Long-term Sentiment Indicators Suggest U.S. Stock Market Exuberance

Despite Fed tightening, the rise of populism threatening the disruption of global trade and supply chains, along with ongoing delays in U.S. tax reform and infrastructure spending legislation, there is no doubt that economic optimism is more persuasive in mainstream U.S. society today than it was relative to just six months ago. Sure, President Trump is in the process of dismantling Dodd-Frank, the EPA, and even the ACA (through loosening IRS rules on the “individual mandate”) through a series of Executive Orders, but such loosening of regulations is not necessarily bullish for corporate profits as they encourage more competition in such affected industries over time. In fact, loosening IRS rules on the “individual mandate” may even lead to the collapse of the U.S. healthcare system, as the “individual mandate” forms the core of the ACA by requiring young, healthy Americans to purchase insurance so they could subsidize older, less healthy Americans with pre-existing conditions. An ACA in the absence of the “individual mandate” will be credit-negative for most U.S. healthcare companies.

Historically, the Conference Board’s Consumer Confidence Index has not just acted as a reliable, coincident gauge of U.S. consumer sentiment, but also as a very reliable contrarian indicator for U.S. stock prices. While it has always been better in pin-pointing bottoms during a bear market, it has also worked well in calling significant stock market peaks over the last 35 years. This was true in the run-up of both the Consumer Confidence Index and U.S. stock prices leading up to the significant peaks in September 1987, July 1998, Fall 2000, as well as its “rounding top” during the first half of 2007. Just yesterday, the Consumer Confidence Index–by soaring through its September 1987 peak and hitting a high not seen since December 2000–gave us a “strong sell” signal on U.S. stocks. Figure 1 below shows the monthly readings of the Consumer Confidence Index. vs the Dow Industrials from January 1981 to March 2017.

consumerconfidenceSuch extreme complacency among U.S. mainstream society has morphed into “irrational exuberance” as retail investors, aided by near-record-high U.S. corporate buybacks, has also made its mark on U.S. margin debt outstanding. As of February 28, 2017, U.S. margin debt surged to an all-time high of $568.6 billion outstanding, more than $18 billion higher than its previous all-time high of $550.0 billion made in April 2015, just a few months before the onset of the July 2015-February 2016 global equity bear market. Over the last 12 months, U.S. margin debt outstanding has risen by $94.5 billion (see Figure 2 below)–its greatest 12-month rate of margin debt accumulation since June 2014.

margindebt

Leading Indicators Suggest Further Upside in Global Risk Asset Prices

Note: I know many of you reading this are either overweight cash or net short U.S. equities. Please don’t shoot the messenger: I am not personally biased to the upside – I am merely channeling what my models are telling me, and they are telling me to stay bullish.

In my January 31, 2016 newsletter, I switched from a generally neutral to a bullish position on global risk assets. Specifically:

  • For U.S. equities, I switched from a “slightly bullish” to a “bullish” position (after switching from a “neutral” to a “slightly bullish” stance on the evening of January 7th);
  • For international developed equities, a shift from “neutral” to “bullish”;
  • For emerging market equities, a shift from “neutral” to “slightly bullish”; and
  • For global REITs, a shift from “neutral” to “bullish.”

My bullish tilt on global risk assets at the time was primarily based on the following reasons:

  1. A severely oversold condition in U.S. equities, with several of my technical indicators hitting oversold levels similar to where they were during the September 1981, October 1987, October 1990, and September 1998 bottoms;
  2. Significant support coming from both my primary and secondary domestic liquidity indicators, such as the relative steepness of the U.S. yield curve, the Fed’s renewed easing bias in the aftermath of the December 16, 2015 rate hike, and a sustained +7.5% to +8.0% growth in U.S. commercial bank lending;
  3. Tremendous bearish sentiment among second-tier and retail investors (which is bullish from a contrarian standpoint), including a spike in NYSE short interest, a spike in the AUM of Rydex’s bear funds, and several (second-tier) bank analysts making absurd price level predictions on oil and global risk assets (e.g. Standard Chartered’s call for $10 oil and RBS’ “advice” to clients to “sell everything”).

In a subsequent blog post on February 10, 2016 (“Leading Indicators Suggest a Stabilization in Global Risk Asset Prices“), I followed up on my bullish January 31st prognostications with one more bullish indicator; i.e. the strengthening readings of our proprietary CBGDI (“CB Capital Global Diffusion Index”) indicator which “suggests–at the very least–a stabilization, if not an immediate rally, in both global equity and oil prices.

I have previously discussed the construction and implication of the CBGDI’s readings in many of our weekly newsletters and blog entries. The last two times I discussed the CBGDI in this blog was on May 15, 2015 (“Leading Indicators Suggest Lower U.S. Treasury Rates“) and on February 10, 2016 (“Leading Indicators Suggest a Stabilization in Global Risk Asset Prices“).

To recap, the CBGDI is a global leading indicator which we construct by aggregating and equal-weighting the OECD-constructed leading indicators for 29 major countries, including non-OECD members such as China, Brazil, Turkey, India, Indonesia, and Russia. Moreover, the CBGDI has historically led the MSCI All-Country World Index and WTI crude oil prices since November 1989, when the Berlin Wall fell. Historically, the rate of change (i.e. the 2nd derivative) of the CBGDI has led WTI crude oil prices by three months with an R-squared of 30%; and has led or correlated with the MSCI All-Country World Index, with an R-squared of over 40% (which is expected as local stock prices is typically a component of the OECD leading indicators).

The latest reading of the CBGDI has continued to improve upon the readings which we discussed several months ago (see Figure 1 below)–just 10 days after we turned bullish on global risk assets. Both the 1st and the 2nd derivatives of the CBGDI have continued to climb and are still in (slight) uptrends, suggesting a stabilization and in some cases, a re-acceleration (e.g. the economies of South Korea, New Zealand, Spain, and India) in global economic activity. So don’t shoot the messenger–but it appears that the rally in global risk assets coming out of the late-January-to-early-February bottom still has more room to run.

CBGDIMay2016

Leading Indicators Suggest a Stabilization in Global Risk Asset Prices

Even as the vast majority of analysts stayed bullish on the global economy and global risk assets early last year, I began to turn bearish for a variety of reasons, including: 1) global liquidity, as measured by the amount of US$ circulating freely in the global financial system, continued to weaken, 2) valuations in U.S. equities were at the 95th percentile of all readings dating back to the late 1970s, as measured on a P/B and P/E basis, 3) U.S. corporate profit margins were already at 50-year highs, while U.S. corporate profits as a percentage of U.S. GDP was at a high not seen since 1929, 4) U.S. corporate earnings growth, ex. energy, were beginning to decelerate, and 5) our proprietary leading indicator, the CB Capital Global Diffusion Index (“CBGDI”) was indicating a global economic slowdown, as well as a pullback in global equity and oil prices.

I have previously discussed the construction and implication of the CBGDI’s latest readings in many of our weekly newsletters, and last discussed it in this blog on May 15, 2015 (“Leading Indicators Suggest Lower U.S. Treasury Rates“). Specifically, the CBGDI is a global leading indicator which we construct by aggregating and equal-weighting the OECD leading indicators for 29 major countries, including non-OECD members such as China, Brazil, Turkey, India, Indonesia, and Russia. The CBGDI has also historically led the MSCI All-Country World Index and WTI crude oil prices since November 1989, when the Berlin Wall fell. Historically, the rate of change (i.e. the 2nd derivative) of the CBGDI has led WTI crude oil prices by three months with an R-squared of 30%, while leading the MSCI All-Country World Index slightly, with an R-squared of over 40% (naturally as stock prices is typically one component of the OECD leading indicators).

In my May 15, 2015 blog entry, I also stated:

Our own studies suggest the global economy has been slowing down significantly since the 2nd half of last year [i.e. 2014]; more importantly, the negative momentum has not abated much … the 2nd derivative of the CBGDI has gotten weaker. It also extended its decline below the 1st derivative, which in the past has led to a slowdown or even a major downturn in the global economy, including a downturn in global asset prices.”

The rest is history, as they say.

Recent readings of the CBGDI, however, paint a much brighter picture. Firstly, both the 1st and 2nd derivatives of the CBGDI have stabilized and are now increasing. Secondly, both global equity prices (i.e. the MSCI All-Country World Index) and oil prices have declined to levels that are indicative of a more severe slowdown than the CBGDI readings imply (see Figure 1 below). To me, the latest readings of the CBGDI suggests–at the very least–a stabilization, if not an immediate rally, in both global equity and oil prices.

CBGDIDecember2015

 

 

Margin Debt Outstanding Remains High but Suggests an Oversold Market

A client said: “U.S. margin debt outstanding remains at a very high level; as such, I expect U.S. stocks to correct further.”

We last discussed the overbought condition in U.S. stocks as measured by U.S. margin debt outstanding in our January 29, 2014 blog entry (“Record Rise in Margin Debt Outstanding = Single-Digit Stock Returns in 2014“). U.S. margin debt outstanding stood at $478.5 billion at the time (measured as of December 31, 2013), after rising by $123 billion over the previous 12 months. The rapid rate of margin debt growth at the time suggests a highly overbought market. For comparison, the 12-month increase in margin debt outstanding leading to the March 2000 peak was $134 billion; for July 2007, an unprecedented $160 billion. At the time, we stated that this rapid accumulation of margin debt would lead to tepid stock returns going forward. The S&P 500 stood at 1,848.56 as of December 31, 2013; as I am typing this, the S&P 500 is trading at just shy of 1,900. After two years, the S&P 500 has gone nowhere; although your portfolio would’ve performed well if you had an overweight in consumer discretionary and tech; less so if you had an overweight in energy or materials.

As of December 31, 2015, U.S. margin debt outstanding stood at $503.4 billion–a tepid $25 billion increase over a period of two years. With the recent sell-off in U.S. stocks, margin debt would likely have declined by at least $20 billion this month. This means U.S. margin debt outstanding as it stands today is likely to have revert to its December 31, 2013 levels. Figure 1 below shows the 3-, 6-, and 12-month absolute change (in $ billions) in U.S. margin debt outstanding from January 1998 to December 2015.

usmargindebt12312015

A margin debt outstanding of around $480 billion is still high by historical standards; however–based on the 3-, 6-, and 12-month rate of change–U.S. margin debt outstanding is actually at an oversold level–reminiscent of similarly oversold levels in late 1998, early 2008, and the 2nd half of 2011. In two of these instances (late 1998 and the 2nd half of 2011), the S&P 500’s subsequent returns were phenomenal (38% and 27%, respectively, over the next 12 months); in the case of early 2008, however, not so much. With that said, March 2008 still represented a tradeable bottom–as long as one got out of U.S. stocks by summer of 2008.

As I discussed with my clients, I do not believe the current liquidation in energy, materials, and EM assets will morph into a globally systemic event. As such, I believe U.S. stock returns will be decent over the next 6-12 months.

The Re-leveraging of Corporate America – Part II

We last discussed the increasing leverage in U.S. corporate balance sheets in our April 1, 2015 commentary (“The Re-leveraging of Corporate America and the U.S. Stock Market“), when we asserted that the combination of historically high U.S. stock market valuations, extremely high participation in the U.S. stock market by hedge fund managers (from a contrarian standpoint), and near-record high corporate leverage makes the U.S. stock market highly vulnerable to a major correction over the next several months.

At the time, we noted that U.S. corporate debt issuance averaged $650 billion a year during the 2012-2014 time frame, or 40% higher than the 2009-2011 period. Moreover, U.S. corporate debt issuance was on track to hit a record high in 2015, buoyed by the ongoing surge in M&A activity, sponsor-backed IPOs (companies tend to be highly leveraged upon a private equity sponsor exit), along with record share buybacks and the pressure to increase dividends. At the time, we noted that U.S. corporate debt issuance was on track to hit $1 trillion this year.

Since April 1, U.S. corporate debt issuance has continued to increase, although the pace has slowed down since concerns about the Greek debt crisis and the Chinese economic slowdown materialized this summer. Moreover–with energy and metals prices still underperforming–high-yield issuance has slowed down dramatically, although investment-grade issuance has continued to plough ahead. Nonetheless, U.S. corporate issuance has already set a record high this year, with nearly $800 billion of debt issued on a YTD basis (as of last Friday). At the current rate, U.S. corporate debt issuance could still hit $900 billion this year given the still-substantial pipeline of debt issuance driven by the recent frenzy of M&A activity.

Figure 1: U.S. Corporate Debt Issuance at Record Highs ($ billions)

uscorporatedebtissuanceNov2015

Moreover, U.S. net cash levels–that of Apple notwithstanding–have been crumbling under ever-increasing dividend yields, corporate buybacks, and M&A activity. Figure 2 below shows the substantial increase of debt/EBITDA ratios in Goldman’s universe coverage–especially since 2011–while companies with positive net cash levels are down by about one-third in the same time frame.

Figure 2: Rising Corporate Leverage While Cash Levels Continue to Decline

uscorporateleveragevscashDespite the August correction, we believe U.S. stocks remain overvalued. Combined with increasing and near-record high corporate leverage levels, this leaves U.S. stocks in a highly vulnerable position. With the Fed poised to begin a new rate hike cycle at the December 16 FOMC meeting , we believe there is a strong likelihood of a more substantial (15%-20%) correction in the S&P 500 from peak to trough sometime in 2016.

Our Leading Indicators Still Suggest Lower Asset Prices

In our March 12, 2015 commentary (“The Weakening of the CB Capital Global Diffusion Index Suggests Lower Asset Prices“), we discussed the shortcomings of Goldman Sachs’ Global Leading Indicator (GLI) based on its over-reliance on various components such as the Baltic Dry Index and commodity prices & currencies (specifically, the AU$ and the CA$). To Goldman’s credit, the firm has been highly transparent and vocal over the last several months about the distortions created by an oversupply of dry bulk shipping capacity and an impending wall of additional supply of industrial metals, such as copper and iron ore.

Goldman Sachs thus recognized that the GLI’s downturn in December last year (by that time, the bear market in oil and metals prices were well under way) was providing misleading cyclical signals of the global economy, with the exception of certain economies such as Australia, Canada, Brazil, and Russia. Indeed, our own studies suggest that global economic growth was still on par to hit 3.5% in 2015–with U.S. economic growth hitting 3.0%–while energy-importing countries such as India would actually experience an acceleration to 7%-8% GDP growth.

That being said, Goldman’s GLI remains highly instructive. Since December, other components of the GLI have begun to exhibit weakness that is consistent with a contraction of the global economy. Components exhibiting significant weakness include global industrial survey data (PMI), as well as new orders to inventory data (NOIN). Countries exhibiting significant weakness include the U.S., China, Norway, Japan, Turkey, and surprisingly, India. Meanwhile, Germany, France, and Italy are experiencing industrial production growth–likely due to the declining euro and record-low borrowing rates.

In a nutshell, our latest studies are now finally confirming Goldman’s GLI readings (a high probability of a global economic contraction). In our March 12 commentary, we asserted that global asset prices (especially equity prices) are poised to experience a +10% correction, given the weakness in the readings of the CB Capital Global Diffusion Index (the CBGDI).

The CBGDI is constructed differently in that we aggregate and equal-weight the OECD leading indicators for 30 major countries, including non-OECD (but globally significant) members such as China, Brazil, Turkey, India, Indonesia, and Russia. The OECD’s Composite Leading Indicators possess a better statistical track record as a leading indicator of global asset prices and economic growth. Instead of relying on the prices of commodities or commodity currencies, the OECD meticulously constructs a Composite Leading Indicator for each country that it monitors by quantifying country-specific components including: 1) housing permits issued, 2) orders & inventory turnover, 3) stock prices, 4) interest rates & interest rate spreads, 5) changes in manufacturing employment, 6) consumer confidence, 7) monetary aggregates, 8) retail sales, 9) industrial & manufacturing production, and 10) passenger car registrations, among others. Each of the OECD’s country-specific leading indicator is fully customized depending on the particular factors driving a country’s economic growth.

The CBGDI has historically led or tracked the MSCI All-Country World Index and WTI crude oil prices since November 1989, when the Berlin Wall fell. Historically, the rate of change (i.e. the 2nd derivative) of the CBGDI has led WTI crude oil prices by three months with an R-squared of 30%, while leading the MSCI All-Country World Index slightly, with an R-squared of over 40% (naturally as stock prices is typically one component of the OECD leading indicators). Since we last discussed the CBGDI on March 12, the 2nd derivative of the CBGDI has gotten weaker. It also extended its decline below the 1st derivative, which in the past has led to a slowdown or even a major downturn in the global economy, including a downturn in global asset prices. Figure 1 below is a monthly chart showing the year-over-year % change in the CBGDI, along with the rate of change (2nd derivative) of the CBGDI, versus the year-over-year % change in WTI crude oil prices and the MSCI All-Country World Index from January 1994 to April 2015. All four indicators are smoothed on a three-month moving average basis:

OECDleadingindicators

With the 2nd derivative of the CBGDI declining further from last month’s reading, we believe the global economy is very vulnerable to a major slowdown, especially given the threat of a Fed rate hike later this year. We believe two or more Fed rate hikes this year will be counter-productive, as it will reduce U.S. dollar/global liquidity even as many Emerging Markets economies are struggling with lower commodity prices and declining foreign exchange reserves. We also remain cautious on global asset prices; we will mostly sit on the sidelines (or selectively hedge our long positions with short positions on the market) until one of the following occurs: 1) global liquidity increases, 2) the 2nd derivative of the CBGDI begins to turn up again, or 3) global risk asset or equity prices decline by +10% from current levels.

We will look to selectively purchase energy-based (i.e. oil, natural gas and even coal) assets given the historical divergence of the CBGDI and WTI crude oil/natural gas prices. We continue to believe that U.S. shale oil production is topping out as we speak. Should the WTI crude oil spot price retest or penetrate its recent low of $44-$45 a barrel (or if the U.S. Henry Hub spot price declines below $2.50/MMBtu), there will be significant opportunities on the long side in oil-, gas-, and even coal-based assets.

The Re-leveraging of Corporate America and the U.S. Stock Market

The U.S. stock market as of the end of 1Q 2015 is overvalued, overbought, and overleveraged. As we discussed in our weekly newsletters over the last couple of months, the S&P 500 is trading at its highest NTM (next 12 months) P/E and P/B ratios since early 2001, just prior to the bursting of the bubble in U.S. technology stocks. Note that today’s record P/E ratios are being accompanied by the highest corporate profit margins in modern history, which in turn are supported by ultra-low borrowing rates and a highly accommodative environment for corporate borrowing.

On the demand side for stocks, we also know that global hedge fund managers are now holding the largest amount of long positions in U.S. stocks (56% net long as of year-end 2014) since records have been kept. With the global hedge fund industry now managing $2 trillion in assets, we believe it is a mature industry–as such, we believe the positions of hedge fund managers could be utilized as a contrarian indicator. In addition, note that no major U.S. indices (e.g. Dow Industrials or the S&P 500) have experienced a 10%+ correction since Fall 2011. Coupled these with the immense leverage on U.S. corporate balance sheets–as well as the U.S. stock market–this means that U.S. stocks are now highly vulnerable to a major correction over the next several months.

According to Goldman Sachs, U.S. corporate debt issuance averaged $650 billion a year during the 2012-2014 time frame, or 40% higher than the 2009-2011 period. U.S. corporate debt issuance is on track to hit a record high this year, supported by the ongoing rise in M&A activity, sponsor-backed IPOs (companies tend to be highly leveraged upon a PE exit), and share buybacks and increasing dividends. In fact–at the current pace–U.S. corporate debt issuance will hit $1 trillion this year (see figure 1 below). Over the last 12 months, member companies in the Russell 1000 spent more on share buybacks and paying dividends than they collectively generated in free cash flow. Across Goldman’s coverage, corporate debt is up 80% since 2007, while leverage (net debt / EBITDA)–excluding the period during the financial crisis–is near a decade-high.

Figure 1: U.S. Corporate Debt Issuance at Record Highs ($billions)

uscorporatedebtissuance

We believe the combination of high valuations, extreme investors’ complacency, and near-record high corporate leverage leaves U.S. stocks in a highly vulnerable position. The situation is especially pressing considering: 1) the high likelihood for the Fed to raise rates by 25 basis points by the September 16-17 FOMC meeting, and 2) the increase in financial market volatility over the last six months.

Finally, investors should note that U.S. margin debt outstanding just hit a record high as of the end of February. Our studies and real-time experience indicate significant correlation between U.S. margin debt outstanding and other leverage indicators (including ones that may not be obvious, such as the amount of leverage utilized by hedge funds through the OTC derivatives market), as well as major peaks and troughs in the U.S. stock market. Since the last major correction in Fall 2011, U.S. margin debt outstanding has increased by 69%–from $298 billion to $505 billion–to a record high. In other words, both corporate America and the U.S. stock market have “re-leveraged.” With the Fed no longer in easing mode–coupled with extreme investors’ complacency and increasing financial market volatility–we believe U.S. stocks could easily correct by 10%+ over the next several months.

margindebt0215

The Weakening of the CB Capital Global Diffusion Index Suggests Lower Asset Prices

The Economist just published an article discussing the Baltic Dry Index (“BDI”) and its lack of usefulness as a global leading economic indicator. We know Goldman Sachs constructs its global leading economic indicator with the Baltic Dry Index as one of its components. To its credit, Goldman discloses this and quantifies the impact of the BDI (along with each of its other components) on a monthly basis. Over the last decade, the BDI has become increasingly volatile–first, due to the rapid industrialization of China; then the subsequent over-building of ships just as the 2008-2009 global financial crisis led to a drop in global trade.

Today, the BDI sits at an all-time low; it is down by 65% in the last 13 weeks alone. This is the major reason why we do not include the BDI as one of our leading indicators on the global economy; it is very difficult to strip out the BDI’s volatility due to fluctuations in shipping utilization, as well as idiosyncratic events such as port or iron ore mine disruptions. We prefer to utilize leading indicators that are less dependent on fluctuations in shipping utilization or commodity supply. This is why we like the OECD Composite Leading Indicators, which we incorporate into our CB Capital Global Diffusion Index (“CBGDI”).

The OECD’s Composite Leading Indicators, unlike those compiled by others, are much less dependent on commodity prices or exchanges rates of commodity currencies, i.e. the Australian dollar, the Brazilian real, the Canadian dollar, and the New Zealand dollar. Instead, the OECD meticulously constructs a Composite Leading Indicator for each country that it monitors by quantifying country-specific components including: 1) housing permits issued, 2) orders & inventory turnover, 3) stock prices, 4) interest rates & interest rate spreads, 5) changes in manufacturing employment, 6) consumer confidence, 7) monetary aggregates, 8) retail sales, 9) industrial & manufacturing production, and 10) passenger car registrations, among others. Each country-specific leading indicator is fully customized depending on the particular factors driving the country’s growth.

To recap, the CBGDI is constructed by aggregating and equal-weighting (on a 3-month moving average basis) the OECD leading indicators for 30 major countries, including non-OECD members such as China, Brazil, Turkey, India, Indonesia, and Russia. The CBGDI has historically led or tracked the MSCI All-Country World Index and WTI crude oil prices since the fall of the Berlin Wall in November 1989. Historically, the rate of change (i.e. the 2nd derivative) of the CBGDI has led WTI crude oil prices by three months with an R-squared of 30%, while tracking or leading the MSCI All-Country World Index sightly, with an R-squared of over 40% (naturally as stock prices is typically one component of the OECD leading indicators).

We first introduced our CB Capital Global Diffusion Index (“CBGDI”) in our March 17, 2013 commentary (“The Message of the CB Capital Global Diffusion Index: A Bottom in WTI Crude Oil Prices“), when WTI crude oil traded at $93 a barrel. Based on the strength in the CBGDI at the time, we asserted that WTI crude oil prices have bottomed, and that WTI crude oil is a “buy” on any further price weakness. Over the next six months, the WTI crude oil spot price would rise to over $106 a barrel.

We last discussed the action of our CBGDI in our November 19, 2014 commentary (“The CB Capital Global Diffusion Index Says Higher Oil Prices in 2015“). At the time, we mentioned that–due to the strength in the CBGDI–WTI crude oil prices will likely rise in 2015. We obviously were early on that call as: 1) OPEC subsequently refused to cut production leading to the “Valentine’s Day Massacre” in global oil prices, and 2) the supply of U.S. shale oil continued to rise despite lower prices (a trend that is now ending).

Even though both the 1st and 2nd derivatives of the CBGDI are still positive, they are beginning to flash ‘caution’ signals. For example, the 2nd derivative of the CBGDI just declined below its 1st derivative–which in the past has led to a slowdown or even a major downturn in the global economy (as well as global asset prices). Note the following monthly chart shows the year-over-year % change in the CBGDI and the rate of change (the 2nd derivative) of the CBGDI, versus the year-over-year % change in WTI crude oil prices and the MSCI All-Country World Index from January 1994 to March 2015. All four indicators are smoothed on a three-month moving average basis:

OECDJanuary2015Despite the recent weakness of the CBGDI, however, the historic divergence between the CBGDI and WTI crude oil prices suggest that the latter is bottoming. The case for higher crude oil prices is compounded by the fact that U.S. shale oil production growth is now stagnating (which we discussed in our recent weekly newsletters, and just confirmed by the Energy Information Administration). Should the WTI crude oil spot price retest or penetrate its recent low of $44-$45 a barrel, there will be significant opportunities on the long side of the commodity.

With the CBGDI expected to weaken further this year, we also do not believe the Fed should hike rates anytime soon (even a one-time 25 basis point hike)–especially given the recent strength in the U.S. dollar. A Fed rate hike will be counter-productive as it will simply reduce U.S. dollar/global liquidity at a time of global risk-aversion and reduced economic activity. We thus remain cautious; we will mostly sit on the sidelines until one of the following occurs: 1) global liquidity increases, 2) the CBGDI begins to turn up again, or 3) global asset prices correct by more than 10% from current levels.

The CB Capital Global Diffusion Index Says Higher Oil Prices in 2015

We first introduced our CB Capital Global Diffusion Index (“CBGDI”) in our March 17, 2013 commentary (“The Message of the CB Capital Global Diffusion Index: A Bottom in WTI Crude Oil Prices“), when WTI crude oil traded at $93 a barrel. Based on the strength in the CBGDI at the time, we asserted that WTI crude oil prices have bottomed, and that WTI crude oil is a “buy” on any further price weakness. Over the next six months, the WTI crude oil spot price would rise to over $106 a barrel.

To recap, we have constructed a “Global Diffusion Index” by aggregating and equal-weighting (on a 3-month moving average basis) the leading indicators data for 30 major countries in the Organisation for Economic Co-operation and Development (OECD), along with China, Brazil, Turkey, India, Indonesia, and Russia. Termed the CBGDI, this indicator has historically led or tracked the MSCI All-Country World Index and WTI crude oil prices since the fall of the Berlin Wall. Historically, the rate of change (i.e. the 2nd derivative) of the CBGDI has led WTI crude oil prices by about three months with an R-squared of 30%, while tracking or leading the MSCI All-Country World Index slightly, with an R-squared of over 40% (naturally, as stock prices actually make up one component of the OECD leading indicators).

Our logic rests on the fact that the vast majority of global economic growth in the 20th century was only possible because of an exponential increase in energy consumption and sources of supply. Since 1980, real global GDP has increased by approximately 180%; with global energy consumption almost doubling from 300 quadrillion Btu to 550 quadrillion Btu today. That is–for all the talk about energy efficiencies–the majority of our economic growth was predicated on the discovery and harnessing of new sources of energy (e.g. oil & gas shale fracking). Until we commercialize alternative, and cheaper sources of energy, global economic growth is still dependent on the consumption of fossil fuels, with crude oil being our main transportation fuel. As such, it is reasonable to conclude that–despite the ongoing increase in U.S. oil production–a rising global economy will lead to higher crude oil prices.

This is what the CBGDI is still showing today, i.e. WTI crude oil prices should rise from the current $74 spot as the CBGDI still suggests significant global economic growth in 2015. The following monthly chart shows the year-over-year % change in the CBGDI and the rate of change (the 2nd derivative) of the CBGDI, versus the year-over-year % change in WTI crude oil prices and the MSCI All-Country World Index from March 1990 to November 2014. All four indicators are smoothed on a three-month moving average basis:

CBGDI September 2014As noted, the rate of change (2nd derivative) in the CBGDI (red line) has historically led the YoY% change in WTI crude oil prices by about three months. The major exceptions have been: 1) the relentless rise in WTI crude oil prices earlier last decade (as supply issues and Chinese demand came to the forefront), and 2) the explosion of WTI crude oil prices during the summer of 2008, as commodity index funds became very popular and as balance sheet/funding constraints prevented many producers from hedging their production.

The second derivative of the CBGDI bottomed at the end of 2011, and is still very much in positive territory, implying strong global oil demand growth in 2015. Most recently, of course, the WTI crude oil prices have diverged from the CBGDI, and are now down 20% on a year-over-year basis. While we recognize there are still short-term headwinds (e.g. U.S. domestic oil production is still projected to rise from 9 million barrels/day today to 9.5 million barrels/day next year), we believe the current price decline is overblown. We project WTI crude oil prices to average $80 a barrel next year. In addition to our latest CBGDI readings, we believe the following will also affect WTI crude oil prices in 2015:

  1. An imminent, 1-trillion euro, quantitative easing policy by the ECB: The ECB has no choice. With the euro still arguably overvalued (especially against the US$ and the Japanese yen), many countries in the Euro Zone remain uncompetitive, including France. On a more immediate basis, inflation in the Euro Zone has continued to undershoot the ECB’s target. A quantitative easing policy by the ECB that involves purchasing sovereign and corporate bonds will lower funding costs for 330 million Europeans and generate more end-user demand ranging from heaving machinery to consumer goods. While such a policy will strengthen the value of the U.S. dollar, we believe the resultant increase in oil demand will drive up oil prices on a net basis.
  2. The growth in shale oil drilling by the independent producers are inherently unpredictable. Over the last several years, the U.S. EIA has consistently underestimated the growth in oil production from fracking. With WTI crude oil prices having declined by nearly 30% over the last four months, we would be surprised if there is no significant cutback in shale oil drilling next year. Again, the EIA has consistently underestimated production growth on the upside, so we would not be surprised if the agency overestimates production growth (or lack thereof) on the downside as well.
  3. Consensus suggests that OPEC will refrain from cutting production at the November 27 meeting in Vienna. With U.S. shale oil drilling activity still near record highs (the current oil rig count at 1,578 is only 31 rigs away from the all-time high set last month), any meaningful production cut (500,000 barrels/day or higher) by OPEC will only encourage more U.S. shale oil drilling activity. More importantly, Saudi Arabia has tried this before in the early 1980s (when it cut its production from 10 million barrels/day in 1980 to just 2.5 million barrels/day in 1985 in order to prop up prices), ultimately failing when other OPEC members did not follow suit, while encouraging the growth in North Sea oil production. Moreover, OPEC countries such as Venezuela and Iran cannot cut any production as their budgets are based on oil prices at $120 and $140 a barrel, respectively. As a result, it is highly unlikely that OPEC will implement any meaningful policy change at the November 27 meeting.

With U.S. shale oil drilling activity still near record highs, we believe WTI crude oil prices are still biased towards the downside in the short run. But we believe the recent decline in WTI crude oil prices is overblown. Beginning next year, we expect U.S. shale oil drilling activity to slow down as capex budgets are cut and financing for drilling budgets becomes less readily available. Combined with the strength in our latest CBGDI readings, as well as imminent easing by the ECB, we believe WTI crude oil prices will recover in 2015, averaging around $80 a barrel.

An Imminent Correction in Risk Assets

In our 2014 U.S. stock market outlook (published on December 22, 2013), we asserted that U.S. stocks will only return in the single-digits in 2014, due to: 1) a tightening Fed, 2) the reluctance of the ECB to adopt quantitative easing policies, 3) higher-than-average valuations, as well as 4) increasingly high levels of investor speculation (e.g. record high levels in margin debt outstanding). We stand by our 2014 S&P 500 year-end target level of 1,900 to 2,000.

Conversations with our clients suggest one overarching investment concern/theme. Investors are concerned with the unprecedented global monetary experiments, while most of Asia is concerned about runaway Chinese credit growth and the country’s shadow banking system. The shift from a unipolar investment environment (one dominated by U.S. policy and institutions) into a multipolar one–beginning with the fall of the Berlin Wall in 1989 and accelerating with China’s entry into the WTO in 2001–means an understanding of global macro is essential to understanding the main drivers of future asset prices (hint: it is not classical indicators such as P/B, P/E ratios, etc.). Going forward, monitoring the actions of the People’s Bank of China and Chinese credit growth will be just as important as monitoring the actions of the Federal Reserve.

We believe 2014 represents a transition year as the Federal Reserve definitively halts its QE policies/asset purchases and as Chinese policymakers adopt financial reforms (e.g. allowing companies to go bankrupt to prevent future moral hazard problems) in an attempt to alleviate investors’ long-term concerns. In many ways, these recent moves–including Fed Chair Janet Yellen’s surprisingly hawkish comments at the March 18-19 FOMC meeting–are reminiscent to the events of 1994, when the Greenspan-led Fed unexpectedly began hiking the Fed Funds rate in February 1994. The Fed Funds rate rose from 3.0% to 5.5% by the end of the year, while the two-year Treasury yield surged from 4.0% to more than 7.5%. The S&P 500 experienced significant volatility and finished down the year by 1.5%.

We do not believe the Fed will hike the Fed Funds rate anytime soon; however, we anticipate the Fed to halt its QE/asset purchase policies by the end of this year; and to begin hiking rates in the 1st half of 2015. That is, global liquidity will get tighter as the year progresses–further compounded by overbearing U.S. financial regulations, a hike in the Japanese sales tax this week from 5% to 8%, and the ECB’s reluctance to adopt a similar QE policy. The action in the S&P 500 in the 1st quarter of this year has so far proved out our thesis. The S&P 500 ended 2013 at 1,848.36 and as of last Friday, sits at just 1,857.62 for a meager 0.5% gain. We reiterate our year-end target of 1,900 to 2,000. In the meantime, we believe the S&P 500 is heading into a significant correction, i.e. 10-15% correction over the next 3-6 months–for the following 3 reasons.

1) Hot Money Action is Getting More Risk-Averse

Since the global financial crisis ended in early 2009, EM fund flows from DM countries have been highly positive. Fund flows to EM countries turned negative during the summer of 2013. Many EM countries never implemented much-needed reforms during the last boom (Russia leadership just proved it is still stuck in the 19th century), nor made much-needed infrastructure and educational investments (with the major exception of China). Investors have forgotten that EM growth (actual and potential) rates no longer justify such investment fund flows–and have continued to dial back risk-taking in general. Most recently–the stock prices of two of the hottest industries, i.e. Big Data and Biotech–have taken a significant hit in recent trading. We believe momentum investors are now leaving the stock market; and that there is a good chance this will turn into a market rout (i.e. S&P decline of 10-15%) over the next 3-6 months.

2) The Federal Reserve’s Monetary Policy Tightening

Once the Federal Reserve wrapped up its “QE2” policy of purchasing $600 billion in Treasuries at the end of June 2011, the S&P 500 subsequently corrected by 14% over the next three months. The S&P 500 had already declined by 3% during May/June 2011, as the Fed did not provide a clear indication of further easing (i.e. QE3) until later in 2012. Prior to the end of QE2, the Fed purchased an average of $17.5 billion of Treasuries on a weekly basis. At the peak of QE3 (i.e. before the recent tapering), the Fed was purchasing an average of $20.0 billion of Treasuries and agency-backed mortgage securities on a weekly basis. The current tapering process is already having an effect on global liquidity, as foreign reserves held by global central banks have been declining over the last couple of months. Based on the current tapering schedule, the Fed will halt its QE policies at the October 28-29, 2014 FOMC meeting. The Fed’s balance sheet of $4 trillion of securities will take a decade to unwind (if ever). Unless the ECB chooses to adopt similar QE policies, we believe global central bank tightening (EM central banks are projected to tighten further over the next six months) will act as a significant headwind to equities and other risk assets for the rest of 2014.

Feds Balance Sheet

 3) A Record High in U.S. Margin Debt Outstanding

Our studies and real-time experience indicate significant correlation between U.S. margin debt outstanding and other leverage indicators, as well as major peaks and troughs in the U.S. stock market. We first discussed this indicator in our January 29, 2014 commentary (“Record Rise in Margin Debt Outstanding = Single-Digit U.S. Stock Returns in 2014“). We asserted that the record rise in margin debt outstanding (a 12-month rise not seen since July 2007–during the last major peak in stock prices) is indicative of significant speculation in U.S. equities. Since our January 29 commentary, U.S. margin debt outstanding has risen another $23.6 billion to a record high $502 billion. Meanwhile, the 6-month rise in margin debt outstanding hit $88 billion–again, a high not seen since July 2007 (when it hit $105 billion). More important, it is clear to us–based on the action in Big Data and biotech stocks over the last couple of weeks–that the willingness to speculate is declining. All of these indicators suggest to us that the S&P 500 will experience a major 10-15% correction over the next 3-6 months. We also assert that Emerging Market stocks will experience a significant decline, along with gold prices. We expect gold prices to bottom at the $1,000 to $1,200 an ounce level over the next 3-6 months. We will look for a buying opportunity in both gold and North American gold-mining stocks sometime in the next two quarters.
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