WEEK OF JANUARY 16, 2018 Weekly Relative Value

WEEK OF JANUARY 22, 2018

Weekly Relative Value Fear of Missing Out “How do we know when irrational exuberance has unduly escalated asset values?” – Alan Greenspan The current overriding sentiment in the market is irrational euphoria, also known as “buying panic.” Consider this: In the past four weeks alone, a record $58 billion has flown into stocks. Today’s ratio of bullish to bearish investors is six-to-one. Portfolio managers have record-low cash ratios. And here’s another fun fact: At the end of last week, the S&P 500 was one day away from setting a record for its longest run without a 5% dip. It is now widely accepted by virtually everyone that markets are now in the irrational, meltup, “blow-off top” phase. Even the Wall Street Journal writes, “‘Melt-Up’ Rally Propels Dow Above 26000 as Fear Turns to Greed.”

Tom Slefinger is Senior Vice President, Director of Institutional Fixed Income Sales at Balance Sheet Solutions.

THIS WEEK… • Fiscal Train Wreck • Who’s Gonna Buy? • Three Million Billion Suns PORTFOLIO STRATEGY • Market Outlook Insights

The markets aren’t just grinding higher, but rather gapping higher. Wall Street is fueling the fire by proclaiming that one-third of a typical bull market’s gains take place in the very last year. This in turn fuels the greed sentiment, which instills FOMO (“Fear of Missing Out”) among sidelined investors.

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Famed value investor Jeremy Grantham recently warned that a market melt-up has arrived, and calculated that the average final bubble phase of the “great equity bubbles” lasts just under three-and-a-half years, with gains between 58% and 104%. An estimate of three-and-a-half years before the market bubble finally bursts is hardly helpful, especially if there are no other markers or indicators to keep an eye on. However, Bank of America's Michael Hartnett has come up with not one, but three distinct indicators to keep watch, which (when triggered) would suggest the market bubble’s days are finally numbered. According to Harnett, the correction will occur only once real GDP forecasts greater than 3%, wage inflation greater than 3%, 10-year Treasury yields greater than 3% and the S&P above 3000. Sounds very plausible, but the truth is that nobody knows how long this phase can last. Blow-Off Top?

Many investors believe the markets will continue to run for a few more months. Most institutional investors now expect the market to peak in 2019; a month ago, however, they were forecasting the peak for this year. The prevalent consensus is: 1. 2. 3. 4. 5.

The stock market is still cheap because of low interest rates. Not all the tax reform is fully priced in. The Jay Powell Fed will do very little in the way of rates. NAFTA will not be abandoned. A booming economy and stock market will win the day for the Republicans come November of this year. “History doesn't repeat itself, but it often rhymes.” – Mark Twain

To a contrarian like myself, the current groupthink alone is reason enough to be concerned.




In the 1999 dot-com blow-off top, participants believed the Internet would grow at phenomenal rates for years to come, and, therefore, the parabolic move higher was fully rational. In the housing bubble's 2006-2007 blow-off top, a variety of justifications for soaring valuations and frantic flipping were accepted as self-evident. Today, the collective wisdom holds that global growth is just getting started, and corporate profits will soar in 2018. Therefore, current sky-high valuations are not just rational, but they clearly have plenty of room to rise much higher. In addition, central bankers have pumped over $14 trillion into financial assets, and have stated that they will do, “Whatever it takes.” In other words, equities are a protected asset class that will not be allowed to decline. “When all the experts and forecasts agree, something else is going to happen.” – Bob Farrell I remain a skeptic nonetheless. Let’s begin by examining stock market valuations. Most professional observers of financial markets would agree that stocks’ valuations are high compared to their historical range. This is demonstrated in the chart of the Shiller CAPE Ratio (Cyclically-Adjusted Price-Earnings Ratio) below. CAPE: Second Highest Valuation EVER!

While no single statistic perfectly describes reality, the CAPE Ratio highlights how cheap or expensive the stock market is relative to its historical average. Excluding the tech mania of 2000 (CAPE = 45), stocks are currently more highly-valued than at any other time during the past 140 years. Indeed, comparing the current CAPE Ratio of 33.91 to its median value of 16.15, stocks would have to fall by more than 50% to be in line with historical norms. Also, I’m not sure this is well known, but since the Fed’s second round of quantitative easing (QE2) was unleashed five years ago – when former Fed Chair Ben Bernanke made it perfectly clear that the Fed was going to boost equity prices to generate a “wealth effect” on spending – we have seen the S&P 500 surge at an annual rate of over 12%. Meanwhile, profits have risen by less than half that pace (even with the massive corporate buybacks). If the S&P 500 had merely risen in line with profit growth since that time, the Index would be approximately 40% lower (1,800) at the current time.




The strong economy has not been the catalyst of rising equity prices. Nominal GDP growth has averaged an annual rate of 3.6% in this nine-year-old bull market. Over the same period, the S&P 500 rose at an annual rate of 17.3%. In other words, the S&P 500 has risen at a pace roughly five times faster than nominal GDP growth in this manic cycle. This is bizarre. During the 1980s-1990s, for example, equity bull market nominal growth averaged over 7% and valuations rose at just two times the pace of economic growth. So, again, had this market acted “normally” (relative to the growth in nominal GDP), the S&P 500 would be 50% lower. To drive home the point of how overvalued the market is, consider the following by 720Global. The graph below charts price-to-earnings (CAPE) divided by the GDP growth (10-year average), allowing for an apples-to-apples comparison of valuations to fundamentals over time. Today, the market is the most expensive ever. In fact, it’s 50% higher than the dot-com bubble. Remember, growth in the late 1990s was more than double that of today, and the expected trend for economic growth was also more encouraging than today. CAPE: Adjusted by Growth

The fact of the matter is, easy money and liquidity have led to a massive increase in the inflation of financial assets. This occurred in the late 1990s and again in the 2003-2007 cycle, and we know how these manic phases ended (even if they are next-to-impossible to time). “In short, an excessively easy monetary policy has led to overvalued equities and a precarious financial situation. The Fed should have started raising the federal funds rate several years ago, reducing the incentive for investors to reach for yield and drive up equity prices. Since it didn’t do so, the Fed now faces the difficult challenge of trying simultaneously to contain inflation and reduce the excess asset prices – without pushing the economy into recession.” – Martin Feldstein So, how do central banks deflate the bubbles gently? How do they change the market psychology without triggering a crash? If central banks cut off the stimulus and send messages of, “Now we will let markets decline,” then what's the rational response? Sell, and sell everything now, rather than ride the bubble collapse down.




I believe central bankers are deluding themselves if they think they can calibrate and fine-tune human emotions. When the bullish certainty that, “Central banks have our backs,” erodes, the switch to bearish impulses to sell before everyone else sells will be sudden and irreversible. When? I don't know. In the meantime, if hope does continue to triumph over experience, this melt-up will surely go on.

FISCAL TRAIN WRECK The theory behind the tax cuts is that U.S. economic growth will ramp higher to 3-4% (See the red-shaded area in graph below). Hope vs. Reality

Source: The Washington Post, Skënderbeg Alternative Investments AG

Readers know where I stand. I believe the recently enacted tax cuts will provide a short-term stimulus to growth, but the impact to growth over time will be de minimis. What happens if growth follows the much lower non-partisan growth trajectory? (See the yellow line in the previous graph.) For starters, the U.S. will face a federal deficit “train wreck” in the next few decades. (See the following graph below.)




The fiscal deficits as a percentage of GDP could expand rapidly over the next two decades. This, of course, does not account for the massive off-balance sheet obligations (i.e. Social Security, Medicare and Medicaid) that also need to be funded. To get a preview of how this will play out, just watch the developments in Japan. U.S. Fiscal Train Wreck Ahead

Source: Scotiabank Economics

While the GOP argues that higher growth will generate higher revenues to offset the rising deficits, there is simply no evidence that will occur. The U.S. economy is currently thought to be expanding at full capacity, with the gap between the actual and potential GDP now closed. The U.S. government’s projections of 3-4% GDP growth over the next decade, therefore, appears to be completely unrealistic. The Gap is Closed: U.S. Economic Output Has Reached its Potential

Source: The Washington Post, Skënderbeg Alternative Investments AG




Furthermore, the current economic recovery is in its ninth year. Many economists expect U.S. growth to slow substantially by 2020, ending the longest expansion on record.

Source: John Burns Real Estate Consulting

Over the long run, economic theory states that demographics dictate long-term growth and inflation trends. As shown in the following graph, the U.S. labor force has been steadily declining, and it is projected to continue. Economic Growth = Growth in Labor + Growth in Productivity Thus, the collapsing growth in the U.S. labor force is expected to be a drag on both growth and inflation.

Source: BofAML, Skënderbeg Alternative Investments AG




WHO’S GONNA BUY? I have been and will remain a secular bond bull for two primary reasons: excessive debt and aging demographics. But, as I have stated repeatedly, nothing moves in a straight line. The bull market in bonds has now lasted 36 years with 10-year Treasury rates declining from their 1981 peak of 15.25%. Yet, over this long bull cycle, yields did rise a cumulative 20%. So, undoubtedly there will be intermittent rises in rates over the foreseeable future. But the point to understand is every period in which rates have risen, the economy eventually slowed, and rates reversed lower. Excessive leverage combined with unfavorable demographics will thwart any protracted rise in long term rates. So, the secular story remains intact. However, the bond market is now facing some cyclical pressures. First, inflation (due to higher energy costs) may rise over the next few months, but, more importantly, supply pressures have begun to impact bond market sentiment and pricing. The Fed is set to roll off $222 billion of its Treasury holdings this year. By combining quantitative tightening (QT) with expanding fiscal deficits, supply is expected to increase significantly in 2018 and beyond. The U.S. is projected to have to raise over $800 billion of net new bond issuance this year (net of the Fed’s QT) versus $357 billion last year. Therefore, the trillion-dollar question is: What happens to the bond market this year in light of increased supply? According to Treasury Department data released last week, China’s and Japan’s combined share of Treasuries fell to about 36% of all foreign-held U.S. government debt in November – the lowest level in about 18 years. China – the biggest foreign holder of U.S. bonds, notes and bills – saw its total drop 1.1% to $1.18 trillion from the previous month. Japan’s holdings dropped 0.9% to $1.08 trillion – the lowest in more than four years.

It will be interesting to see how institutional investors respond to this change. Will bonds be different from, say, oil – where a move from global excess supply to balance has helped take the price from below $50 per barrel to $64 per barrel currently? As big of a secular bond bull as I am, how the bond market reacts to this supply binge is a very valid




question. Bond yields are potentially susceptible to near-term cyclical pressure. As shown below, the 10-year yield has now surpassed DoubleLine Capital Founder Jeff Gundlach’s 2.6% redline. That said, I would be a tad more concerned about how the stock market is priced right now.

THREE MILLION BILLION SUNS In 2014, astronomers using the NASA/ESA Hubble Space Telescope found that this enormous galaxy cluster contains the mass of a staggering three million billion suns – so there’s little wonder why it’s earned the nickname “El Gordo” (“The Fat One” in Spanish). Known officially as ACT-CLJ0102-4915, it is the largest, hottest, and brightest X-ray galaxy cluster ever discovered in the distant universe. Three Million Billion Suns

Source: ESA/Hubble & NASA, RELICS




MARKET OUTLOOK AND PORTFOLIO STRATEGY “Were it left to me to decide whether we should have a government without newspapers, or newspapers without a government, I should not hesitate a moment to prefer the latter.” – Thomas Jefferson Despite last minute “compromise” meetings, and continued “hopes” from various sides, the Senate failed to reach the 60 votes necessary to keep the government funded (even for a stopgap), so the government has shut down. From a market perspective, the impact should be limited because, let’s face it, we have all grown quite comfortable with the dysfunction in our nation’s capital. In terms of portfolio strategy, many credit unions have been paralyzed by the fear of rising rates. As such, many have elected to hold excess cash reserves instead of investing further out the yield curve in securities that provide higher yields. Undoubtedly, an immediate rise in rates will negatively impact bond prices over the short-term. Credit unions should also consider the loss of income while waiting. The table below shows how a standard Treasury security ladder would have performed in secular bear markets. Please note that the shorter ladders (which are standard for credit unions) have generated positive returns in bear markets. Also remember, should the Fed reverse its tightening stance, the intermediate rates will adjust downward rapidly. For those who don’t want to spend too much time gazing through the crystal ball and/or trying to time the markets, a simple ladder strategy could be the most prudent of all strategies.

Note: Registration is now open for the 2018 Credit Union Executive Leadership Symposium, September 5-7 at the Westin River North in Chicago, IL! You will hear from a wide range of speakers, including NFL Legend Mike Ditka, “The Attitude Guy” Sam Glenn, and other industry experts. Back by popular demand on Friday, September 7, CUNA Mutual’s Steven Rick and Balance Sheet Solutions’ Tom Slefinger will battle it out in another round of “Dueling Market Views.” To view the agenda and to register, click here.




More Information In terms of relative value, please click here for the Relative Value Analysis. For more information about credit union investment strategy, portfolio allocation and security selection, please contact the author at [email protected] or (800) 782-2431, ext. 2753. Tom Slefinger, Senior Vice President, Director of Institutional Fixed Income Sales, and Registered Representative of ISI, has more than 30 years of fixed income portfolio management experience. He has developed and successfully managed various high profile domestic and global fixed income mutual funds. Tom has extensive expertise in trading and managing virtually all types of domestic and foreign fixed income securities, foreign exchange and derivatives in institutional environments. At Balance Sheet Solutions, Tom is responsible for developing and managing operations associated with institutional fixed income sales. In addition to providing strategic direction, Tom is heavily involved in analyzing portfolios, developing investment portfolio strategies and identifying appropriate sectors and securities with the goal of optimizing investment portfolio performance at the credit union level.

Information contained herein is prepared by ISI Registered Representatives for general circulation and is distributed for general information only. This information does not consider the specific investment objectives, financial situations or needs of any specific individual or organization that may receive this report. Neither the information nor any opinion expressed constitutes an offer, or an invitation to make an offer, to buy or sell any securities. All opinions, prices, and yields contained herein are subject to change without notice. Investors should understand that statements regarding prospects might not be realized. Please contact Balance Sheet Solutions to discuss your specific situation and objectives.


WEEK OF JANUARY 16, 2018 Weekly Relative Value

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