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First Quarter Outlook and Opinion

Stock market indices have shrugged off Iran, and begun the year by moving higher. Unless Iran chooses to somehow disrupt the supply of oil to the West, it is unlikely to have much of an impact.

There has been consistent selling in the U.S. by retail investors in 2019. Flows have been drifting out from retail investors and into the hands of companies buying back their own shares. Assuming that there is no recession in 2020, and assuming that Donald Trump is re-elected, retail investors may experience FOMO, or a fear of missing out. Historically, the period of mid-October through May is a good period for stocks, but January is, on average, particularly good for small cap stocks. The relative peak for small cap stocks was in August of 2019. Today, despite the overall rise in the stock market, small cap stocks are some 8% lower.

Despite all off the inputs that affect the stock market, there is still a strong correlation
between the balance sheet of the Federal Reserve and stock prices. This is what the Fed’s balance sheet has been doing lately:

temp-post-image Source: Federal Reserve

The Fed was on a course to reduce their balance sheet until the end of August 2019, draining liquidity from the economy until it began contributing to a crisis in the repo market. This drain of liquidity, combined with certain bank regulatory issues, provoked banks to stop lending money overnight to other banks. The “regulatory issue” here involves the requirement imposed upon banks to put up some regulatory capital when they lend excess reserves to other banks in the repo market, as opposed to just parking their excess capital with the Federal Reserve.

The problem that the Fed faces today is that they cannot reduce their balance sheet, i.e. remove liquidity from the system, without causing problems in the repo market, which is an important piece of plumbing within the financial system. The Federal government, with its tax cuts, have incurred deficits of an additional $1-$2 trillion, which needs to be addressed with more Treasury borrowing, which in turn removes cash from the system as investors buy them. Accordingly, the Fed is forced to remain accommodative, which will continue to drive stocks up. Liquidity is driving stocks, and that liquidity is being provided by the U.S. central bank. Just this week alone, the Fed had to inject $82 billion dollars to support the repo system, and $99 billion last week.

To summarize, much of the stock market’s performance can be explained through the above chart.

The need to provide liquidity to the repo market (uptick on the right side of the above chart) will not stop until regulations change for the repo market.

The 2019 stock market rally was fueled almost entirely by multiple expansion rather than earnings growth. As previously mentioned, the Federal Reserve had a lot to do with that. The other source of pure liquidity-driven stock increases was due to stock-buybacks from corporations. Since 2009, non-financial corporates have borrowed $5 trillion through the bond market (both investment grade and high yield). With the proceeds, they have purchased nearly $4 trillion cumulatively of their own shares back. This massive-scale buying will continue by corporates until interest rates go up. To emphasize the importance of the size of these stock buybacks, the number of shares outstanding in the stock market overall is now at a 20 year low.

Oil and gold are now geopolitical, since the escalation of tensions with Iran. There are risks of oil prices going considerably higher for obvious reasons. Energy stocks have underperformed the overall stock market, and are some 25% lower than in October of 2018, despite a bull market for stocks. Wall Street’s perception of oil prices remains skeptical, as it believes that higher oil prices will be met with a flood of supply by U.S. shale oil producers. Nonetheless, Iran remains the wild card in the short and medium term.

Phase 1 of the trade deal between the U.S. and China is expected to be signed on January 15th. Trump has indicated that Phase 2 will not be addressed until after the election. For the moment, its perceived significance has diminished. It took more than two years to arrive at phase 1, which is considered the “easy part” of a trade deal with China. Phase 2 and Phase 3, if they happen at all, are not likely to occur in the next six months.

The percentage of publically traded U.S. companies which are unprofitable has increased sharply. This may come as a surprise, given the rising stock market and the perception that the economy is so strong. Just over 40% of all publically listed companies were unprofitable in 2018, although very few of those are included in the S&P 500.

While overall manufacturing numbers are still weak in the U.S., the American consumer has been robust, suggesting solid growth close to trend. We are likely entering the last stages of a bull market which may unfold with even higher liquidity driven equity prices before it’s over. While there is a possibility of a pullback, the outlook until April remains bullish, barring macro shocks. Nonetheless, we should bear in mind that stock multiples are expensive, and as the following chart implies, the valuation of the stock market overall relative to U.S. GDP is at historically all-time highs:

temp-post-image

Source: Doug Short, Advisor Perspectives

Investors are extremely long equity exposure. The “fear/greed” index indicates that bullish sentiment is approaching extreme levels. While this may portend some volatility ahead, the bull market is not yet over until the Fed begins withdrawing liquidity from the economy rather than adding to it.

Grant Rogers

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