I will have some expanded later thoughts tomorrow as I have a research call now.

Thanks for reading and enjoy the evening.

Macro Strategy - Brief market thought in initial swoon

The market has been correcting for a while now, but the widely followed market indices, driven by the mega-cap Info Tech stocks, have masked it.

It looks like a pretty on the back of increased fear of a sharp increase in global coronavirus cases outside of China and a big Sanders win in the Nevada primary. 

This could be the correction and opportunity we have been waiting for. I am on a flight, but will be updating our four key tactical indicators later this evening. Absent a stunning turnaround, our more sensitive two - the VIX and percentage of S&P 500 (SPX) components above their 10- and 50-day moving averages - appear likely to reach the required oversold level.

Typically what happens on swoons like this is that there is a temporary bounce (likely Tuesday or Wednesday) followed by a move back to/or through the low. That will likely be the time we want to get more offensively positioned. For now, we are staying out of the way, with the intention to act swiftly when appropriate.

Remember, corrections only feel natural, normal, and healthy until you are actually in one. We went market and sector neutral on January 20 in anticipation of one, and when fear is really pervasive (not yet), our core fundamental thesis backed by credit should allow us to take advantage of it. 

At some point the 200 day moving average may be tested.

Today was a jolt to the capital markets.

To me it was a clear indication that for some time risk has been underpriced.

From Mikey:

badgolfer22

ok, let me summarize mr. market's view of things as of right now looking at the new low ..or nearly new low list. We're never gonna A. drive our cars again with gas, heat our homes with natgas or oil. B. take a plane flight anywhere..especially to take a cruise. C. never stay in a hotel again. D. never cruise again. E. never drink budweiser or miller again...or eat Heinz ketchup again. F. never go into a physical store again..except for Home depot, lowe's walmart, target, costco and kroger.

I will be out at a business luncheon (doing more research) from about 1:00-2:30 pm.

The three month 10 year spread is the most inverted since last October:

The correlation between 7-10 year Treasuries and the S&P has fallen with the outbreak of coronavirus:

In gross and net terms, I am as liquid as I have been in several years.

* Blame free trades on the current speculative fervor?

* E*Trade and the new investing game.

* Has the market been rigged?

At or right after the opening I covered the following trading shorts: (BX) , (KKR) , (CAT) and (TROW) .

Peter is looking forward to spring:


Spring time can't come soon enough to put a test to ending this virus or at least slowing it down in its spread. As for markets, the buy on the dip mentality is about to be tested again but let's be honest people, the buy the dip over the past few weeks was quite amazing and reflecting a lot of self confidence in light of a continued fall in bond yields and with no signs whatsoever that the virus was anywhere close to being contained.

I believe part of this mentality and its persistence is the continued widespread belief that whatever challenges come our way, central bank easing will save the day. I have to opine again that please don't rely on it anymore with rates already so low and so much ammunition already expended. Also, I hear it all the time the argument that the average P/E ratio should be higher because rates are so low. It makes perfect sense if all else is equal but a large reason for the very low rates is because economic activity, earnings and cash flow growth are slow and slowing further. That is a major offset to the low rate argument. Just look at the Nikkei over the past 30 years in light of very low rates and all that QE.

And with respect to central bankers, listening to them certainly doesn't engender any confidence. Listening to Lael Brainard on Friday talk about wanting to drive inflation higher, implementing yield curve control and acting bold quickly made me feel like I'm listening to a member of the Bank of Japan. With all due respect to Brainard, these are strategies that are tired and have failed, just look around. And is the "persistent undershooting of the inflation target, and the risk to inflation expectations" really a bad thing when 40% of the US population may need to use credit to cover an expense of more than $400?

Bank of Japan Governor Kuroda yesterday said with a straight face that in the face of the economic impact of the virus spread "we will be well-prepared to act when we need to act." He would sound more credible if he just said "there is nothing we can do" to fight a virus induced economic slowdown.

The investing reaction to hearing Brainard and Kuroda is to own gold and silver (my favorite right now).

GOLD


SILVER

The US 10 yr yield is now testing its summer of 2016 yield lows right after the UK Brexit vote.

While we can throw out the economic data as long as this virus keeps spreading, I'll report some anyway. The February German IFO business climate index held in at 96.1 vs 96 in January. The estimate was 95.3. The expectations component rose a touch offsetting a slight drop in the current assessment. IFO said "The German economy seems unaffected by developments surrounding the coronvirus." At least not yet.

GERMAN IFO

* Risk happens fast - as we now take the elevator down
* At 4:45 am S&P futures were -90 and Nasdaq futures were -315 handles
* Market structure - in which the majority of products and strategies are bullish and lie on "the same side of the boat" - has introduced the sort of risks we last experienced in October, 1987 when 'Portfolio Insurance' was the rage
* Vast changes in market structure have also a firewall and have introduced the rising risk of spontaneous selling and additional "Flash Crashes"
* The impact of an outside and unexpected force that no one projected six months ago (e.g., coronavirus) could push the market lower - possibly exacerbated by the risks and uncertainties associated with an interconnected and flat world and the dominance of ETFs and risk parity
* Lower interest rates don't cure viruses
* Coronavirus, unlike many other headwinds (valuation, economic growth), is not impacted by central bank policy
* Global QE is losing its effectiveness - it's yesterday's news (the market discounts the future not the past)
* As is typical in mature bull markets, many have taken their collective guards down - buying speculative stocks (many of which are losing large sums of money) simply because these "shiny objects" were advancing in price
* The steady and relentless climb in stock prices has caused me to question how long and how far deteriorating fundamentals and historically high valuations can coexist
* Downside risk dwarfs upside reward - by my calculus there is limited "margin of safety" at today's prices

"As previously noted, there are some positions I take that I don't discuss in my Diary as they might be too speculative, are sometimes based on "gut feel" (and on four decades of experience in assessing stages of a stock market cycle), insufficient information for a full analysis and for other reasons. Like many subscribers and contributors on Real Money Pro I even trade for a very quick buck (over a short time frame of as little as sixty minutes), as many will be surprised, based on looking at a stock chart! That approach to me, is more of a "shot" and doesn't differentiate my product (and I leave it to the technically oriented professionals like Bob Lang or Rev Shark) -- so I typically refrain from discussing these sort of trades as they are really out of my skill set.

In today'sSubscriber Comment of the Day my pal Mikey and I got into a (trading) style discussion. What Mikey doesn't write but should know is that, again, I do trade speculative stocks (both long and short) just like him but I have chosen not to disclose some of these for the reasons I just mentioned. (Unfortunately, as we learned this week with ViacomCBS (VIAC) it's hard enough to get it right with "thorough" fundamental analysis -- incomplete analysis or gut feel raises risks that I don't want to put on subscribers who deserve my full fundamental treatment.)"
- Kass Diary, Restating the Objectives of My Diary

Last week's market decline and this morning's spectacular drop in stock futures should remind investors that it is not necessarily a price target (unusual "call activity" or a nice looking stock chart) that should be the sole determinant of our trades, investments and portfolio structure.

Rather, it is the calculation and assessment of the risks and probabilities associated with (fundamental and/or technical) outcomes that should account for our market actions and portfolio positioning in order to determine whether today's share price of an individual security offers sensible value.

Many traders and investors too often ask the question as what is the market's upside or what is the price target of Tesla's (TSLA) shares (or that of other stocks) - failing to ask an equally important question as to what is the downside risk of Tesla's share price (or that of other stocks) and what are the associated probabilities of both outcomes.

To us fundamentalists, it underscores the importance of "margin of safety" which lies at the epicenter of analysis embraced by practitioners like Warren Buffett and forms the basis for modern Security Analysis promulgated by Ben Graham and David Dodd.

It is my assessment of downside risk vs. upside reward and the absence of "margin of safety" which contributed to the comments about an observed greater recent tendency of trading in speculative, highly-conceptualized stocks above (and that I wrote on Friday). As we will likely learn (again) today (and did last Friday), chasing the latest iteration of "shiny objects" can also yield losses. Trading these stocks are made more difficult by our inability to value them as they decline (much like in 2000 as the dot.com area implode). Many lost fortunes buying the 2000-01 weakness because speculatively induced behavior which artificially inflated those "shiny objects" almost never (with few exceptions) produced value and future share price gains.

I simply don't buy the concept (at least for me) of buying speculative stocks (many of which are overvalued and are simply made popular by the interest of the trading community) in the belief that one will "know" when (and will most certainly) get out before the inevitable collapse. History is a bad precedent to hold that view!

Let's now delve into the proximate cause for the market's schmeissing this morning, the coronavirus:

The Coronavirus Differs From Other Market Headwinds

* The impact of coronavirus on the supply chain and on demand has been underestimated
* The coronavirus can not be "cured" by the injection of central bank liquidity
* The coronavirus will likely move global economic growth to "stall speed" or less in 2020

It is important to recognize that the big difference between the depth of the potential (disruptive impact of the) coronavirus vs. other issues (valuation, lack of earnings growth, sluggish global economies, political/policy uncertainty, etc.) is that the coronavirus can not be "cured" by central bankers. Moreover, the length and breadth of the disruption is unknown.

Basically, the coronavirus is a fundamental and unknown shock to the global economy - especially to China which appears to be virtually paralyzed by the possible contagion.

And the coronavirus will not be alleviated by the injection of central bank liquidity (as China did a week ago).

Which gets me to my Thursday column, Irrational Exuberance which made the case that the rise in financial asset prices has increasingly decoupled from the weakening fundamentals of the real economy and that the predictable spigot of central bank liquidity has encouraged excessive risk taking (and has contributed to too high valuations), raising corporate incentives to over borrow and over engineer. Stated simply, the steady and relentless climb in stock prices has caused me to question how long and how far deteriorating fundamentals and historically high valuations can coexist:

Slowing Data as the Impact of QE Diminishes

There is now evidence of a clean sweep of the data in terms of the limiting effect (and diminishing return) of QE on real global economies:

*As far as the Eurozone is concerned, five years of negative nominal interest rates and a renewed €20 billion ($22 billion) monthly asset purchase program has yielded nothing in the way of tangible results. Eurozone economic and inflation data remain moribund, as fourth quarter GDP grew 0.9% from a year ago, its weakest since 2013, while CPI inflation has averaged just 1.2% year-over-year in the last 12 months.

* Japanese GDP has been a source of continued disappointment.

* Low rates have gutted the Japanese and European banking industry. Japanese banks are -90% from highs and the Euro bank index is trading below its 2009 level.

My strong view is QE and QE plus (negative rates, central banks buying equities) have been counterproductive, for a number of reasons - including the reason that its numbing effect takes pressure off politicians to make structural change. Though I cannot prove I am right, central bankers who believe QE and QE plus have been helpful, also cannot prove they are right. But the evidence favors me more than them. In fact there is no real world data that shows QE has helped, only hypothetical self-justifying analysis from the same Central Bankers whose programs resulted in missed GDP forecast after missed GDP forecast:

* Every major economy that has embarked on QE or QE plus (negative rates, central banks buying equities) including the U.S. has MISSED the forecasts that were put in place for the improvement those initiatives were meant to garner

* The only economy that saw any bump while this stuff was going on was the U.S., and just recently, only AFTER the last batch of QE ended and prior to the recent batch of QE started. That bump was due to a set of very different economic and structural policies that were put in place with a new administration. In fact the economic bump to the real underlying economy happened as liquidity was being withdrawn and rates were being increased. Goes back to my point yesterday that fiscal and structural policy is really where the focus should be, and central bankers should show more discipline with regard to trying to plug holes the other side of the house should be addressing. I am not trying to make any arguments as to whether the new policy set is good or bad, just stating the obvious that there was a change, and it has created a short term bump at a minimum.

* Not one country where QE was implemented has made any real structural reform, with the exception of the U.S. per above point, due to a radically different administration. Maybe if Japan and Europe didn't put all their eggs in the financial engineering basket and focused more on structural reform, their economies would be better off.

* In every country where QE was implemented, including the U.S., since these programs were implemented, measures of societal well being have plummeted. GDP does not proxy everything. It does not tell you how people feel. Across the U.S. and Europe, social/political tension is through the roof. A fair portion of that is due to the hyper wealth gap that has emerged, and QE has a lot to do with this. For all intents and purposes the rich (with large balance sheets) got richer from asset appreciation, the super rich got so much super richer that it even pissed off the normal rich, and the poor made little to no progress.

(1) If a side effect of QE is that due to push back against the super wealthy, investors must ask that if Senator Bernie Sanders becomes president, how will Democratic Socialism make the U.S. better off?

(2) Would the Central Bankers then put MMT (modern monetary theory) in place to fund giveaways of everything, which would for all intents and purposes make everyone equally poor as it is toxic central banking policy on top of toxic economic policy?

In the face of all of this, any admission from Central Bankers that maybe they have been wrong and misguided? Nope. Their view is we just need to do more.

As an example, Janet Yellen was out yesterday with this little nugget (hey Janet you been paying attention to Japan and Europe???) - h/t Zerohedge:

"It could be useful to be able to intervene directly in assets where the prices have a more direct link to spending decisions," she said, adding that buying equities and corporate bonds could have costs and benefits. Keep in mind that what Yellen said was merely a paraphrase of Ben Bernanke's famous April 2010 WaPo oped in which he defended easy monetary policy is facilitating higher stock prices, which would "boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion."Of course, none of this "trickle-down" ever happened, and instead what did happen is that the top 10% of US society who own 93% of all equities got fantastically rich...while the bottom 90% who own virtually no stocks and owe most of the debt, got very, very angry as they watched how the Fed plundered their future and hopes to become wealthy, and resulted first in the election of Trump, and the upcoming election of a socialist candidate as America goes full-on populist in response to the Fed's catastrophic policies."

This is all absurd. Although I am not in favor of what I am about to recommend, if it comes to this rather than relying on very blunt and very indirect transmission mechanism that seems to disproportionately benefit the wealthy, wouldn't it just be easier and more direct to send money directly to those most in need? Ergo the poor and not the rich? Or a payroll tax reduction or other things of that nature?

And if the politicians fail at this stuff, in come the central bankers right away, and the politicians never do what they should do. And at the end of the day we are worse off for it.

My Solution

I wish there was a Supreme Court for Central Bankers.

When the U.S. Fed and Fed Mandate was put in place, something tells me it was never the intent of the founders of the mandate that it would be taken this far. By the same token, if Central Bankers lived in the real world where performance is measured against plan, they would have all been fired long ago. These guys get to fail, and just do more. Quite the job description!

That said, there is one aspect of QE I am comfortable with. That is the portion of QE1 that was specific only to the bailout of the U.S. financial system. Fed balance sheet shenanigans beyond that, not good.

The lender of last resort role of the Federal Reserve is an important one. There are many bright people that argue that should be the only role of the Fed. Rates and everything else can be handled by free markets. Some bright people even argue the Fed should not have bailed out the financial system (certain large banks) and let the system fend for itself. They may be right, but in my view that is a bet you cannot afford to take, because if you get it wrong, the consequences could be dreadful. The mere act of only serving as a lender of last resort alone, and then stopping there, I think does not have much in the way of adverse consequences. Sure there are some (like people in banks continuing to believe they can lend with no regard to risk), but there are other careful regulatory ways of dealing with that issue.

I have also referenced the notion that fiscal and structural policy are more effective at dealing with many of the problems modern economies are facing. What I neglected to mention is that capitalism itself was always an effective way of dealing with these issues. Cycles, while painful in the downcycle, really do cleanse the system. The U.S. became the best and most powerful economy in the history of the world while going through periods of sharp downcycles.

With QE, there are no longer cycles. Interest rate suppression is a powerful numbing agent. I am not sure why the Federal Reserve believes it is important to remove cycles from the economy. There seems to be a pathological focus on never having a recession. By definition, that is no longer capitalism. I am not sure what it is, but it seems to have elements of a planned economy and is as close to communism as it is capitalism. I know Central Bankers have models that suggest GDP and trendline employment is better when there are no cycles (their models suggest strong upcycle does not make up for downcycle), but all the actual data shows otherwise. QE seems to certainly reduce volatility, but the data shows trendline growth has also been halved in recent years, and GDP is not too far from zero in the economies that have implemented QE and QE plus absent structural change. All sorts of excuses for this, secular stagnation, etc. How about every major economy has embarked on QE, prevented recessions, taken volatility out of the system, but at the expense of sharp recoveries and healthy growth, like we used to have!

And Back to Reality and the Bottom Line

Speaking of the numbing effect on volatility, there is a major virus outbreak the likes of which has not been seen in our lifetimes, volatility sits near lows, and financial markets are at highs.

We have a numb economy. That is what QE gets you. And that is the best case assuming nothing eventually blows up due to all the imbalances that are created in the process or the wealth disparity that has emerged does not cause massive social upheaval.

All problems cannot be solved with monetary policy. When you try to do that, there are real negative and unintended and unknown consequences. Most of the change needs to come from governments themselves (elected officials as opposed to unelected ones) and from the natural mechanism of capitalism itself.

Tactics

Throughout the last several months there were few souls (save the Perma Bears) that expressed the notion that there was outsized risks associated with a meaningful market drawdown as The Bull Market in Complacency and higher stock prices had a way of numbing investors to the possibility of any real market risk -- changing sentiment dramatically from the depths of December, 2018, almost eliminating skepticism and doubt over the last 15 months.

But, risk happens fast as we often take the staircase up in stock prices and the elevator down at the point of time in which investors are only look up (and not down).

I see a plethora and growing list of substantive headwinds - many of which have been heretofore ignored by those that worship at the altar of price momentum. (Near the top of the growing list is that the Fed "is pushing on a string.")

In the last few weeks I have aggressively sold many of my long holdings that experienced large gains and reached my year end 2020 price targets (eg, Goldman Sachs (GS) , Facebook FB , Twitter (TWTR) , etc.) - some of which I want to buy back on weakness at lower prices than Friday's close.

As I have written, even my most favorite stocks (Bank of America (BAC) , Citigroup (C) , Amazon (AMZN) and Alphabet (GOOGL) - all of which I have reduced ) seem vulnerable to a sharp selloff - though I favor them, too, over the intermediate- to longer-term.

Though this morning (in a flight to safety) interest rates have moved back towards generational lows in June, 2016 -- I reject the notion of TINA ("there is no alternative"), preferring CITA ("cash is the alternative"). At the same time I recognize that the level of interest rates is a core determinant to the value of equities (as it is integral to stock valuation models - discounted cash flow, etc.). However, I don't think the current level of interest rates is anywhere near a permanent condition - actually my view is just the opposite.

Reaching for yield, a condition that has existed in the last several years (just look at credit spreads) rarely ends well. I don't expect the consequences to be different this time - especially in light of the size of the U.S. deficit and the rise in the national debt.

Let me conclude by saying that I recognize the validity and depth of meaning of this terrific quote by my pal, the iconic Byron Wien:

"Disasters have a way of not happening."

Nevertheless, in light of the above factors, a relatively large level of cash reserves seems to be an appropriate strategy.

I am following my Diary's pen (and eating my own cooking) with that strategy.

More from Danielle DiMartino Booth:

• Evident in the 80% of its 2019 GDP attributable to net exports, Mexico's economy has been buoyed by trade; because the country is in recession, its dependence on Chinese imports and close U.S. supply chain ties mean its manufacturing economy is not immune to Coronavirus
• Mexican President Andrés Manuel López Obrador's (AMLO's) aggressive social spending at the cost of needed infrastructure improvements have exacerbated the trade war fallout; resentment surrounding USMCA concessions will compound the collapse in capital investment even as the drug war rages on
• AMLO has alienated global energy players by shutting out foreign participation in a corrupt and neglected sector starved for investment; the cancellation of an international conference in Cancun due to the Coronavirus reveals a risk to Mexico's massive tourism economy

Sometimes history's sequel bests the original. Consider this earliest known etymology of a phrase you'll recognize via John Wycliffe circa 1340: "How should God approve that you rob Peter and give this robbery to Paul in the name of Christ?" We prefer the 1540 version. London's St. Paul's Cathedral was taxed to convert Rome's St. Peter's Church into the Basilica it is today. In the interim, St. Paul's fell into disrepair, triggering fresh taxes on British estates. Paul was robbed to pay for Peter.

Mexico's President's Andres Manuel López Obrador, or "AMLO," as he's known, is doing something much more straightforward. He's fleecing the rich, not with new taxes but rather by a more coercive means to compensate for a political stunt run awry. While campaigning, AMLO vowed to sell the presidential plane for which his predecessor, Enrique Peña Nieto, had paid $200 million. Setting a fire sale price of $130 million, AMLO proceeded to instead rack up $1.5 million in maintenance costs as the plane lingered on a U.S. airstrip for a year finding no buyers. The solution? Raffle off the plane! To kick off the festivities, he "invited" (read: summoned) 75 of Mexico's business leaders to dine at the National Palace where they were handed forms with check boxes to commit between $1 to $10 million.

AMLO has lost sight of the forest. The $80 million "raised" from the business leaders to pay for medical equipment and continued plane maintenance is a fraction of the $84 billion Mexico imported from China in 2018. The president's focus right now should be the supply shock to his country given it only exported $7 billion to China.

Let's keep this in context. Mexico imported nearly $346 billion from the United States last year and exported $265 billion to its largest trading partner north of its border. It's a symbiotic relationship and one of the reasons Mexico's GDP didn't collapse last year with 80% of its GDP attributable to net exports and the remaining 20% to consumption.

In theory, with not one Coronavirus case, Mexico's economy should be relatively shielded. But today's chart suggests the country is indeed at risk given its trade dependence and being in a slight recession as a pre-virus starting point. Mexican GDP fell to -0.1% in 2019 from 2.1% in 2018.

Since AMLO took office December 1, 2018, his energies have been directed at continuing to curry favor with the masses who put him in office. The enigmatic leader conducts daily press conferences and focuses on side shows such as the raffle. But in the name of eradicating corruption and building a social safety net, he's also nixed infrastructure projects and cut ties to foreign investment in energy, even as Pemex production declines, that could have raised the country's competitiveness and fortified its long-term economic prospects.

To be sure, the social programs aimed at correcting deep income inequality -- from scholarships, pensions and small business price supports to raising the minimum wage, healthcare initiatives and launching a public telecommunications company to open internet access -- have been popular.

But AMLO's battle with Corporate Mexico has come at a steeper price than the cost to fund the laundry list of subsidies. Capital investment has collapsed. And the drug war ravaging the country has escalated.

Adding insult to injury, the recently signed United States Mexico Canada Agreement provided last-minute concessions to U.S. Democrats and unions. In the words of AFL-CIO President Richard Trumka: "For the first time, there truly will be enforceable labor standards," including "inspections of factories and facilities that are not living up to their obligations."These "labor standards" in Mexico will be "enforced," in part, by Americans, which many in Mexico say violates its sovereignty.

One can only imagine how much more resentment will build among Mexico's biggest manufacturers. More than a fifth of the country's intermediate products are sourced from China. This, combined with the virus-triggered U.S. supply chain disruption, means that the red line above - China's collapsing CKGSB Business Conditions Index - will bleed through to Mexico's trade economy and pull down its stock market. Mexico's factory sector will not be immune to the Coronavirus.

As for that plane, the government hopes to bring in a total of $150 million in tickets, which will begin to be issued in late February for a September drawing. Perhaps the amusement will distract the country from a deepening recession and a threat to its massive tourism industry. Due to the Coronavirus, the Internet Corporation for Assigned Names and Numbers (ICANN) just cancelled its ICANN67 Public Meeting which was to be held in Cancún next week. The event normally attracts thousands of attendees from more than 150 countries. In the case of permanently lost tourism revenues, Peter cannot be robbed. Paul cannot be paid.