Overview of last year +
As many of you know, or the ones who follow me on twitter / have read my more in depth write ups, I’m very bearish. My bearish tone manifested towards the end of 2014, as I had a tough time identifying anything attractive in the market. At the time, I was long names that were beaten up or had false narratives surrounding them – J.C. Penney for example – but began shorting individual names such as GoPro and Netsuite towards the end of 2015.
Throughout ‘15, I also gravitated toward marco oriented themes. After peeling back the layers, I found more and more shit the market was blatantly overlooking, likely due to the Fed’s accommodation and its conditioning on participant perceptions. From here I started shorting the S&P, primarily through options, and after feeling some pain for a few months following the markets stagnation, I was paid off in August, but flipped long via some near dated calls too soon and paid the price on August 24th. I was fortunate that my core shorts made up for most of the drawdown.
I sat out for the first leg of October’s rally and decided to dip back in on the short side via some OTM March puts. I got my face ripped from the second leg of the move from $202 – $210, but was very confident in my thesis, which gave me the conviction to hold the position. I added to it heavily after writing S&P ($2,100): The Perfect Short and was paid off in Jan and Feb. I feel the same way now.
Where I’m at now.
Recently, as many of you know, I completely missed this rally. I’ve been bearish and have been adding through both the options market and on the short side via SPY from $193 down (and now up), as well as via HYG (past week). I believe this rally was predicated on false hope that has been disproven.
The bounce off of $1,800 got its legs from a tweet out of a WSJ reporter stating the UAE was ready to cooperate on a production cut. The timing could not have been better, as it was just as the market was breaking through a significant level of support. Apparently, this was out the night before but in Arabic, so it should have already been in the price, but for some reason the next day at a serious inflection point it mattered to a larger degree.
The market subsequently shot higher and left many covering as no one knew for sure whether the story was true or not. We’ve seen this repetitive jawboning over the past few months to save the price of oil while no action has been taken.
The narrative tapped out like Conor McGregor on February 23rd when Al- Naimi, the Saudi Oil Minister, said there will be no productions cuts. Why? Because they don’t trust anyone. That was all you needed to hear. There will be no cuts going forward due to lack of trust. So the first leg of the rally was predicated on a production cut that did and will not manifest.
Since there has been such a strong correlation between crude and the SPX, I thought it would be important to look at what crude means for SPX fundamentals, see below.
Energy makes up 2.33% of $SPX operating earnings. Made up 9.72% in Dec '13 when oil was $100. Was 7.5% Dec '14 at $65 per barrel.
— Teddy Vallee (@TeddyVallee) March 3, 2016
After this false narrative blew up the market turned to the possibility of coordinated global stimulus out of the G-20. That also didn’t happen, but given price action in commodities and risk assets one could make the case otherwise.
But this wasn’t the only additional support for the move upward. On Feb 12th following the OPEC rumor, the Atlanta Fed released its GDPnow estimate, shown below. This was up from 1.2% two weeks earlier.
— Atlanta Fed (@AtlantaFed) February 12, 2016
This made little sense to me given the deterioration in the macro data.
So here we are, 11% off the lows on ‘hope’ that is more of a ‘nope’. Nothing is different today than it was on February 11th other than further deterioration in the macro data and declining forward estimates. Yes, crude and WTI are higher, but given cost per barrel and oil’s current percentage of SPX earnings, there is no change in the fundamental picture. If anything, analyst should start looking at the adverse effects on other companies such as airlines.
So let’s look at some truth, since it’s been very hard to find any over the past few weeks.
In my two previous posts on the SPX, I showed how ludicrous current SPX valuations are across every metric you can think of. Given that forward EPS have fallen materially and price has risen, multiples have only gotten worse.
With top lines contracting, companies have become accounting maestros, finding operating expenses to add back to boost non-gaap EPS, thus price targets. These include acquisition related expenses, legal settlement fees, stock based comp, and restructuring charges. Don’t be fooled by this horseshit.
Below you can see the material difference between gaap and non-gaap margins. The lighter blue line, that is moving in a straight line higher, is what analysts use to price the S&P. With these margin estimates, they see earnings growing at 8.39% next year. This forward estimate has come down over the past month and will continue to deflate as Wall Street realizes the economy is slowing materially. I’m looking for $96.5 in earnings for FY16, which I get from zero growth and netting out non-gaap addbacks, previously described. I break it down here if you would like more clarity.
After predicting ~4% growth in November of 2015, the Street is now looking for Q1 EPS to contract by 6.7%, according to FactSet. While I said in November that 4% growth was a long shot given the current trends, the Street is back at it looking for flat numbers in Q2 then a 5% pop in Q3 and a 9.2% ramp in Q4. I’m not sure what the fuck they are looking at here. The economy will likely worsen throughout FY16 given the trends below.
The most important piece of data we got over the past moth was Markit’s services PMI. The bull thesis primarily hinges on the service sector’s strength driving GDP growth, as it is 80% of the aggregate number. Well it contracted in February and has done a swan dive in 2016, shown below. While snowfall was mentioned, I would like to note that the weather has been spectacular this year for the service sector – warmer temperatures result in people going out and spending – so I’m not entirely sure what they’re talking about. The chart below shows Markit services versus US GDP. This would mean GDP is flat, negative, or trending below zero. This is a stark contrast to the Fake Lanta Fed’s GDPnow forecast, which is looking for 2.2% growth in Q1.
Here are the comments from Markit’s chief economist, Chris Williamson, on the survey:
“Business activity stagnated in February as malaise spread from the manufacturing sector to services. The Markit PMIs are signaling a stagnation of the economy in February, suggesting growth has deteriorated further since late last year.”
“Prices pressures are waning again in line with faltering demand. Average prices charged for goods and services are dropping once again, down for the first time in five months, as firms compete to win new business”
“Worse may be to come, as inflows of new business have slowed sharply, causing backlogs of work across both sectors to fall at the fastest rate seen since the 2008-9 financial crisis. Such weak demand suggests that business activity and price discounting look set to continue”
The drop in the restaurant index below is another indication that the services sector is slowing materially. It’s probably just weather though.
We are seeing the same thing in the manufacturing economy, which is already in a recession.
The trend is very apparent. Here’s more from Williamson:
“The February data add to signs of distress in the US manufacturing economy. Production and order book growth continues to worsen, led by falling exports. Jobs are being added at a slower pace and output prices are dropping at a rate not seen since mid-2012. “The deterioration in the manufacturing sector’s performance since mid-2014 has broadly tracked the dollar’s rise, which makes US goods more expensive in overseas markets and leads US consumers to favour cheaper imported goods. “With other headwinds including the downturn in the oil sector, heightened uncertainty due to financial market volatility, global growth worries and growing concerns about the presidential election, it’s no surprise that the manufacturing sector is facing its toughest period since the global financial crisis.”
And here are Williamson’s comments from the flash PMI:
“U.S. factories are reporting the worst business conditions for over three years. Every indicator from the flash PMI survey, from output, order books and exports to employment, inventories and prices, is flashing a warning light about the health of the manufacturing economy,”
So it is pretty evident from the data, and not my bias, that things are not improving. Some may point to the slight uptick that was still contractionary in the ISM manufacturing print, but I tend to use Markit, as they have a larger respondent base. The Street’s forecasts are completely oblivious to what is going on in the economy, which would mean price targets are materially inflated.
The Marco economy is clearly contracting at an alarming pace due to the slowdown in China and it is adverse effects on the rest of the world. Two days ago, we got data out of China showing that exports contracted at 25.4% (below). We are at levels seen during the financial crisis and the SPX is something like 5.5% away from all-time highs. There is something materially wrong with this picture.
The global slowdown is adversely affecting US exports, as shown below. The previous two times there was this large of a drawdown were in 2000 and 2008. 46% of SPX earnings are from abroad, so this trend n’est pas positive for the forward 8.4% earnings estimate. If we’re not in a recession, we’re pretty damn close to it, but please please tell me how many fucking jobs the economy added. Don’t forget to include the productivity of those jobs as well though. Great thanks.
Speaking of jobs. Here is the Federal Reserve’s labor market conditions index. Looks like things are fine.
There is so much fairy dust in the air it’s scary. What’s scarier is the amount of people who are bullish here. Look, long term I think the US is a power house, but what’s going on today is concerning. I tried to look at the bull argument the other day. I got eight lines in before saying ‘you gotta be kidding me.’ Global debt to GDP is 300%. 300%…..Acting like this is nothing is alarming. The market no longer has a means to price risk due to central bank manipulation.
What are they going to teach in school? There is $6.4 trillion of sovereign debt that carries a negative rate. How many text books will need to be reprinted to take into consideration negative interest rates?
It’s a services economy though and man are we creating a good amount of jobs.
I have been reading Jesse Livermore’s biography – The Boy Plunger – and have been very intrigued by these two paragraphs as they relate to the market today.
How great is that? I’m not saying that today is 1929, but what was going on then is happening today in relation to how people view the economy and the market’s multiple. A large factor of the 1929 crash was amount of margin debt taken on by participants. Jesse Felder had a good post on the 4th speaking to this and forward returns.
“There are only two prior occasions where margin debt-to-GDP rose above 2.5% and then fell to a 2-year low. Those were March of 2001 and October of 2008. Now it’s hard to glean anything from just two prior occurrences but they would suggest, at a minimum, that we are at risk of falling into another major bear market if we haven’t done so already.”
Those that have read my previous posts know I have been following an analog form 2001 due to the similarities in P/EBITDA, debt/assets, love for tech, and material increases in debt and cash flow deficits. The chart above further adds another element of similarity and below I provide the analog as of todays close. Seat belts please.
I also decided to go ahead and look at 2008 since everyone and their brother doesn’t think it’s 2008. Here if the first longer term analog. Take from this what you will, I’m just here giving you the evidence.
Here is a zoomed in analog from August to today’s close. There is an 82% correlation between the two time periods.
“What has happened in the past will happen again, and again, and again. This is because human nature does not change, and it is human emotion, solidly build into human nature that always gets in the way of human intelligence. Of this I am sure.” – Jesse Livermore
The Federal Reserve has created a monster that they no longer know how to deal with. The only way to save face is through intervention, which only works for so long. Due to liquidity issues in the market, when the time to sell comes, things will be far worse than August or the beginning of this year. I think that time is around the corner and am currently positioned for such a move. Good luck and look forward to your input.