Doug Kass of Seabreeze Partners is known for his accurate stock market calls and keen insights into the economy, which he shares with RealMoney Pro readers in his daily trading diary.
This past week, Kass talked about the many reasons he's worried about the current rally, and some secondary impacts of rising interest rates.
The Calm Before the Storm?
Originally published Nov. 23 at 9:49 a.m. EST
"Someone told me long ago
There's a calm before the storm,
I know; it's been comin' for some time.
When it's over, so they say, it'll rain a sunny day,
I know; shinin' down like water."
-- Creedence Clearwater Revival, Have You Ever Seen the Rain?
If you think that this rally is picture perfect, I have a bridge to sell you in Brooklyn.
Economic news and corporate profits matter, and so does market breadth. Healthy bull markets have broad participation, but unhealthy ones have narrowing participation.
Here's a look at both the technical and fundamental issues that I see facing the market:
The Technicals: The Rally Has Bad Breadth
The best gauges of market breadth are the advance/decline line and the number of stocks hitting new 52-week highs.
Strong bull markets exhibit bold cumulative advance/decline lines and expanding 52-week highs, which confirm the highs reached in the broad indices (where large-capitalization stocks dominate). But weak bull markets show breadth that diverges from the big indices on these two measures, failing to confirm the new highs.
To measure this accurately, analysts often look at the relationship between an index's equal-weighted and capitalization-weighted versions. A rising relative line between the two denotes a healthy market, while a declining line means a few large-cap stocks are driving the advance.
This year, the New York Stock Exchange's common-stock-only advance/decline line peaked in May and lagged during the market's recovery from late-September lows.
Moreover, new NYSE 52-week lows have eclipsed new 52-week new highs for some time, as you can in the chart below (which is a bit small, but shows new lows in purple and low highs in black). This is a signpost of underlying weakness:
We can also clearly see a declining trend if we compare the S&P 500's equal-weighted and cap-weighted versions. This shows that the index's large-cap components have outperforming their smaller brethren since mid-April -- and remarkably, still made new lows in the face of a 12% recovery in the overall S&P 500:
This raises the question of whether investors should chase the TFANGs or the NOSH -- Nike, (NKE), O'Reilly Automotive (ORLY), Starbucks (SBUX) and Home Depot (HD). These stocks could eventually get defanged because the rest of the market might be unusually vulnerable to a correction.
Large-cap quality holdings might work for a longer time. But without support from the majority of lesser stocks, attrition seems likely to eventually take a toll on the market's current leaders. As the old saying about Wall Street's traditional "Santa Claus Rally" goes: "If Santa Claus should fail to call, bears may come to Broad & Wall."
The Fundamentals: Good News is Great, Bad News Is Even Better?
The fundamental front shows concerns about punk domestic economic data, as seen in weak retail sales, a manufacturing contraction and a possible peak in housing and autos. We also see the prospects for moderating operating profits, slowing Chinese and Eurozone growth rates and a new multiyear low in high-yield bond prices.
On that last point, high-yield bonds are definitely acting "junky." This chart amplifies just how significantly weak the sector has been this year:
CCC-rated bonds have underperformed BBs over the last 12 months by 700 basis points (and by over 450 basis points ex-energy). There are only three previous instances of such deep underperformance. Two coincide with the mature credit cycles of early 2000 and early 2008 and one was a "false positive" in late 2011.
On the point of slowing global economic growth, Goldman Sachs recently opined that the U.S. economy's natural state has deteriorated from the past and "will remain lower for longer." Indeed, some seven years of monetary easing have served to weaken the economy to the point where secular-growth prospects might be nearly half of what we experienced over the last three to five decades.
Deutsche Bank goes one step further, arguing that after decades of bubbles, reducing the equilibrium real rate of federal funds serves as a negative to growth:
"The real case for policy error -- equilibrium short real rates may be below zero. There are two interpretations of the macroeconomic data that have vastly different implications for the effect of imminent rate hikes. The first is the 'conventional' view, which the Fed subscribes to. This view posits that the short-term real equilibrium rate is around zero. Since the nominal funds rate is at the zero lower bound, policy is accommodative, and this is why the labor market has improved rapidly. Inflation has not picked up because it as a lagging indicator. ...
The alternative view is more worrying. In this view, the equilibrium nominal rate is at present much lower than the Fed thinks, and the equilibrium real rate is meaningfully negative. Policy at present is not very accommodative, and to the extent that it is, inflation is actually running above its equilibrium level, which is close to 1%. ...
This is the important policy-error scenario, because even a very shallow path of rate hikes might drive the real fed funds rate well above the short-term equilibrium real rate, further depressing demand. It is then plausible that the economy would be driven into recession, and the Fed would quickly be forced to abort the hiking cycle."
-- Dominic Konstam, Deutsche Bank
Moreover, there is simply too much debt. Unconventional monetary policy simply expands the debt load and makes the U.S. economy extremely vulnerable to an interest-rate hike. So, the Fed is trapped.
Meanwhile, the conspicuous flattening in the yield curve is another possible signpost of slowing domestic economic growth and/or a Fed policy error:
Source: Zero Hedge
The Bottom Line
The "Ah-Ha" Moment, where investors lose faith in central bankers, might be ever closer at hand. Both the technicals and fundamentals are conspiring to form a possible toxic market cocktail.
Be alert to foul weather ahead. As Creedance Clearwater Revival once sang: "Sun is Cold and Rain is Hard."
Position: Long BGB, SDS, NFLX (puts), TSLA (puts), SPY (puts); Short SPY, SBUX, NFLX (small), TSLA (small), FB (small)
Corporations' Cost of Capital Rises
Originally published Nov. 24 at 8:28 a.m. EST
There's been a lot of discussion of the likely 25-basis-point rise that we'll see in the fed-funds rate following the Federal Open Market Committee's December meeting.
But other interest rates are rising -- increasing the cost of capital to corporations while reducing the value (and raising the costs) of stock buybacks.
Yesterday's two-year Treasury-note auction got little notice, but the yield rose to its highest level since 2010.
It's also important to note that other interest rates have risen even more rapidly. For example, the KDP High Yield Daily Index was at 6.92% as of Friday, compared to only 5.07% back in February. And Moody's BAA index was yielding 5.46% as of Friday compared to only 4.29% in February.
In yesterday's opening missive, I wrote:
"On that last point, high-yield bonds are definitely acting 'junky.' This chart amplifies just how significantly weak the sector has been this year:
CCC-rated bonds have underperformed BBs over the last 12 months by 700 basis points (and by over 450 basis points ex-energy). There are only three previous instances of such deep underperformance. Two coincide with the mature credit cycles of early 2000 and early 2008 and one was a 'false positive in late 2011."
At the time of publication, Kass and/or his funds were long BGB, SDS, NFLX (puts), TSLA (puts), SPY (puts); and short SPY, SBUX, NFLX (small), TSLA (small), FB (small).
Doug Kass is the president of Seabreeze Partners Management Inc. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.