Ever wonder what folks were thinking in 1929 before “the big one” blew up? Just look around at what’s happening now, and you’ll get a pretty good idea.
Then, like now, a mania had set in as Federal Reserve bond buying had lulled investors into a false sense of security. Things like fundamentals stopped mattering. Things like unsustainable optimism, record margin debt and growing income/wealth inequality didn’t matter either.
Deutsche Bank, by looking at the S&P 500’s price-to-earnings ratio and the CBOE Volatility Index, has this market deep into mania territory — above the heights of complacency seen in 2007, 2000, and the early 1990s.
The question is: How long will this last?
It’s all about expectations. For the bulls, the conventional wisdom is that the economy will grow at a 3% annual rate, inflation will remain low, central banks will keep the spigots of cheap money flowing, and corporate earnings growth (fueled mainly by debt-funded stock buybacks) will keep rising.
If anything disrupts this outlook, the fever dream will break because the hurdles have been set so high.
Already, after dropping at a 1% annualized rate in the first quarter, the economy is hitting the skids again. The Citigroup Economic Surprise Index, which measures where the economic data is coming in vs. analyst expectations, has hooked down again and has spent most of 2014 in negative territory.
What about earnings?
The Street is looking for year-over-year earnings growth of 5.4% in Q2, up from 2.1% in Q1, before accelerating to 9.7% in Q3 and 10.3% in Q4. That 10.3% figure is actually an improvement from the 9.9% expected at the start of the year. And according to Bank of America Merrill Lynch, analysts are now making more positive revisions to earnings than negative ones for the first time in two years.
That’s probably not going to happen as the share buyback frenzy is nearing the end of the road. As companies accumulate more and more debt — which they’ve used to juice earnings per share and thus their share prices via debt-funded buybacks — they are increasing their operational leverage. This represents how sensitive their earnings are to changes in revenue and costs.
The chart above tells the story. The surge of debt, like the rise of mortgage debt during the housing bubble, hasn’t mattered yet because CEOs have been able to absorb the debt through record profits. But if profits come under pressure, it’ll be game over.
This could come from either a drop in revenues (which have been fairly lackluster throughout the recovery) or an increase in costs.
As for revenues, U.S. consumers still are responsible for roughly two-thirds of the economy. And they’re not exactly showing signs of strength lately as food and fuel inflation bite. Just look at the deterioration in clothing sales shown above. We’ll know more when the latest retail sales numbers are released this week.
But what is really set to change is labor costs as productivity falls. The job market is getting tighter and tighter as baby boomers start retiring and the pool of skilled labor is drying up. More than 92 million American’s aren’t working. And the labor force is at a 36-year low. These are folks that will need education and training to get the needed skills.
That will be expensive. And it will take time. Companies will be faced with the choice of either bidding up the wages of the available skilled labor, or spending the time and money to train greenhorns.
No surprise, then, that labor costs are on the rise.
Hope is so strong, potential negatives are simply being ignored as risk expectations — via the CBOE Volatility Index — are compressed to levels not seen since February 2007.
The complacency can be seen in the way stocks are consistently closing near the top end of their daily trading ranges. Over the last two weeks, the SPDR S&P 500 ETF (SPY) has, on average, closed within 15% of its daily high. That’s the second-highest level in the history of the fund. The highest was back in February 1996 amid a “blow off” following 1995’s rally that led to an immediate correction and very choppy trading over the nine months that followed.
The complacency is getting entrenched not only in stocks but in bonds too. Corporate bonds are yielding just 1% over U.S. Treasury bonds — the lowest level since July 2007. Ireland and Spain can raise money at a lower rate than the U.S. government. Junk bond issuance has become a flood.
It’s getting so bad that the Federal Reserve — which encouraged and facilitated this behavior in the first place — is becoming concerned about the drop in volatility expectations in the market.
Fed chair Janet Yellen recently warned that small-cap valuations are being stretched (remember, Credit Suisse is looking for the Russell 2000 to drop to the 1,000 level after swelling its valuation metrics to near record highs). Other Fed officials have called out some of the growth in small tech stocks.
The market mania has been maintained via a fragile status quo. The fantasy of improved earnings/GDP growth discussed above. But also factors like continuation of the yen carry trade, low inflation, no escalation of the conflict in Ukraine, and weakness in precious metals.
Some of this is changing. Gold and silver are inching higher on a slight increase in bond market inflation expectations.
Deutsche Bank notes that there have been 10 years since 1960 when the S&P 500 pushed meaningfully to new highs during the summer during a bull market. But only two years (1964 and 1965) held the gains into year end. In 1985, 1989, 1997 and 1999, the summer highs gave way to a late summer/fall correction. And in 1987 and 1998, the market dropped into a bear market shortly thereafter.
And history is against it.
We’re entering a period of marked seasonal weakness. The VIX has reached a historic level of compression that suggests, with 100% probability, that the CBOE Volatility Index will hit 14.4 by August and likely will hit higher than 17.4.
A move to the mid-14s would merely return the VIX to its 200-day moving average. And with it, the return of a long-forgotten emotion: fear.