&P 500 when opportunities present. I am setting limit prices for buying QQQ on any correction. If real estate pulls back, I will be looking for real estate investment trusts that offer strong dividends and long-term margin of safety. I have several under consideration.
Bottom Line Summary
The markets are overvalued historically.
Stocks are currently overbought.
Money flow into stocks is weakening.
The Federal Reserve is moving into neutral (or so they say).
Global economics are trending sideways.
The tax code may change yet again.
Businesses are cautious on spending and stock buybacks are slowing.
Thus, we are positioned for a correction and awaiting better opportunities. I expect those opportunities sooner than later.