NICK REECE: Well, I'm Nick Reece from Merk
Investments, senior analyst and portfolio
manager.
I've been there since 2012.
Before that, I was working in Hong Kong for
a US corporate law firm, post-2008 Global
Financial Crisis.
I was working for a hedge fund out there and
then had an interim period and a stint working
for a law firm there while I was working through
my CFA exams, and then moved to San Francisco
to join Axle and for the past 3 years, I've
been working here in New York City.
Over the past couple of years at Merk, I've
been publishing on a regular basis, both business
cycle reports and US equity market reports.
That's evolved out of the internal research
meeting process that we have at Merk, very
heavy on data and on charts.
One of the things that I noticed over the
years of following sell side analysts and
the FinTwit community and any usual sources
that are out there is that you'd see these
really interesting charts and frameworks come
up but they might be cherry picked or it might
just be a confirmation bias thing where they're
trying to present a certain view.
Those charts were, I thought interesting and
worthwhile and so over the years, what I've
done is develop a chart library within Bloomberg
where I'll try to recreate the chart that
I see, number one, to confirm that that's
really what the data is saying, and then maybe
change the time horizon to make sure that
that time period isn't just selected to paint
a certain picture.
Then at this point, I've got thousands of
charts in that chart library, and I go through
them on a weekly basis.
Then for the published reports, I select what
I think are the most relevant charts and then
stick to a consistent set of charts that I
look at and analyze so that there is an intellectual
consistency to it.
It's the same data with the same frameworks,
month in, month out and then go through those
chart by chart, analyze them positives, negatives,
and then come up with an overall assessment
both for a short term outlook and a longer
term outlook.
This is an extremely challenging environment
to analyze in terms of the business cycle.
In my view, there's a lot of mixed data.
I'd say that recession risk is real, it's
elevated, it has not yet become my best case
scenario but I've estimated it to be between
30% and 45% chance of going into recession
over the next six months.
Keep in mind that the NBER that does the official
recordkeeping for recessions doesn't announce
the recession the month that it starts, it's
not a real time announcement.
It might take several months or a year later,
and then they'll look back and say, "Oh, the
recession started in December of 2007," as
was the case last time.
The idea is to have some real time indicators
to gauge whether we're likely heading into
recession.
I'd say the recession risk is as high as it's
been, certainly in the last couple of years,
I'd say even for this entire expansion and
one of the key reasons for that is that we've
finally gotten yield curve inversion.
Now, it's been on the 10-year versus the 3-month,
but pretty classic inversion pretty similar
to what we see historically, we did not have
inversion on the 2s 10s or the three stands.
In other words, looking at the 10-year yield
versus the 2-year yield or 3-year yield, and
I think that there are some important potential
reasons for that and implications for it.
One thing is that the way that the curve inverted
was actually with yields both on the short
end and the long end coming down.
It wasn't the classic situation where you
really had the Fed fighting inflation and
hiking above where the 10-year yield is and
that's why I think we never saw the 2-year
versus the 10-year invert or the 3-year versus
the 10-year invert, but we did get it on the
10-year, three-month.
In my opinion, just looking at the historical
data and historical pattern, that needs to
be respected, that needs to be taken seriously.
We do have the steepness now taking place,
the un-inversion, and some people are interpreting
that as a positive but it's not entirely clear,
at least not yet, in my view, because we do
historically see the steepness, the un-inversion
happening really leading up to the recessions.
Now, typically that's happening because the
Fed is cutting rates aggressively, which they
have done, at least to some extent, they've
cut three times.
In those situations where you've got the steepening
going into recession, you still usually have
the 10-year yield coming down.
Right now, what we've seen is short and rates
have stabilized and the 10-year has actually
started to move up a little bit.
To me, gauging whether this un-inversion,
the steepening that's taking place right now
is actually a positive sign for the economy,
it's going to be really important to watch
what happens with the US 10-year yield.
That keeps moving higher, if it moves above
two and we see that not just in the US, but
in Germany as well, I think that is a positive
sign that growth prospects are genuinely improving.
The inversion that we've seen so far could
be somewhat like the 1998 inversion where
it's a late cycle inversion, but it's not
the end of the cycle.
Then we get-- maybe the Fed stabilizes on
pause for a while, maybe they hike again before
the end of the cycle.
Something to really keep an eye on here, I
think, is the US 10-year yield with respect
to that inversion being a genuine indicator.
One of the indicators that I haven't seen
anybody else specifically look at is the New
York Fed puts out the quarterly household
debt survey.
The focus is always on the dollar value of
household debt.
I think that that is not that relevant.
It's, I think, taking things out of context.
The more important data point there is the
percentage of household debt that's delinquent.
That's been continuing to go down with the
exception of earlier this week, or maybe it
was late last week, we did see a notable uptick
there.
That's something to really keep an eye on
but up until my latest report, that had been
giving pretty much an all clear signal that
US household delinquency rates were reaching
cycle lows, and that survey data only goes
back to the very early 2000s or the late '90s.
You do see this moving average crossover,
if you want to look at it in that framework,
which I do in my report, you see that going
into the early 2000s recession, you see that
again, going into the late 2007 recession.
It actually is a pretty good leading indicator
because that crossover actually happened well
in advance of the beginning of the recession.
We have seen a notable uptick there.
Not yet crossover in terms of the moving averages
that I look at which is looking at the three
quarter versus the sixth quarter, but it's
I would say at this point, it's a neutral
to negative and that had been in the positive
camp before this latest data point.
In terms of other classic business cycle indicators
that aren't quite flagging recession risk,
at least not eminently are the LEIs.
We just got the new LEI data this month.
Year over year, we're still slightly positive.
Certainly, the trend has decelerated and if
that continues, we will go negative in the
coming months, but the LEIs year over year
is still positive.
That's been a really good indicator historically
that we haven't had recessions if on a year
over year basis, that is still positive.
That's still one that hasn't crossed over
yet into the negative.
The labor market, I know a lot of people say
that the labor market is a lagging indicator,
but there are a couple of frameworks that
I think you can use that are helpful for gauging
where we are with the labor market.
The initial claims, for example, we're seeing
some weakness in that trend but still not
seeing a recession warning out of the initial
claims.
This is one of good luck's favorites but the
US U3 unemployment rate versus its 12 month
moving average, we still haven't crossed over
there.
If you look at the backdrop for that unemployment
rate, we actually see the participation rate
making new multi-year highs which is generally
a positive for the economy.
A couple of data points that I look at with
regards to labor market slack, that are also
in the report is the number of people that
are on the disability roles.
I don't see a lot of focus on that so I think
that's something that might be something that
I focus on more than others.
We see that continuing to come down.
I think a lot of people went on to disability,
not necessarily for physical disability reasons
during the Great Recession, and are now coming
back into the labor force as labor market
improves, and as the demand for workers improves.
Coming back to the point about yield curve
inversion, the fact that we did not see the
2s, 10s invert, I think part of the reason
is because we haven't had that classic overshoot
of inflation that we get late cycle.
That's one reason to have a little bit of
pause about whether we're really going to
into a recession here is that you typically
see at the end of the cycle, inflation overshoots
the Fed's target so it's running well above
2%.
You see the Fed coming in to tighten, they
interact the yield curve, and then you roll
over into recession.
Oftentimes, I think historically, the dynamic
there is that why do you get that inflation
buildup because you've run out of slack in
the economy.
Whether that's capacity utilization, factories
are running at full capacity, and there's
pressure there, or whether it's labor inputs,
you've run out of slack in the labor market.
There are some signs on both of those fronts
that we have not exhausted the available slack.
That, to me, at least implies that this cycle
can continue for a while longer.
It's a very mixed picture.
I think the number of positives that you can
hang on to on this checklist of where we are
in whether we're headed into a recession and
what that risk is, is diminishing, because
now you've had for the first time in the cycle,
yield curve inversion so you've checked that
box.
LEIs are not negative yet year over year,
but they might be within the next few months.
We've got the manufacturing PMIs below 50
which is a good leading indicator, services
have remained above 50 and we'll see how that
develops.
Labor market still looks okay to me.
I think it still looks relatively strong.
If you look at the output gap, we are arguably
above our potential GDP, which is typically
a late cycle indicator.
That can persist for a number of years so
it's not a great short term timing indicator,
but it does indicate that we are probably
more towards the end of this cycle than the
beginning, which shouldn't be a surprise given
that we're 10- years into it, even though
I agree with the statement that's often made
that expansions don't die of old age.
We can't just say it's 10-years old, and therefore,
it's time to have a recession but certainly,
I would say we are late cycle.
The high yield spread, we're not seeing really
any signs of stress in the credit markets.
As I said, the household seems to be pretty
strong.
We've seen a lot of deleveraging of households
in this cycle.
There are number of indicators that I think
still point to the idea of this expansion
potentially continuing for a while longer,
I think it'll be key to watch what happens
with the 10-year yield and if we see a turnaround
in US and global manufacturing, where we've
had really, I think we've clearly observed
the brunt of this recent slowdown in that
sector and in those areas.
If we continue to see some further improvement
with the manufacturing PMIs in the US and
in Germany and some of the other big international
economies, that would be further indication
that we might weather this soft patch, and
that it might be like that 1998 period where
you get a few rate cuts.
The Fed supports things, you weather the soft
patch and the expansion continues.
It's often said, and I would agree, that the
equity market and the economy are different
things, and maybe that's best observed in
looking historically at the fact that you
can have bear markets outside of recessions
and you can also have recessions that don't
coincide with bear markets.
What we can know historically is that by far
the worst bear markets do coincide with recession.
The most recent one, which is probably weighs
heavily on people's minds, the 2008 bear market
and recession and the early 2000s, ahead of
recession, we had a big bear market then as
well.
Then the biggest one of all, 1929 and the
Great Depression.
It's important to note that there is a relationship,
but it's not a perfect one for one.
Moving over to the US equity market analysis,
I've remained generally positive on the equity
market.
For me, my unit of analysis is the S&P 500
and basically remaining positive has been
calling for the market to continue to make
new all-time highs, which we did again recently.
The business cycle analysis does make this
a little bit challenging because as I noted,
the recession risk in my view is elevated,
but it's not clear that we're rolling over
into imminent recession.
We have a number of other indicators that
we can look at to gauge where we are with
respect to the equity market.
There, in a similar way that I'm trying to
look at a checklist of indicators for the
business cycle, there's a checklist of indicators
for the equity market.
I'm asking the question, if we make new all-time
highs, does this look like it's historically
consistent with previous major market tops?
There's a range of both fundamental and technical
indicators to review when trying to answer
that question.
One of the things that's kept me positive
over the past couple of years on the equity
market is that the breadth has actually looked
pretty healthy.
The way that I look at breadth and I look
at a range of indicators, and I know that
they're even more than that people look at
and some of them are showing a couple signs
of concern even recently, but let me talk
about two or three that I think are relevant.
Every time that bull market makes a new all-time
high, I look at the percent of member companies
that are above their respective 200-day moving
averages.
Right now, we're still at a pretty healthy
level at 75%.
What you can see over time, as the bull market
ages, is that that percentage goes down as
the index keeps making new all-time highs.
The number of-- or the percentage of stocks
that are above their 200-day moving averages
is coming down and down.
There's a critical threshold level that I
have that's a classic, at least in my interpretation
of the historical data, a level that's a warning
level where I would say there's a real risk,
at least just judging by that indicator that
we're at a major market top and that's below
65% for at a new all-time high in the S&P
500.
We're below 65% in terms of the participation
as measured by member companies being above
their 200-day moving averages, that would
be cause for concern.
The other two indicators when the index makes
a new high is to say is the equally weighted
S&P 500 also making a new high because that
takes out the effect of market cap and that
has been confirming these new highs by also
making new highs.
The other one is the cumulative advance decline
line.
If that's making you all-time highs in lockstep
with the market, that's a generally healthy
sign.
If you start to get a divergence where the
market is making new highs, but the advanced
decline line is not, that's a concern that
you have potentially a major market tops.
Those are a few of the market breadth indicators
that I look at with respect to that question.
Earnings are definitely a factor and there
are a number of different ways to look at
to look at earnings.
The chart that I use is actually relatively
straightforward but it does an okay job historically,
which is to say is earnings per share on the
S&P 500 above its 12 month moving average
or not, if it dips below, that's signaling
an earnings recession.
You can have earnings recessions in the midst
of an ongoing bull market and we did in 2015-2016,
have a pretty pronounced earnings recession.
That was weathering and the bull market continued,
that right now is neutral, the negative I
would say.
We did just finish up, we're at the end of
Q3 earnings.
Apples to Apples on aggregate earnings were
basically down year over year 1%.
That is a little bit of a concern, certainly
probably a neutral to negative there, although,
perhaps more importantly on what's happening
with forward guidance.
It's a little bit of a mixed picture.
Earnings, I'd say in terms of fundamentals,
neutral to negative.
The other thing to keep in mind with fundamentals,
I suppose, is what can happen with the multiple.
Oftentimes people like to break down equity
market performance in terms of earnings growth,
and then multiple expansion or contraction.
In my view, the multiple can fluctuate far
more than what people think so a lot of times,
you'll hear forecasts are subdued because
of maybe the fact that earnings can only grow
a certain amount but I think the market can
actually fluctuate far more than that just
based on multiple expansion or contraction.
We do have yields at pretty low levels, which
would all else being equal, warrant higher
valuations.
Just a few weeks ago, we had the dividend
yield on the S&P 500 at 2% and the 30-year
US Treasury yield below 2%.
If you're asking yourself the question, what
would I rather own for the next 30 years?
Is it a US Treasury bond that's going to pay
me 2% nominally per year guaranteed?
Or should I take the risk and the volatility
of owning the basket of S&P 500 companies
that's probably going to have a dividend that
grows over time, and that's going to deliver
some capital gains as well?
I think the valuation question is to put in
the context of the available alternatives
that are out there, and this relates to that
ongoing discussion of TINA, there is no alternative,
and I realized that people can make a lot
of money in bonds with yield fluctuations
over six months or a year or shorter timeframes,
but if you're looking at it from the standpoint
of a buy and hold investor, I still think
there's a strong case to be long equities.
Some of the historical classic valuation indicators
do look like this as an overvalued market.
That indicator that you're referring to is
what I referred to as the Z1 indicator, which
looks at allocation to equities versus bonds
and rattle and it does correlate pretty well
with the forward 10-year returns.
Right now, if history is any guide, it's suggesting
a low single digits returns on the S&P that's
excluding dividends reinvested but as we were
just discussing, maybe that's not so bad when
you're only getting maybe 2% on treasuries.
It's possible that this low interest rate
environment is moving the benchmark for what
should be considered overvalued or undervalued.
I'm not going to go that far.
I think that it's warranted to be concerned
about these valuation levels and to respect
the historical analysis.
That does indicate that maybe we're at some
stretched valuations here and take that into
account.
Valuations aren't a great timing indicator
and so in my reports, I have a short term
time outlook, which is within the next six
months, and then a longer term outlook.
My longer term outlook is neutral to negative
because I do think that we are again, going
to have a bear market but really, I think
you could have another two years of economic
expansion and two more years in a bull market
that maybe you're 30% or 40% higher on the
S&P.
I know that sounds crazy, but historically,
it's not that unusual.
If you're going to have a bear market that's
maybe 30% to 50%, but it's only going to start
30% or 40% higher than current levels, I think
it's just you have to be careful about when
you really want to get defensive and how much
you want to try to time things.
I think there's also an argument to be made
that central banks are now really supportive
of equities here as well, arguably, many have
made this point, QE and in general, balance
sheet expansion of central banks has been
a driver for this bull market over the past
10-years.
Whether or not it's called QE or not in the
US, I don't think is really that important.
The point is that the balance sheet is expanding.
The Fed does grow its balance sheet in normal
times, if you look at the pre-QE era, the
pre-Global Financial Crisis era, and so it's
getting back to that dynamic of growing its
balance sheet.
If you chart the cumulative balance sheet
assets of the Fed and the ECB and the Bank
of Japan, it does look like it has a pretty
strong relationship to what's happening in
both US and global equity markets.
I think that that makes sense and what we
saw last year with the peak in equities in
October, early October of 2018, that actually
coincided with the peak in the cumulative
G3 central bank balance sheet assets and now,
what we've had happen is the-- because at
the time, the Fed was doing the quantitative
tightening, the ECB was tapering and then
ending QE at the end of last year.
Now, what we have is we have the Fed has wrapped
up quantitative tightening, they're expanding
the balance sheet again, ECB has now reintroduced
QE.
That overall total, and by the way, Japan
never left QE, so the overall total balance
sheet is now moving higher again and making
new all-time highs, which is consistent with
the equity market making new all-time highs.
That's something to keep track of that a lot
of people say, well, central banks are distorting
markets.
I just think you have to put it into your
analysis.
It's just part of the dynamics that move markets
so it has to be part of the analysis that
goes on when you think about what's happening
in this case with the equity market.
One of the things that I think is a little
bit near term concerning is we've seen sentiment
get pretty optimistic now with this breakout.
Looking back at the history, we're actually
not that inconsistent with where sentiment
was when we had the breakouts coming out of
the 2015-2016 market consolidation and the
2011-2012 market consolidation.
We broke out of those and had about a 46%
advance over about a 2-year period coming
out of that 2011-2012 consolidation, about
a 35% advance coming out of the 2015-2016
consolidation.
Pull back any day any week, of course, is
possible.
Advances won't be in a straight line, but
I think that least short term sentiments probably
a little bit overdone here.
The other thing that coming back to the point
about whether this looks consistent with a
major market top is to keep in mind what's
happening with, I guess, it's related to sentiment,
but I look at in terms of the uncertainty
index are the headlines, positive or negative,
is basically what that's looking at and the
headlines have been really negative.
A lot of fear has been out there.
There's been a lot of fear in the headlines
about trade war and about Brexit and about
Hong Kong and all these potentially concerning
geopolitical issues.
When you have that, it's typically not at
a major market top.
A major market top uncertainty is very low.
As the expression goes, if you wait for an
all clear signal, you'll buy at the top, you
actually need that fear to be out there.
You want that uncertainty there in order for
the market to continue to go higher.
Because the market needs that wall of worry
to be able to climb.
What would be concerning is if we had no fear
out there, the uncertainty index is very low,
sentiment is measured in the way I look at
it by the AAII survey of bulls and bears,
if that's at extreme readings, and you have
breadth deteriorating, then I think you've
got the right recipe for potentially a major
market top, but this market can likely continue
to push higher.
In my checklist summary, there are four indicators
that I look at that my frameworks are contrary.
One that's an obvious one is sentiment.
If everybody's bullish, that's actually a
time to be potentially cautious.
There, I look at the AAII bulls to bears,
and that's been a pretty good indicator to
use.
Another one that I use is margin debt.
I know a lot of people focus on the dollar
value of margin debt.
I think that's a little bit misleading.
It needs to be put into more context, if you
actually measure market debt relative to the
size of the market, we're not at extreme readings,
it does not look like a euphoric buildup of
margin debt or leveraged long positions in
the equity market.
It's not so much a positive as it is the absence
of a negative in looking at that one.
Then I have a framework for looking at correlation
and volatility.
The basic framework, which again is confirming,
is that when volatility is really high, and
that's measured as the realized volatility
trailing over the past year.
When correlations are really high, that's
actually a time to be potentially bullish
on the outlook, because the way that people
look at their portfolio risk is with trailing
portfolio standard deviation and the inputs
are volatility, the volatility of the components
and the correlation between those components.
Your portfolio is going to look extremely
risky when correlations are high and when
volatility is high.
That also means that there's a lot of room
for both to decline.
That's what we've seen in this bull market
that nine correlations were extremely high
and volatility was extremely high and they've
been able to fall for these past 10-years.
Now, right now, they're in the middle of the
long term range so the interpretation is neutral.
It's probably most relevant to look at that
when we're at extremes, either extreme lows
or extreme highs, but that's another contrarian
framework.
Then the third one is the uncertainty index,
which I just talked about a little bit and
that's basically trying to measure the wall
of worry, is there still a wall of worry here
left to decline?
If there's not, that's a concern, but if there
is still a lot of fear out there, that's actually
indicating that this market can potentially
continue to climb the wall of worry.
Those are the four contrarian frameworks that
I use.
Wrapping up in summary, both the business
cycle analysis and the equity market analysis,
starting with the business cycle, as I've
said in my reports, this is an extremely challenging
environment to analyze with a lot of mixed
signals.
Each data point matters.
I think, tonight, we've got preliminary PMI
figures coming out.
That's going to each data point that comes
in is going to continue to be relevant and
potentially move those odds of recession.
It's the odds of a recession, in my opinion,
are elevated and real, even though they're
not yet my best case scenario, which does
to some extent, complicate the equity market
analysis.
Looking at some of the sentiment indicators
longer term where we're coming from with this
choppy sideways period that we had for 21
months from the beginning of 2018 up until
the recent breakout where the market went
nowhere with a lot of drawdowns and a lot
of volatility, a lot of fear in this market,
I think that still says to me that this market
can push higher.
If we do see recovery in the US and global
manufacturing sector, which we very well might
see, then I think you could see this market
really continued to move higher.
That's something that I'm keeping in the back
of my mind, but I think every data point takes
on, I'd say renewed importance here, just
given where we are potentially in the business
cycle.
