I love college football, and as I watched the conference championship games this past weekend it occurred to me that kickers and investors have something in common. If you outkick your coverage in football, you kick the ball too far and leave your coverage teammates at a distinct disadvantage. In markets, you outkick your coverage when you get caught up in the frenzy of rapidly moving markets, ignore risks, and blindly chase markets higher, leaving your portfolio vulnerable to a blind side hit. The only time that outkicking your coverage is a good thing is if you happen to be Jonah Hill’s doppelgänger (fat Jonah, not skinny) with MC Hammer’s net worth, and you land Blake Lively.
Since the election, everyone and their mother is outkicking their coverage in U.S. equities because they’re caught up in Trump mania and what his plan could mean for U.S. growth and inflation. These investors had better keep their head on a swivel, because rising U.S. yields are getting ready to turn from Beauty into the Beast.
They Got That Exuberance
As I pointed out last week, Trump’s victory and the accompanying dramatic shift in investor expectations has led to a record amount of cash being put to work in the last few weeks. Institutional investors reduced their cash position from 5.8% to 5% in just two weeks! This is the largest two-week drop in cash since August 2009, and a cash drawdown of this magnitude has only occurred twice in the last 20 years.
During the last 10 years, investors have plowed over $1.5T into bond funds and $0 into equity funds. That’s right, equity funds have seen a zero net inflow over the past decade. Since the election, investors have been flipping that decade-long script by dumping bonds and loading up on stocks, causing a record-breaking disparity between stock and bond flows. U.S. equities have seen the largest inflows in more than two years, while bonds are experiencing the largest outflows ever! Not to mention that speculators in the futures markets are shoring Treasuries at a level not seen in close to six years.
But it’s not just investors of all sizes who are outkicking their coverage right now. It wouldn’t be true exuberance if big banks and Wall Street firms didn’t join the frenzy.
Wall Street Guesses Forecasts
Regular readers know how I feel about forecasts. For you new folks, forecasting is about as useful as a one-legged man in a butt-kicking contest. If someone could tell me the closing price of the S&P 500 next week it would be more surprising than if I woke up tomorrow with my head sewn to the carpet. That doesn’t stop Wall Street from telling us exactly where the S&P will be trading a year from now… but I digress.
It’s downright comical how every firm on Wall Street has raised their S&P 500 price forecast based on Trump’s election and the ensuing reflation narrative. That said, I recognize that most investors pay close attention to these forecasts. The one aspect of the forecasts that I do find interesting is what they tell us about the reward-to-risk potential in U.S. equities.
Deutsche Bank has avoided a “Lehman” moment long enough to put out a 30-page S&P 500 research piece, and Goldman released their own version of an S&P 500 “War and Peace.”
I swear these guys must own a rainforest somewhere and they get a tax benefit for clear felling it quickly. Either that or their research departments get paid by the page.
After pages and pages of ratios, tax policy analysis, and a dizzying array of charts, both firms concluded that the 12-month upside potential in the S&P is between +5% and +14% from Friday’s closing price of $2,191. Tuck that forecast away for a moment.
There’s one way I know to limit the occasions when you outkick your coverage in markets: be data dependent. While everyone is focused on the presumed resurgence in Reaganomics, a large downside catalyst for U.S. stocks is percolating that will overshadow any Trump narrative.
Too Much of a Good Thing
Low rates have allowed U.S. corporations to binge on debt like the Nutty Professor at a Golden Corral, which is why corporate debt has more than doubled since 2007.
The kicker is that this debt hasn’t been used for productive things like capex or research and development. No, it would make too much sense to borrow cheap money to improve your business. Instead, corporations have leveraged up to historic levels to buy back stock and to juice dividend payments to shareholders.
In fact, corporate buybacks have been the largest source of U.S. equity demand for the last three years. This demand was the only thing propping up the S&P 500 during the first half of this year when the U.S. economy looked like homemade sin.
Next year, S&P companies are planning to increase the amount of cash they use for stock buybacks by 30% over the amount they spent this year. In fact, for only the second time in 20 years, stock buybacks and dividend payments are expected to account for 48% of the cash outlays of S&P 500 companies. This is an important data point, because the only other time in history that this much cash was returned to investors was in 2007, just ahead of that little episode known as The Financial Crisis.
The Beauty of a low interest rate is that it allows corporations to borrow money practically for free. That’s how corporate debt has been able to double, while interest expense has only increased 40%.
The Beast emerges when low rates normalize again and these massively leveraged corporations can no longer sustain the debt servicing cost. For now, no one seems to be concerned about the Beast, because they are focusing on the Beauty, or the favorable outcomes, from rising inflation and higher rates.
To those people, I have only two questions: What happens when yields rise to a point where cash that is earmarked to go towards “shareholder value” must instead be diverted to keep the debt train rolling? What happens when the primary buyer of U.S. equities doesn’t have enough cash to both prop up the U.S. equity market and to service its debt?
If U.S. 10-year yields break through the 2.75% level on a sustained basis, the Beast will be out of the castle.
The Bottom Line
With every trade I make, I think in terms of reward-to-risk, and I rarely take a trade that offers less than $3 of potential upside profit for every $1 of risk I’m taking.
If the Wall Street price forecasts are even remotely close to being accurate (which is highly debatable), then being LONG the S&P 500 over the next year has approximately a 10% profit potential. Based on the quantitative factors in my gravity framework, I estimate the immediate downside risk of the S&P to be in the $2,066 to $2,000 range, which is 6-9% below Friday’s closing price.
Put simply, getting LONG the S&P right now could possibly earn you $1.50 for every $1 you’re risking. That’s not exactly ideal.
Another thing to keep in mind is that U.S. 10-year yields spiked 30% during November. There have been only five other occasions in the last 20 years when 10-year yields rose by 20% or more in just one month.
Over the 12 months following those five occasions, the S&P gained an average of 6%, with drawdowns averaging 13%. So, historically, after a monster move in 10-year yields, there has been twice as much downside risk in the S&P 500 as upside potential. That’s a reward-to-risk profile that only Dennis Gartman could love.
At best, outkicking your coverage is going to guarantee you below-average returns with above average risk. At worst, it will swiftly transition your daily retirement routine from the golf course to “Hi, welcome to Walmart.”
Hedge fund giants with multi-decade track records of exceptional returns, like Soros, Druckenmiller, and Paul Tudor Jones, aren’t in the habit of outkicking their coverage. Peter Lynch didn’t earn 29% a year for well over a decade by investing in companies with twice as much downside as upside. Do you think that guy in Omaha, who seems to know a thing or two about investing, ignores potential risks and chases markets simply because they keep moving higher?
Exceptional returns, and more importantly, exceptional risk-adjusted returns, are earned by disconnecting from the mob mentality, staying data dependent, and only taking trades where the reward-to-risk balance is tilted heavily in your favor.