‘It’s a fine line between stupid…and clever.’
David St Hubbins, This is Spinal Tap
Every time a new idea for the business crosses my mind, I can’t help but think of that line.
I wonder if the same thought ever crosses the minds of the world’s central bankers as they fiddle with interest rates and print money.
Probably not. But it should.
Common sense says this can’t last
That line at the top of today’s article, from the iconic movie This is Spinal Tap, can fit almost any situation.
For instance, it’s a fine line between stupid and clever when…buying junk bonds.
It was stupid to buy junk bonds on 12 September 2008…just before the market fell 31% over the next month.
But if you bought junk bonds on 10 October 2008…even though the market would have been volatile, you could have clocked up a 43% gain over the next two years.
After last night’s drubbing, our favourite junk bond ETF, SPDR Barclays High Yield Bond ETF [NYSE:JNK], is down 16.9% since the peak last year.
Source: BloombergClick to enlarge
As you can see in the market data table at the end of today’s Port Phillip Insider, the dividend yield on this ETF has edged higher again.
Today, it yields 6.76%. That’s up from 5.96% one year ago.
Yet, it wasn’t so long ago that junk bonds were a great momentum trade.
From mid-2013 to mid-2014, junk bonds were a good buy trade. Interest rates were low, and the US Federal Reserve was still trying to make investors believe that interest rates were about to rise.
The markets didn’t buy a word of it.
How do we know that?
Because junk bond prices were rising and junk bond yields were falling.
Savvy investors aren’t likely to buy high-risk junk bonds if they think interest rates are going higher. After all, junk bonds are called junk bonds for a reason — it’s because they have a higher chance of default.
But the upward momentum for junk bond prices started to break down in 2014. And although prices have been volatile since then, they have been in a distinct downtrend.
The momentum has shifted — bullish to bearish.
It’s the kind of shift that, because it happens so slowly, can catch many investors off guard. And it’s not just in junk bonds. As Bloomberg notes:
‘Trades that kept the ceiling from crashing in last year are giving way now, as momentum stocks and others beloved by hedge fund managers lead a plunge that is pushing the Standard & Poor’s 500 index toward its August low.
‘With U.S. equities sinking the most since September on Wednesday, the 20 stocks in the S&P 500 with the most hedge fund ownership declined even more — an average of 4.4 percent, data compiled by Bloomberg show. Among the 10 most-owned shares, losses averaged 5.6 percent.’
The US S&P 500 index is now down 7.5% since the start of the year. And it’s the first time it has closed below 1,900 points since last September.
Could this be of any major significance? I’m sure the technical analyst types can look at the chart and make a better hash of it than me at interpreting what’s going on.
I admit to not knowing much about charts and technical analysis. The smart kids can look at those.
I have a much simpler view of the markets. It’s the common sense test. To me (and I’m sure to you), common sense says that the billions and trillions of dollars artificially injected into the world’s economies will lead to a negative reaction.
Arguably, it has already led to a negative reaction. That’s why the markets have been so volatile for the past seven years. The problem is that governments and central banks have intervened to postpone the inevitable collapse.
But how long can that last? Here at Port Phillip Publishing, we’re surprised it has lasted this long. It’s more than seven years since the financial meltdown in 2008.
The lack of a severe crash has sucked a lot of investors into thinking that the market may never crash again.
Even several of our normally bearish analysts are sceptical that the current decline is the beginning of a real crash. Take that as a sign, if you like.
When some of the last remaining bears turn bullish, a terrible bear market usually isn’t far behind. As for one bear in particular, there isn’t much chance of him turning bullish.
Check out why here.
Here comes, and there goes the circus
Famed bearish investor Peter Schiff used a great analogy to describe this several years ago.
He liked the billions and trillions in stimulus money to a circus coming to town. The circus arrives and brings a bunch of people, who have a bunch of money.
The local restaurant owner sees the increase in customers and revenue, and decides to expand his restaurant. He buys the building next door, puts in new tables and chairs, and upgrades the kitchen.
Business is great…until the circus leaves town.
The restaurant owner thought the boom would last forever. But it didn’t. Now he’s left with a huge restaurant, but without the customers to cover the increased costs or to justify the capital costs of expansion.
It’s a neat analogy. And it applies to the Aussie economy too. Aussie mining stocks sucked in billions of dollars from China in return for exporting raw materials.
The big mining companies spent big. They built infrastructure, expanded rail lines, invested in new technology, and increased output.
They, and most mainstream analysts, thought the resources boom would last at least 50 years. And why wouldn’t they think that? China is a huge and growing economy. It was growing at 10% or more.
Even when the economy only grew at 7%, given its size, that was still a big growth rate.
As for commodity prices, well, high oil and iron ore prices were here to stay too…until they weren’t.
Overnight, the crude oil price fell below US$30. And the iron ore price has dipped below US$40.
Dare we say it? Yes, we dare. The circus has left town.
Little Aussie battler
Try telling that to that little Aussie battler, the Aussie economy. As Bloomberg reports:
‘Defying the demise of a once-in-a-century mining-investment boom, Australia last month capped its strongest year for job growth since 2006, with the country’s services sector propelling gains.’
The unemployment rate was steady at 5.8%. Full time jobs increased by 17,600, while part time jobs fell 18,500.
The Aussie economy keeps growing. We’re now in the 27th year of economic growth. Maybe this growth spurt will never end!
Except it will. It always does.
US earnings crunch
Finally, it seems that US investors and analysts have woken up. According to the Financial Times:
‘Equity investors are braced for the worst earnings season since 2009 from a host of large US companies hit hard by the combination of a stronger dollar and sliding commodity prices.
‘The S&P 500’s drop of more than 5 per cent this year and erosion of $1tn of market value — after 2015 marked the benchmark’s first annual loss since 2008 — reflects the concern among many investors that the earnings power of many large blue-chips has stalled.’
If you’ve read Port Phillip Insider for some time, you’ll know that we’ve worried about US company earnings for a while.
A simple chart shows you the cause of that worry. Check this out:
Source: BloombergClick to enlarge
The green vertical line denotes today. The white line to the left of the green line shows per share earnings for the S&P 500. The white line to the right of the green line shows forecast earnings.
As I said earlier, I’m no chartist. But even I can tell you that it’s going to take one heck of an earnings season for them to match the forecast.
In order to get there, US company earnings will have to increase around 11%…in one quarter. Based on historical numbers, earnings have rarely achieved that growth through the course of a year, let alone one quarter of the year.
As always, we could be wrong. But, markets don’t fall without reason. Remember, two things move markets: earnings and interest rates.
Interest rates are going up, and earnings are going down. That’s not the kind of thing most stock investors like to see.
Publisher, Money Morning
Editor’s note: The above article was originally published in Port Phillip Insider.
From the Port Phillip Publishing Library
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