Herding Cats

The Fed was front and center last week with the latest comments from Janet Yellen as she spoke at the New York Economic Club. In her 3rd dovish commentary in just as many weeks, it was clear that Yellen was attempting to herd the proverbial Fed cats. We’ve heard a lot of hawkish commentary from Fed members in recent weeks and Yellen made it clear last week that there is only one view that matters, hers. Along those lines, there is only one view of the broader US equity market that matters, the SHORT view. 

Yellen emphasized downside risks to the US economic outlook stemming from slower global growth and that the Fed is in no rush to hike rates because it has plenty of room to raise rates if inflation picks up but they are limited on how much they can cut if the downside risks materialize.


US Growth is a Train Wreck


In case you don’t have the time, energy or inclination to track US economic data, the Atlanta Fed has a nifty tool built just for you. GDPNow is a forecasting model that attempts to give people a real-time indication of where US GDP growth is currently tracking. Before this tool became available, the average investor had to wait until well into the next quarter before initial GDP estimates for the prior quarter were released. So now you ask, what does GDPNow say about US economic growth? GDPNow says that US growth looks like a train wreck. 

The first estimate of Q1 GDP growth was calculated by GDPNow on February 1 at a 1.2% growth rate. And it peaked on February 12 at 2.7%. Since then growth estimates have slid all the way down to +0.7% as of last Friday, April 1. What a round trip! Growth estimates on net basis deteriorated by 50 basis points from February 1 to April 1. No wonder Yellen is concerned. But is this economic decline really a surprise? It shouldn’t be because we’ve been talking about it consistently since the Fed chose to raise rates back in December. Global growth slowing is not a new theme, at least not to us.


High Growth vs. Slow Growth


Regular readers of TWR know that I combine lagging economic data with real-time market indices to help give us a differentiated view on price action in various markets.

In order to monitor the US, my two go-to indices are my high growth index and my slow growth index. As a quick primer, the high growth index is made up of markets that perform well when US growth is elevated or accelerating higher. The slow growth index, on the other hand, is made up of markets that perform well when US growth is slowing or in outright contraction. 

We can look back now and see that the annual growth rate of US GDP peaked in Q1 2015 and has been decelerating in each of the last 3 quarters, and most likely for the 4th consecutive quarter here in Q1 of 2016. However, my trusted real-time indices have been giving us clear signals ahead of the data as to the most probable direction of US economic growth. Notice I said “most probable.” Nothing in financial markets is full proof or 100% accurate. The best you can strive for is to tilt the probabilities in your favor on a consistent basis and make $2-3 for every $1 you risk.

My high growth index peaked during the week of June 26, 2015 and began to make a series of lower highs. Keep in mind that we didn’t get a first estimate of Q2’s GDP until the beginning of August. So my real-time indicator was already declining for close to 6 weeks before the actual data came out. Not to mention that those initial estimates are generally nowhere near the finalized numbers in terms of accuracy. But I digress. 

In global macro, it’s never about 1 market or 1 indicator. It’s about the relationship across markets and data points that matter. And here again, when you monitor multiple relationships it allows you to further tilt probabilities in your favor.

To this end, my slow growth index bottomed in early September 2015, just a couple of months after the high growth index peaked. By the middle of October, I had a very clear picture that the probabilities favored a continued slowdown in US growth and began to position accordingly. 

At the time this was a very contrarian view to have. The S&P 500 was continuing to rally unabated and wouldn’t peak until early November and the Fed was on a path to raise rates because they believed the US economy was in a position to withstand the shock.

As a recap, for the first 3 months of the year, my slow growth index is up 11%, the S&P 500 +1.5% and my high growth index is down 12 basis points. It has been a massive out performance by slow growth assets and a clear signal that US growth was abysmal during Q1.


Where Do We Go From Here?


That brings us to today and the beginning of Q2 2016. What do we do now? It’s clear to look back and see what markets have performed well so far, but that doesn’t help us. We need to know where the probabilities are tilted going forward. 

Here are the key factors at play right now in markets: slowing global growth, negative rates and a US Dollar that is in a 4-month downtrend and making new lows each week. Yes, economic data out of China last week showed signs of life. Yes, the monthly US labor reports “met expectations.” But I haven’t seen any data in the last month that convinces me that the global picture is improving as we move through 2016. For that reason, I continue to favor long-dated US Treasuries and Gold from the LONG side, as I have since early December. That said, I started this commentary by saying that the only correct view of US equities is a SHORT view. So let’s dig in to why. 

Fundamentally, I’ve seen nothing in the last 2 months and I didn’t see anything in the deluge of data last week that shouts to me that US growth is getting ready to accelerate higher. The consumer is far from robust and despite a small uptick from the manufacturing sector, it’s a long way from bucking its current downtrend. In addition, there is a growing divergence between corporate profits and job growth. US labor growth has been fairly steady for quite some time. However, corporate profits have been declining since early in Q4 2015. Typically, falling corporate profits is a leading indicator and the US economy tends to follow.

Behaviorally, institutional players have been net sellers of US equities for 9 consecutive weeks. This is the longest such streak in over 5 years. Last week also marked the 5th straight week where institutions and retail investors were both net sellers of US equities. If no one is left to believe in this rally and everyone is using it to lighten their exposure, it’s only a matter of time before the market rolls over.

Quantitatively, the S&P 500 has shown no conviction to the upside. Last week marked another series of lower highs since it peaked back in November. From Friday’s close, the S&P is about 2% from its all-time high and 6% above its lows from early March. That means there is a 3-to-1 reward-to-risk, skewed to the downside. In addition, there is no fundamental or behavioral catalyst in sight.

The probabilities are skewed to the downside and since we are short the SPY in TWR’s trade ideas, the probabilities are skewed in our favor.