By Teddy Vallee,
Looking out over the next six months, it is likely that equity markets face increasing headwinds. With the VIX just off the lowest levels since 1993, the unemployment rate at its lowest level since 2001, and the S&P pricing in both a 15% corporate tax rate and 15% earnings growth, the probabilities favor downside risk.
The envisioned downside catalyst/s will likely be a result of:
- The US labor market – which based on labor market breadth is signaling negative NFP prints towards the end of the year.
- The US consumer – who is tapped out on credit financed consumption and is now forced to repair his/her balance sheet.
- A slowdown in Chinese credit – which will likely further pressure commodities, and in turn the US industrial rebound.
Below is a summary of these topics and four trade ideas covered in a recent deck. If you’re on the buy/sell side and interested in the full deck, feel free to email me at [email protected].
US Labor Market
The market continues to misprice the strength of the US consumer due to the misleading nature of the unemployment rate, which fails to capture those that have left the labor force. This is apparent by backing into the current unemployment rate given average weekly earnings and discretionary consumption, as they indicate the real rate is closer to 6-7% versus the quoted rate of 4.3% today.
That said, the market is operating under the assumption that the labor market is very tight, which has led to a rise in average hourly earnings (AHE); however, this too is false due to the misinterpretation of AHE, as it is not a payment for a given unit of work or time, but a derived ratio from two separate BLS surveys.
The ratio is based on two principal inputs:
- Average weekly earnings – which is the aggregate amount of total weekly payments from an employer to its employees; and
- Average weekly hours – the total amount of hours that employers are reporting employees are working
With earnings flat, and hours declining, the ratio of average hourly earnings has recently been rising; however, total earnings are not moving higher. We can illustrate this point by the negative correlation between average hourly earnings and retail sales. This is to say that as consumers make more per hour they spend less, which is not the case for average weekly earnings, as it is positively correlated.
That said, looking out over the next 6-8 months, it is likely that participants change their view on the labor market, as its current breadth is indicating non-farm payrolls will turn negative in the next 6-8 months.
The Consumer
This slowdown in jobs growth is coming at a very precarious time for the consumer, as she is no longer able to finance spending or core living expenses with revolving credit due to rising delinquencies. Based on our indicators, we should see a continuation of trend in delinquencies over the next year, which will put downward pressure on consumption and likely forward EPS estimates.
The equity market is on the other side of the trade however, as EPS estimates are expected to grow by 10-15% primarily from energy and financials, which have been positively affected by the industrial rebound. This is set to fade as China slows.
China
In 2015, in response to slowing domestic growth, China enacted a $4.3T (39% of GDP) stimulus program that lasted roughly one year. The market missed a large portion of this due to its focus on total social financing, which fails to include credit to non-bank financial institutions and local government bond issuance – where the majority of the growth came from.
Given that the Chinese economy is industrially driven, the policy choice led to increased demand for commodities, which began to take shape in February 2016. We can see this by overlaying total Chinese credit creation y/y with the Bloomberg commodities index, which is also highly correlated to US industrial production and the ISM.
That said, total credit creation leads commodities and the industrial economy by roughly five to seven months and is indicating we should see a swift move lower into years end. This has recently begun to show up in commodities, as well as the Citi economic surprise index.
Technicals
With the probabilities favoring a fundamental deterioration over the next 6-8 months, the current technical picture is also showing some weakness, as the percentage of stocks below their 50 and 200 day moving averages have recently diverged from price. This is happening at a time when excess liquidity – or the dollars freely able to move into markets – has turned lower and participants are positioned aggressively long.
In addition, we have also seen multiple upside Demark exhaustions across the broader indices, as well as the top 10 performance constituents of the S&P, indicating the probabilities favor a move to the downside.
Four Trades
Given this thesis, there are four trades that are actionable today, shown below:
- Sell S&Ps [S&P 500]
- Buy TLT [Barclays 20+ Year Treasury Bond]
- Sell XRT [ S&P Retail ETF]
- Sell DBB [Powershares Base Metals ETF]
Good luck.
