I hate trading volatility -- its tough. And I even hate disclosing what vehicle I am trading, because these are such volatile and speculative products! Since some subs are pissed, I refuse to mention my speculative basket of stocks I consider to be worthless (you all should be able to guess, as I have mentioned many already in my Diary), I guess I have to acquiesce and detail my volatility plays. My principal vehicle is the leveraged exchange-traded fund, (TVIX) . I have also purchase short dated VIX (June 17 and July 22) 28, 29 and 30 calls.
I ended the day much shorter than I started the day.
Jay Powell presented a realistic and negative intermediate-term view of the domestic economy, which will be growing far more slowly than the consensus expects:
* The global economic issues are far deeper than can be solved by lower rates for longer. * The problems are not about the cost of capital. * There are significant structural problems and paradigm shifts that will serve as economic headwinds.
I have moved my short exposure from medium sized to large sized today.
I am long banks (more on today's weakness tomorrow) and the packaged foods space.
I am short (SPY) , (QQQ) , (AAPL) , (CAT) and a speculative basket of stocks I believe to be worthless. I consider my long volatility (VIX) position, taken this afternoon, as on the short side of the ledger.
I do want to add that the Fed included in this meeting their economic and rate projections out to 2022. I didn't initially write about it because it's really useless information as forecasting out past three months is hard enough.
That said, both the bond market and the stock market are picking up on the fact that the median forecast for the Fed funds rate is zero as far as the eye can see (thru 2022). The Fed seems intent on repeating the experiment of the seven year time frame at zero under Bernanke and Yellen, and what the BoJ and ECB have been conducting for many years.
This in addition to not pulling back at all their QE intentions.
Bottom Line
It was hard enough for the Fed to get the Fed funds rate from zero to 2.5% and shrink their balance sheet from about $4.5 trillion to $3.75 trillion a few years ago.
Now I'd argue that it will be almost impossible to get anywhere close to those levels in the many years to come even if they wanted to because of the even greater dependency the markets have on them.
The FOMC statement was about identical to the one seen in April. The only real change was the sentence: "Financial conditions have improved, in part reflecting policy measures to support the economy and the flow of credit to US households and businesses."
They continue to rationalize QE4 (although they haven't called it that yet) by saying it will help "sustain smooth market functioning."
I was aware of problems in the market back in March but certainly not now.
It is thus officially QE regardless of what the Fed wants to call it. This will continue according to the statement. With respect to the Fed funds rate, it will remain at zero "until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals."
Bottom Line
Nothing really new here but I do want to hear more from Chair Powell on the QE side as I'm not clear on what's being accomplished right now by an ever increasing size of their balance sheet. Reopening the economy and an eventual vaccine will do far more to help business activity and also without all the distortions.
My favorite quote I read in today's newspapers came from Peter Fisher, an ex U.S. Treasury and Federal Reserve official who said, "Because of the Fed's interventions, market prices and credit spreads don't have the information content that we think they have. The Fed is mucking up what prices mean."
There is no free lunch, but for now the Fed is paying for it.
An afternoon update - while traders continue to wait to see if Powell's comments affect the market, some internal divergences are arousing traders attention - is this going to be a significant milepost or merely another anonymous noise under the bed.
We hope to deal with that tomorrow after the Fed. But for the first time since the sharp multi-week rally, the market is showing divergences that draw a traders attention.
* We are just fixing broken windows right now - not seeding future growth * It is my view that a lot of earnings capacity is being removed from the economy by the virus and riots * A new Democratic Administration is highly likely - it will prioritize redistribution over growth * The markets are overextended and wholly dependent on the Fed stimulus and liquidity* However that stimuli - being used to stabilize businesses/the economy, employees' incomes - is not likely to provide much of a catalyst for the future growth dynamic * That federal largesse has countered the Covid-19 economic shock by serving to weigh small businesses and large corporations with even more debt - and that's a governor to growth * Meanwhile, paradigm shifts signal some permanence of job losses, a far slower than expected economic recovery and reduced economic potential and business "earnings power" * Watch Goldman's David Kostin solid interview on CNBC yesterday - he objectively weighs reward vs. risk in the markets and in his EPS forecasts for 2021-22
"The broken window fallacy was first expressed by the great French economist, Frederic Bastiat. Bastiat used the parable of a broken window to point out why destruction doesn't benefit the economy.
In Bastiat's tale, a man's son breaks a pane of glass, meaning the man will have to pay to replace it. The onlookers consider the situation and decide that the boy has actually done the community a service because his father will have to pay the glazier (window repair man) to replace the broken pane. The glazier will then presumably spend the extra money on something else, jump-starting the local economy. (For related reading, see Economics Basics.)
The onlookers come to believe that breaking windows stimulates the economy, but Bastiat points out that further analysis exposes the fallacy. By breaking the window, the man's son has reduced his father's disposable income, meaning his father will not be able purchase new shoes or some other luxury good. Thus, the broken window might help the glazier, but at the same time, it robs other industries and reduces the amount being spent on other goods. Moreover, replacing something that has already been purchased is a maintenance cost, rather than a purchase of truly new goods, and maintenance doesn't stimulate production. In short, Bastiat suggests that destruction - and its costs - don't pay in an economic sense.
The broken window fallacy is often used to discredit the idea that going to war stimulates a country's economy. As with the broken window, war causes resources and capital to be funneled out of industries that produce goods to industries that destroy things, leading to even more costs. According to this line of reasoning, the rebuilding that occurs after war is primarily maintenance costs, meaning that countries would be much better off not fighting at all.
The broken window fallacy also demonstrates the faulty conclusions of the onlookers; by only taking into consideration the man with the broken window and the glazier who must replace it, the crowd forgets about the missing third party (such as the shoe maker). In this sense, the fallacy comes from making a decision by looking only at the parties directly involved in the short term, rather than looking at all parties (directly and indirectly) involved in the short and long term."
- Investopedia, "The Broken Window Fallacy"
As Danielle DiMartino points out this morning, over 90% of the companies in the Russell Index are currently losing money and buying the Index is a bet on a sustained economic and profit rebound.
In "2020 is Looking Alot Like 1968..." I noted that the general expectations of a strong trajectory of growth in 2021-22 may be misplaced.
What has been lost in the recent bullish narrative - that there is so much liquidity to buoy domestic economic growth - is that most of the fiscal stimulus is being used to stabilize businesses/the economy, employees' incomes and not to provide much of a catalyst for the future growth dynamic.
Covid-19 was a gut wrenching blow to the U.S. economy.
From my 2020/1968 compare:
The Covid-19 induced shutdown revealed:
* How poorly managed so many of our public companies are. With little in the way of a "cushion" or safety net, many companies and industries were exposed as ill equipped to weather the abrupt downturn - many sought governmental relief. * How leveraged small, medium and even large businesses were. Reverse financial and operating leverage produced a remarkably quick drop in profits and margins. * How dependent private businesses and publicly held U.S. corporations (of all size) are on federal support.
The markets have responded to a huge free lunch being heaped out by the Federal Reserve - but free lunches cannot be a permanent condition.
Unfortunately, as we begin the month of June I have an increased amount of economic, profit and market concerns.
Will a growing sense of social and financial disorder and chaos - delivered by income/wealth inequalities, the economic and health consequences of Covid-19, the accumulation of unprecedented debt loads (in the private and public sectors) and the open wound of institutional racism - lead to a change in political leadership in November?
What will it mean for society, our economy and our markets?
Consensus Profit and Economic Expectations Are Too High
As night follows day, S&P profit and price expectations have risen with the rip your face rally and mother of all squeezes. I believe these expectations will prove wrong footed.
Indeed, reflecting the concerns expressed recently and in today's opening missive, I am reducing both my S&P 2020-22 EPS estimates and my calculation of "fair market value."
It is important to note that my 2020-22 S&P EPS estimates are substantially below consensus. As an example, my pal Thomas Lee expects 2021 S&P EPS of close to $190/share (or +50% above my forecasts) based on historically strong productivity and margin gains (I am looking for the exact opposite). One of us will be very right and the other will be very wrong.
I now believe that it will not be until 2023, at the earliest, that S&P EPS exceeds 2019 actual results (which were $165/share and $155/share - before buybacks).
The lynx-eyed Jim Bianco is calling for a 90% economic recovery - he might be too optimistic (as I am thinking 80% to 85%)!
Here are my new estimates:
S&P EPS Old (per share) New (per share): - 2020E $110 Sub $100 - 2021E $135 $125-$130 - 2022E $155 $145-$155
My new "fair market value" goes from 2800 to a range of 2700-2800 (the mid range is 18.25x estimated 2022 S&P EPS of approximately $150/share).
David Kostin's CNBC Appearance
Yesterday Goldman's David Kostin offered his projection that S&P earnings per share in 2021 will set a new record of $170/share. What is his S&P target at year end 2020? Only 3000, or about 7% below cash. David admitted to say the risks to profits are to the downside - reflecting valuation, tax policy and "momentum."
I don't believe we will even reach David's estimate by 2022, ergo my "fair market value" is 2750, minus 6% from David's forecast and about 13% below the current spot for the S&P. Watch the interview if you get a chance as David provides a balanced view and outlook - as he emphasizes the possible downside risks to his forecast.
Bottom Line
We are just fixing broken windows right now - not seeding future growth.
It is my view that a lot of earnings capacity is being removed from the economy by the virus and riots.
A new Democratic Administration is highly likely - it will prioritize redistribution over growth.
The markets are overextended and wholly dependent on Fed.
The actions by Treasury over the last two months will likely result in a restoration of business and economic stability - but not to a more productive U.S. economy.
The effect of adding even more debt on small businesses and large corporations will be a growth flattener.
I remain bearish as policy is just replacing the broken windows.
Ahead of the Fed today, I particularly want to hear about QE4 which two months ago was meant to 'improve the functioning of the US Treasury market' but today is still consisting of $20b per week of purchases even though the markets are seemingly working just fine. The same can be hopefully explained by Powell about buying corporate bonds which don't need the Fed's help. Just get rid of the Volcker Rule and allow banks to make markets again. Also what they have to say about the Main Street Lending Program will be most interesting as the Fed's balance sheet begins to take on a completely different complexion as 95% of loans banks will make to small and medium sized businesses will end up with the Fed. Lastly, I'm sure Jay Powell will get questions about yield curve control which I believe only helps debtor financing costs but at the expense of economic growth. Here is a chart on the very sharp increase in money supply growth (M2) engineered by the Fed. Jay Powell said a few weeks ago "We crossed a lot of red lines, that had not been crossed before...this is that situation in which you do that, and you figure it out afterward." Let's start hearing about the "afterward" now that the economy is reopening.
M2
The dollar index is now lower for the 10th day in the past 12 to a level no higher than it was 5 years ago and while its coincided with the jump higher in stocks (flight from perceived safety), one has to wonder if the exploding US budget deficit (approaching 20% of GDP in the current fiscal year) in the largest debtor nation in the world is finally having an impact.
DXY
The housing market continues to chug along notwithstanding the challenged economic environment as we continue to assume that people are decamping urban areas for the burbs. With the supply of existing homes still limited, new home sales could continue to improve. Purchase applications rose 5.3% w/o/w and are higher 12.7% y/o/y. Refi's finally bounced after a month of declines. They rose 11.4% w/o/w and are up 80% y/o/y.
China said aggregate financing in May totaled 3.19 Trillion yuan, a touch above the estimate of 3.1 Trillion with bank loans making up 1.48 Trillion of this, below the forecast of 1.6 Trillion. The May figure compares with 3.09 Trillion in April. There was a sharp increase in the level of local government bond issuance typically used for infrastructure projects. Money supply growth, as measured by M2, rose 11.1% y/o/y, in line with the pace of April and the quickest pace since late 2016. Bottom line, as seen everywhere, the liquidity spigot is on and debt continues to rise faster than GDP growth. The data came out after the Chinese markets closed. The Shanghai comp was lower by .4% while the H share index was higher by .2%.
China also reported its inflation data for May with both CPI and PPI coming in below expectations. PPI is seen as correlated to industrial profits while I'm always good with a lower cost of living for consumers but is perceived to be a reflection of softer demand.
Daily Affirmations With Dougie Kass: On My Pal Thomas Lee's S&P Forecasts
"I am going to write a good Diary on Real Money Pro today... and I am going to help people. Because I am good enough, I am smart enough and doggone it, people like me."
I Have Aggressively Shorted a Package of Speculative and Bankrupt Stocks
* I can not ignore this unusual shorting opportunity * Most should not follow this strategy because it involves a large amount of risk Over the last 24 hours I have shorted a package of what I view as highly speculative (some of which are essentially bankrupt companies' shares) - many of which have been actively pushed by Robinhood, other momentum players, some of our contributors and, even, commentators/panelists on Fin TV. The buyers of these companies have adopted Citigroup's (C) Prince infamous quote, "As long as the music is playing, you've got to get up and dance." By contrast I see an epic shorting opportunity - as measured in percentage terms. As a matter of my policy and under no condition will I reveal the names of the stocks I have shorted because my strategy is very risky and not appropriate for most. The strategy requires nerves of steel and enormous price discipline. It also requires a good prime broker that can borrow the shares! However, it should not be hard to deduce some of the names.
From Danielle DiMartino Booth on the Russell and corporate profitability trends:
Increased flexibility afforded the original Paycheck Protection Plan will provide small business a longer lifeline; still a majority of small businesses indicate cash reserves of less than six months with wholesale and retail trade sectors the most stretched
Small businesses hiring plans came off their lows but remain significantly below those expressed in February; even as quick-to-reopen states such as Arizona reactivate their emergency coronavirus plans, the reopening economy is evident in the nascent rebound
Small business hiring plans are highly correlated to the small-cap Russell 2000 Index, in which 90% of companies are in a loss position; caution is warranted if the economy suffers a setback and cannot regain its losses prior to the freshly extended PPP terms
The year was 1962. The location was a Warner Bros. Pictures soundstage where recordings for the soundtrack for the movie The Music Man were taking place. Broadway composer Meredith Willson wrote the music for the Robert Preston film that was nominated for six Academy Awards. Indeed, Best Musical Score was scored that year. But there was one song, also recorded and written by Willson, and sung by Preston, that was commissioned by President John F. Kennedy as part of the President's Council on Physical Fitness. If you are old enough, you were one of the lucky 1960s and 1970s schoolkids motivated to move with "Chicken Fat," played in your school's gymnasium during phys ed class (just ask QI's Dr. Gates).
The song, also known as "The Youth Fitness Song," stirred a generation of students to perform numerous acts of flexibility. Today, another flexibility act has been accomplished, the Paycheck Protection Program Flexibility Act (PPPFA) of 2020. On June 5, 2020, President Trump signed the PPPFA into law. It amends the Paycheck Protection Program (PPP) under the CARES Act to give borrowers more latitude as to how and when loan proceeds are spent while retaining the possibility of full forgiveness.
Key changes to the PPPFA include: reduction in mandatory payroll spending from 75% to 60%; boost to permissible non-payroll costs, like mortgage interest, rent and utilities, from 25% to 40%; covered period for loan forgiveness extended from 8 weeks after funding to the earlier of 24 weeks after loan origination or December 31, 2020; maturity date extended from two years to five years; borrowers may obtain both PPP loan forgiveness and utilize the payroll tax deferral outlined in the CARES Act; deadline to apply extended from June 30, 2020 to December 31, 2020 (that's correct, past Election Day).
The PPP's popularity was picked up by the Wall Street Journal/Vistage Small Business CEO Survey. Ninety percent of respondents to the May survey applied for the PPP; of those who applied, 87% received funds and 10% were approved and waiting for funds. Vistage noted that these programs help to forestall further damage to companies and employees, but most programs provide aid only on a one-time basis. To balance the short-term support offered by the PPP and other CARES Act provisions, 42% of small business CEOs reported plans to seek lines of credit from a local bank.
Small businesses should be encouraged by the additional flexibility, especially when it comes to cash flow. The Vistage survey indicated that more than half of small business CEOs (55%) have less than six months of cash reserves. The top left chart also illustrates this metric by industry. Four cyclical sectors stood out. Construction (53%) and manufacturing (54%) were close to the national figure, while a larger majority in the wholesale (65%) and retail (60%) trade sectors were in greater need of a lifeline. Extending the original PPP provides further runway to generate lift-off for recovery.
The National Federation of Independent Business (NFIB) expanded on the retail theme in its report heavily weighted by small business owners in the retail sector, who account for about a fifth of its survey. NFIB observed that policies to curb the spread of Covid-19 restricted the growth in retail sales, while also producing a major surge in income. NFIB Chief Economist Bill Dunkelberg explained that "consumers will have to feel safe about emerging from lockdown in order to spend the money which, in turn, will shape the pace of the recovery in employment."
On that note, after a record 20-point drop from February through April, the net percent of small businesses expecting to increase employment bounced off the bottom in May. Hiring plans rose seven points to a below-average level of +8; for context, February's hiring plans clocked in at +21. NFIB said the bounce was "driven in part by the forgiveness eligibility requirements for PPP and small business owners planning to re-hire workers as the economy is reopened and stay-at-home orders end."
The trend in hiring plans is illustrated in the right chart above against the performance of the small-cap benchmark Russell 2000 Index. Interestingly, the correlation between these two metrics over the twenty-year timeframe is a robust .67. The best fit in the QE era from 2008 to present is a one-month lag for the Russell 2000 that yields a correlation of .76.
Many small businesses won't have to play "Chicken Fat" on their turntables to get the flexibility they need to help weather a post-COVID economic environment. With luck, that will come from the PPPFA. Cautionary signals from Arizona reactivating its hospitals' coronavirus emergency plans and record Texas hospitalizations suggest vigilance in this space is warranted. For the moment, small investor pessimism is abating with the recovery in the Russell 2000 back to its early March levels. Staying long this index, in which 90% of its companies are sporting losses, is a bet on cash flows building a long enough bridge to a sustained recovery.
