Look, Mom, No Hands!
Wall Street's manic melt-up is pushing stock prices ever deeper into the realm of insanity, and nowhere is that more evident than in the Russell 2000 (RUT). At today's level of 1525, it is now up by 312% from the post-crisis bottom and nearly 80% from the prior tippy-top peak in May 2007.
More significantly, the RUT has risen by 6.8% per year since January 2000 while domestic final sales have increased from $10.6 trillion to $20.0 trillion or by just 3.8% per annum. That is, the RUT index has gained at nearly twice the growth rate of nominal domestic final sales.
Surely it doesn't take an MBA from Harvard to recognize that a gap that wide stretching over 17 years is deeply suspect. For instance, had this broad-based basket of domestic stocks risen in parallel with domestic sales, which over time they must, the index would today stand at 935 or nearly 40% below the current price level.
Skepticism is especially warranted when you put today's index level and valuation multiples into cyclical context. To wit, the US business expansion has reached the ripe old age of 102 months, and there is no evidence that even the quack economic doctors at the Fed have come up with the monetary equivalent of Viagra.
Still, the 2000 small and mid-cap companies represented by the index are main street based and dependent on domestic customers and costs for the overwhelming share of their profits. So the casino is apparently pricing-in one hellacious late cycle domestic boom----since the Russell 2000 PE multiple stands at an absurd 110X LTM earnings, according to the Wall Street Journal's market data page.
Indeed, consider what happened last time the RUT peaked at 850 in May 2007. During Q2 of 2007, domestic final sales had posted at $15.1o8 trillion, but fully three years later---after the recession had taken its toll and recovery was well underway----that figure had made no net progress at all; it was still $15.157 trillion.
Stated differently, the business cycle rolled-over, the main street economy hit the flat-line for three years running and profits of the Russell 2000 companies dropped sharply. Not surprisingly, as of Q2 2010, the RUT index at 660 was still 22% below its pre-crisis peak.
To be sure, we do not know when the next recession will strike---- nor can its depth and duration be easily projected. But pricing earnings at 110X is utterly nonsensical when the chances of a cyclical dip in underlying sales and profits is high and rising.
Indeed, we'd say that 36 months out from this point the overwhelming probability is that the main street economy will look more like the 2007-2010 recession cycle than one perking along with unprecedented octogenarian vigor. After all, that would be month #138 of the current business expansion---or a place where the US economy has never been in all of economic history (the average expansion is 61 months and the longest was 118 months during the tech boom of the 1990s).
The reason we dwell on the rapidly aging U.S. business cycle is that the same Wall Street Journal data page that reports the current PE multiple at exactly 109.56X reported earnings also indicates a PE multiple of just 20.32X for the sell-side consensus "Estimate" of next year's earnings.
We reproduce this jarring contrast below because its precisely the kind of screaming anomaly everywhere present in today's casino that you can't make up.
That is to say, the reported LTM multiple in the first column implies $14 per share of earnings were reported to the SEC by the RUT's constituent companies for the period ending in August 2017. At the same time, the Wall Street ex-items hockey stick for next year, shown in the third column, implies earnings of $75 per share.
That's right. On the fundamental matter of the earnings basis for the RUT index there is a 5X difference between what CEOs and CFOs attest to on penalty of jail time, and what the unhinged crowd on Wall Street manically imagines will happen.
12/8/2017† | Year ago† | Estimate^ | 12/8/2017† | Year ago† | |
Russell 2000 | 109.56 | nil | 20.32 | 1.34 | 1.45 |
Needless to say, this yawning gap is just further proof that there is really no serious information content in today's stock prices. It's surely a case of "look, mom, no hands!"
Stock prices are heading for a giant spill because they are now being mechanically levitated by pure speculation and the huge pro-mania bias that results from $7 trillion of ETFs and other passive funds buying the market solely because it is going up; and also owing to well more than $1 trillion of "vol" short sellers slamming into every feeble effort at stock market correction before it even gets started.
The present moment constitutes a classic case of picking-up nickels in front of a steamroller---if there ever was one. That's because despite the casino's apparent obliviousness to everything except the price action, there are now two monster stock crushing machines heading straight toward the casino---and they are doing so in plain sight.
Namely, Uncle Sam's fiscal equation and borrowing requirements are spinning out of control exactly at the time when the Fed and other central banks are pivoting toward an epochal reversal of the last 30-years of nonstop monetary expansion.
Ground zero of this imminent collision will be the bond market, of course, and the resulting upward shock to yields across the entire maturity curve will trigger a massive "reset" of all financial asset prices. That's because, in the favorite phrase of the talking heads, the elephantine $22 trillion balance sheet of the global central banks (compared to just $2 trillion in the mid-1990s) has become fully "priced-in" to today's stock prices.
Indeed, as recently as a few months ago, the combined central banks were sucking up government debt and corporate securities at a $1.5 trillion annual rate. But with the Fed already shrinking its balance sheet at a $120 billion rate, and heading for a $600 billion annualized shrinkage by next October, the whole supply/demand equation in the world's fixed income markets is heading for a radical adjustment.
And that will be compounded when the ECB taper ends in late 2018 and even the bank of Japan begins to reduce its absurd spree of QQE that has now taken its balance sheet to more than 90% of GDP.
Indeed, the central balance sheet shock that is coming down the pike could not be better crystalized than in the graph below. During the past several years, but especially since Kuroda unveiled his monetary bazooka in March 2013, the BOJ has been buying every government bond that is not nailed down and a massive trove of ETFs, to boot.
Incredibly, it now owns fully 74% of all ETF outstanding on the Japanese exchanges. But even the BOJ has finally indicated that this maniacal purchasing spree will soon be reduced by one-third as part of a reluctant but certain process of weaning the Tokyo markets from years of massive stimulus.
At the same time, the "in-coming" fiscal data in the US leaves nothing to the imagination. On December 8, the net public debt stood at $20.42 trillion, and represented a gain of $950 billion since the day of Donald Trump's shocking election victory on November 8 last year.
We again place this stunning figure in cyclical context. Uncle Sam's borrowing rate was nearly 5% of GDP in the last 13 months, and at a time late in the cycle when historically deficits have always been in a sharply contracting mode.
But that is not remotely where Washington is today as a panicked GOP throws every semblance of fiscal prudence to the wind. Ironically, Congressional Republicans are trying to escape the political albatross of the madman in the Oval Office by passing any tax bill and other fiscal legislation that could possibly appease any lobby, PAC, and constituency which might even remotely bear on the 2018 elections.
Not only will the current tax bill add more than $2 trillion ( when you eliminate all the gimmicks) to the $10 trillion of baseline deficits over the next ten years, but all of that red ink is front-loaded into the years just ahead; and it is being exacerbated by massive spending increases for defense, disaster relief, veterans, border control, the ObamaCare subsidies and a laundry list of other boondoggles which is growing by the day.
The fact is, Federal borrowing will leap over the trillion mark as soon as the tax bill is passed, and keep rising from there as far as the eye can see. Accordingly, the bond vigilantes will return after nearly 25 years in hibernation, causing interest rates and yields to soar.
Interest on the Federal debt, for example, which is being financed on the cheap at $300 billion per year (including the offset from $100 billion of Fed "profits" per year which will soon disappear) will soon double or triple under the weight of soaring issuance and rising rates.
In that context, we think there is not a snowball's chance in the hot place that the US economy can avoid a financial crisis and consequent recessionary blow many months longer. And that means, in turn, that American consumers are heading into the next downturn with absolutely no dry powder left in their collective bank accounts.
The Fed will undoubtedly pronounce that the economy is in fine fettle in its statement tomorrow, and that it is raising the funds rate by 25 bps out of an abundance of confidence and caution; and in the conviction that its massive falsification of financial asset prices since 2008 has not generated any serious financial imbalances or dangerous bubbles.
Then again, we would wager a fair sum on the proposition that egregiously unwarranted and unsustainable financial bubbles do not arise on an honest free market; they get nipped in the bud by two-way trade and short-sellers that keep markets healthy and disciplined.
What gave rise to the RUT at 110X and the bitcoin parabola below is definitely not that.
Disclosure: None.