Long Bond, VIX, & Commodities Show Reflation Trade Is Over
The stock market had another small drawdown on Wednesday as it is down about 2.5% from its all-time high. The last 5% decline was in June 2016 which is about ten months ago. The minimal size of the stock market correction is remarkable when you look at in the context of other markets. As I mentioned in a previous article, the VIX had been rising along with the S&P 500 which is rare. I noticed this has been happening more frequently in the past few weeks. Now I have evidence which proves the VIX’s relationship with the S&P 500 has been wacky lately. The chart below says the stock market is having its second smallest correction with the VIX at a five-month high. One point which downgrades the importance of this move in the VIX is that the VIX had its second lowest quarter in Q1 which means a five-month high isn’t as high as most of the previous five highs.
Along with the increasing VIX, the ten-year bond has been rallying sharply which indicates growth will come in below blue-chip expectations. As I’m writing this post, the ten-year bond yield is at 2.2605% which is below the lows of the range it had been in. This rally goes exactly against the Fed’s rate hikes and unwind of its balance sheet. It shows the Fed has less influence on the long bond than it thinks. It also shows the ten-year and the VIX are more in-line with the bearish Atlanta Fed GDP forecast than the stock market is. The stock market is more resilient because of the dumb money flowing into it.
The dollar also fell Wednesday because Trump said it was overvalued. In terms of the currency wars, Trump hasn’t done anything too dramatic in terms of action (not rhetoric). The best summary of the Trump administration thus far is both the positive and the negative expectations aren’t being realized. Tax cuts haven’t happened and there hasn’t been a trade war. In an interview with Maria Bartiromo, Trump said healthcare reform must come before tax cuts because the money saved from healthcare reform will fund the tax cuts. This is what I’ve been saying for a few weeks. On the other hand, Trump’s meeting with Chinese President Xi Jinping was mainly amicable. Trump got China to give the U.S. better access to financial sector investments and beef exports. In summary, the market got the Trump administration exactly wrong as the tax cuts haven’t come through and instead of a trade war with China, Trump made a deal which may improve U.S. China relations and improve both economies.
It’s not only the VIX and the ten-year bond which have given up on the reflation trade which started during the election. As you can see from the chart below, just as the ten-year bond started to rally in mid-March, commodities started falling. Copper, rubber, iron, and steel futures have given up most, if not all their gains since the election. At this point, the stock market is the last vestige of the reflation trade. However, breaking down the stock market also shows the Trump trade has lost impact. The Russell 2000 is nearly flat year to date. The small caps were supposed to do well under the Trump administration because of regulatory cuts. However, the S&P 500 is up 4.74% year to date as the big caps outperform small caps.
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As I mentioned, the dumb money is driving stock prices higher through the purchase of index fund ETFs. The gain in ETF market share is both secular and cyclical. It’s cyclical in the sense that investors no longer worry about risk because we’re in the late innings of the bull market. If you aren’t concerned with risk, there’s no reason to pay someone to manage your money. It’s a silly idea to ignore risk, but when the market goes ten months without a 5% correction, people forget what risk is. When stocks fall again, investors may put more money into active funds.
The secular trend in investors switching to passive investments over active ones is because of systemic underperformance by money managers. As you can see below, in the past fifteen years 82.23% of all domestic funds performed worse than the S&P 1500. It’s tough to justify using active management when the returns are mostly worse than passive ETFs. The fifteen-year performance includes the bear market of 2008; active managers still performed badly even though their job is to manage risk. With all the money flowing out of active funds, eventually only the best funds will survive and the fees will be lowered. Better performance is the only way to stem the secular trend.
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In the future, active management will become more competitive with passive management, but it’s tough to recommend either because of the overvaluation of stocks due to the debt bubble. As you can see from the chart below, corporate debt and buybacks reached a new record high this cycle. The corporate leverage ratio has gotten higher than the dot com and housing bubbles. Equity financing is at the second highest level since the mid-1990s even with this excess debt which has been issued. All this money is propping up the equity market. At these levels in the past two cycles, recessions were near. The leverage ratio usually peaks after recessions as declining earnings drive them higher. If the next recession causes leverage to spike higher, it would make the prior two bubbles look like small blips.
Conclusion
The stock market has been resilient to the weak economic data and the disappointment that the GOP hasn’t delivered on its tax reform goals. This resiliency is driven by dumb money flowing into ETFs. Places which aren’t influenced by dumb money such as the VIX, the long bond, and commodities are signaling the reflation trade is over. Just because the passive investing strategy is likely to blow up, doesn’t mean active investing in long-only mutual funds is the right way to go either. Mutual funds have historically underperformed their benchmarks. All investment vehicles which aren’t hedged will be hurt by the debt bubble popping. The charts above indicate the pop will be relatively soon.
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