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The quickening March 9, 2020

Trade weighted US$: 116.9; US 10-yr: .56%;  S&P 500: 2746;  Oil: $31.01;  Gold:$ 1,675;  Silver: $16.85

The S&P gapped down over 200 points or 7% today at the open and closed at 2746, down 226 points or 7.6%, the steepest one-day drop since 2008. Given the sustained implosion of global stock markets and a historic decline in the oil price, which was down a shuddering 24.9% from Friday’s closing price, I want to jump in with a few observations today prior to reflecting on Corporate Anorexia’s long tail impact on both solvency and growth prospects in a follow-up video or post.

  • The price of oil is being pummeled by the demand-culling behavioral fallout, which the Corona virus induced lockdowns, cancelled travel, cancelled events (Geneva) and conventions has sharply exacerbated. There is also a market share war that the Saudis are waging by opening their spigots against America’s high-cost, loss-making shale oil extractors on the one hand and against Russian extractors on the other hand.  Given the extensive financing provided by US banks and investors as well as the shale industry’s extensive oil price hedging, this will exert additional earnings and balance pressure on those constituencies that provided the funds and are exposed to the hedges.  Yet, only roughly 20% of worldwide oil consumed per year is found, the current oil price rout will eventually prove to be a great purchase opportunity.  A “supply story” spiked by unprecedented fiat currency debasement in wings.  And a demand story that makes fossil fuels indispensable for leveraged output in industry and agriculture, the resulting sales and earnings, and virtually every product or fixture we look at.  A demand story that reflects our hugely dense energy-dependent lifestyle.
  • (BTW, America’s shale-based oil/natural gas extractors have been the mainstay of “flyover country” industrial strength/growth for over a decade, sucking in huge amounts of chemicals, truckers, truck fleets, domestically made drilling equipment, and capital. When this loss-making party — the industry couldn’t even generate positive net income when oil was at $100 per barrel — finally ends, the fallout on industrial America as well as on investors will be deep and wide.  Plus, the stunning, approximately 7.7m barrel rise in daily US extraction over the past 11 years that it has spawned is set to sharply reverse, which, together with declining legacy field extraction rates, threatens to drive our annual oil replacement ratio even further below 20%, highlighting the “supply” story.)
  • Investment grade government bond yields are plummeting to all-time lows. The US 10-year has crumbled with increasing speed from 1.92% yield on December 31st, 2019 to a stunning 0.56% yield today; meanwhile, the spread that junk corporates (BB rated) have to Treasuries is widening sharply, up about 120 BPs to 3% within one week.  I had mentioned this spread widening as a canary in the coal mine.  Well, that indicator has also failed to be a leading one (just like the stock market), and has become a coincidental or even a lagging indicator, despite the $3.2trn plus bloat in non-financial corporate debt since early 2008 in the US alone and an alleged 20% of all public US companies unable to service debt obligations out of their current, rapidly dropping cash flow, much less earnings …
  • Meanwhile, the yield curve continues to invert, threatening banks’ liquidity, solvency, and margins, thus the Fed is busy in underpinning the repo market with record purchases and is buying short-term Treasuries like a scalded dog — $60bn p.m. with likely upward revisions in an effort to return to a positive yield curve:

Overnight repo purchases: today (3/9/2020), the Fed purchased $113bn.  More bailing out of “casino operations” exposed money center banks in an effort to dictate short-term rates, which shot up to 10% in Repo Land last September.

The Fed’s balance sheet expanded by $83bn in under one week as per 3/6/2020: at a monthly pace, it would amount to over $320bn p.a., blowing away any prior QE by a multiple of 4!

Let me get back to the quickening:

  • A US stock market rally until recently fueled by stock buybacks and record margin debt is proving highly susceptible to downward pressure. With buybacks soon to be throttled and margin debt calls soaring, the stock market may remain under substantial pressure, from this dynamic alone.
  • With cronyism – big business in bed with big government – ever more rampant and Main Street increasingly locked out of contracts and financing even as it footed larger and larger crony-bailout bills from the S&L bailout to the more recent TARP bailout  , small businesses with contracting top lines will likely be even more starved for cash, adding huge pressure to a crumbling economy.  Why?  Because small businesses are still the backbone of the economy and its where the largest percentage of people in the private sector are employed.
  • In short, we may soon face a liquidity crisis on top of a solvency/debt crisis, further pressuring economic activity, which would punish corporate earnings and could precipitate a sustained stock market correction fed by momentum investing in reverse, by algos spitting out a growing frenzy of sell orders, by ETF group think allocations pressuring wide swaths of market sectors now under pressure that rallied so sharply previously, and by technical analysis downside sell confirmations such as 30 – 60 – 120 day moving averages pierced to downside. In short, stock demand may be morphing into sustained share sales — and this is prior to expanding share sales coming from an aging population, which will further pressure P/Es, especially if yield deprivation (ZIRP and NIRP) can be sustained, i.e., investors are forced to liquidate holdings owing to lacking passive income.  Arguably, the demographic/aging “P/E compressor” is just getting revved up.
  • In the interim, the ongoing flight into perceived safety, such as US Treasuries and other OECD investment grade government bonds from Japan to the Netherlands to Germany to Switzerland, has resulted in absolutely record-breaking low yields/steeper negative yields in record breaking time, as mentioned previously. The increasingly palpable, increasingly widespread investor fear, even panic, as typified by disappearing investment grade yields, should set the stage for another dead cat bounce opportunity in the stock market, which would give investors another chance to lighten up on overvalued stocks bought at dear prices.
  • Meanwhile, and this may continue to sound controversial, today’s record-low, (so-called) investment grade government bond yields are also a chance to lighten up on a sector, bonds, that has been in a secular bull market for nearly four decades. For some graphic flavor, consider that yields on the 10- and 30-year Treasuries topped out at 15.8% in September 1981 for the 10-year bond and at 15.2% in September 1981 for the 30-year bond.  We’re now below a 1% yield on both bonds – the 30-yr bond is down to an unthinkable, unprecedented 0.94% yield, also virtually “overnight.”  The takeaway, and I know if I have thought this at substantially higher yields such as at 2% and 3%, is this: investors should consider reducing exposure to 10- and 30-year Treasuries.  Staying on board the 40-year bond bubble brings ever greater duration (extreme interest rate sensitivity), monetary inflation, and solvency risks even as it “imprisons” investors in “yield deprivation land,” which would add insult to injury.
  • Investors should also consider taking gains on Frankenstein Finance long-term government bonds featuring negative yields in countries such as Japan, Germany, the Netherlands, and Switzerland. The bond reallocation story here is a simple one: realize capital gains, take the proceeds, and invest same in very short-term investment grade government securities.  Such securities sometimes sport higher yields (inverted yield curve), have no duration/interest rate risk, and can’t be bailed in, like your bank deposits can be, namely into “equity stubs” of a failing financial institution.  Or, if still possible, just ask to be paid in cash and place your bills/notes in a very safe, accessible place.  But do realize that currency in circulation is typically a single-digit percentage of the wider money supply in OECD countries, with the US having a disproportionately high percentage at 9%.
  • Also consider dipping your toe into the battered oil/gas sector but focus on plays/companies that have relatively sound balance sheets, relatively low-cost structures, and relatively good reserve status. Given the declining property right protections in OECD countries and much lower valuations and debt encumbrances at the Russian country level and in select Russian oil and gas assets, not to mention a ruble that is still on the floor, don’t get scared out of potentially investing there.  You could profit from a great secular supply story that gets another lift from a strengthening ruble that reflects Russia’s much better balance sheet than that of OECD nations.
  • Meanwhile, our rapidly deteriorating economic, financial, and political fundamentals prior to the Corona virus impact are now going from bad to worse, yet widespread stock bubbles, and especially bond bubbles, remain.
  • It’s beginning to look a lot like this is the real asset valuation reset deal, and that we may only be in the first inning of what will likely prove to be a historic reset which will ultimately massively revalue stocks and bonds to the downside while revaluing real money and scarce, vital, real assets to the upside.
  • Once again, I think we will be sailing into a deepening global recession plagued by unprecedented fiat currency creation, unprecedented debt, unprecedented misallocations, and increasingly widespread productivity shortfalls, collectively the difficult progeny of fiat money central banks bent on currency destruction. The Corona virus manifestation serves to speed up and potentially deepen “the quickening.”  Needless to say, leading global central banks will continue to respond to their unruly problem children with yet more fiat currency debasement until they have destroyed confidence in counterfeit currencies.  Why?  Because leading central bankers want to keep their unrivaled power, prestige, privileges – said differently, these bureaucrats want to keep their racket going as long as possible!
  • Our predicament and central “banksters” doubling down on more widespread money printing — which could result in a) more expanded stock purchases (beyond the SNB and BOJ “hedge fund portfolios”), b) checks sent to directly to consumers, c) more misallocating, moral hazard bailouts financed by the printing press, and d) other such Keynesian calamities — threaten to bring us a much more virulent version of the 1970s stagflation.  Our increasingly displaced free market capitalism, which has been replaced with increasingly entrenched socialism, even cronyism morphing into fascism, is quite the prosperity denuding, productivity pummeling, growth eviscerating, toxic public policy stew.  Against this backdrop, expect a much more savage stock and bond repricing, especially given the epic valuation bubbles (especially in OECD nation bonds) we still have juxtaposed against collapsing growth, profits, and solvency ahead of an atypically long and deep recessionary funk.   The associated “bust” sentiment shift of investors may prove as difficult to dislodge as the more-than-decade-old bullishness has proven to be.  That would result in investors again demanding extremely attractive valuations (low P/Es and high bond yields) in order to invest, especially given the large demographically-based bond and stock sales pressure increasingly in the pipeline.


Concluding thoughts:

Finally, and I know I sound like a broken record, but remember that markets are reversion beyond the mean machines. We spend hardly any time at an average S&P 500 P/E of 16 or an average 10-year Treasury yield at 4.5%.  We slice through these valuations on the way up in equity bull markets, and we compress well below them in bear markets, such as with single-digit P/Es (double-digit earnings yields) and double-digit bond yields.  Just think back to the late ‘60s, ‘70s, and into the early ‘80s for valuation flavor also known as a 12 – 13-year bear market.  After decades of bullish valuations in bonds and stocks — they travel together over time — we are now set for bust valuations that may be with us for a long time, given the extensive damage central banks have done or enabled.

Oh wait, one more thought: if you layer much lower P/Es that will reflect a bond bear market on top of what may be sustainably reduced earnings power/EPS, then you have a value at risk double-whammy: substantially lower EPS and higher discount rates. Not quite a recipe for higher stock NPVs.  In fact, quite the stock valuation pressure cooker; combined, I believe stock prices could easily fall between 50% – 75%, possibly more, especially if the ‘70s stagflation on steroids around the corner?  I think the odds of that being in our future are higher than 50% that this happens.  Caveat Emptor!

I hope you’ve found my “the quickening” observations worthy of your investable assets allocation time!

This is Dan Kurz, DK Analytics, it is March 9th, 2020.

Obligatory boilerplate:
This commentary is not intended as investment advice or as an investment recommendation. Past performance is not a guarantee of future results. Price and yield are subject to daily change and as of the specified date. Information provided is solely the opinion of the author at the time of writing.  Nothing in the commentary should be construed as a solicitation to buy or sell securities. Information provided has been prepared from sources deemed to be reliable but is not a complete summary or statement of all available data necessary for making an investment decision.  Liquid securities can fall in value.