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Is the Wall of Worry Becoming Vertical?

(Click on charts below for better viewing)

The melt-up, and break-out, in the U.S. stock market recently is a classic case of the market once again climbing the wall of worry in a convincing fashion. Political and economic uncertainty has surged. Trump is now real contender, the Brexit limbo persists, Italian banks are on the brink, and Turkey is wobbling. But the mighty S&P 500 has no time for such petty headwinds, as low yields press investors to seek returns in the equity market. We have seen this movie before, and it ends badly eventually, but it could go on for a while. This is especially the case if investors are starting to discount that EU politics are about to get really ugly. 

The Brexit vote and rise of Trump effectively are proxies for the U.S. and the U.K. turning their backs to Europe. This entails a number of unpleasant consequences if taken to its extreme. The U.S./U.K. will not go to war with Putin over the Baltics, Europe’s soft underbelly vis-a-vis the Middle East and Turkey will become further precarious and unguarded. In the end, this could lead to disintegration on the EU continent. This, admittedly, is a “glass is half-empty” view of the world, though. Other scenarios are possible. It could herald a move towards unconditional integration. Germany gets control over the economy, and France gets its EU army. If individual countries don’t want to play along, they can leave. It will be interesting to see where the pieces land once the dust settles in Europe.  

Meanwhile, our most trusted indicators suggest that investors fade the rally, reduce their exposure or even short U.S./global equities outright. This message is clearest by looking at at dynamic valuation scores, which point to falling returns soon. In addition, a very low put/call ratio which points to complacency.

Other indicators, however, give room for pause. Global real M1 growth point to a surge in the MSCI World, and breadth in the U.S. has improved strongly, which suggests that the rally has “good internals.”








This divergence is not unusual, and essentially is a question of difference in time horizons. What it does indicate, though, is that if the sell-off comes soon, it is unlikely to be the gut-wrenching 50%-to-70% decline the uber-bears are waiting for. Plus ca change. 

Bonds remain very expensive with the main consequence that they are unlikely to protect investors if risk assets sell off. Finally, macroeconomic leading indicators point to lower global growth, but no recession. GDP growth in the U.S. probably rebounded in Q2, while it slowed in the Eurozone. Amazingly, though, leading indicators point to a relatively resilient EZ economy despite the towering political uncertainty. In the U.K. the initial evidence suggests that the economy has fallen off a cliff in the immediate aftermath of Brexit, but it is too early to say for sure. In addition, the economy should rebound quickly from a short-term slowdown driven by a spike in uncertainty unless underlying fundamentals deteriorate. 


The Sweet Spot of Zero Leverage Equity?

Global economic momentum is modest at best, equities and bonds are overvalued, and while allocating your funds entirely to gold, cash and shorts is enticing, it isn’t possible for the majority of money managers. What are investors to do then? The ranking of creditors and equity in the capital structure suggest that high grade corporate bonds—and sovereigns—is the optimal allocation. When the goings get tough, the equity is wiped out, but as creditor you are at least assured a recovery on your investment; even if it may be a slim one. This time could be different, however. 

As an alternative I propose equities with zero leverage. There aren’t many around, and those that do remain unlevered are looked upon with suspicion by the market. After all, if the CFO hasn’t jumped on the bandwagon and issued debt to finance dividends and buybacks, she must be an idiot. But if you believe—as I do—that corporate bonds is the new bubble, being overweight equities with no leverage isn’t a bad idea. These securities won’t be immune to a crisis, but they offer two key advantages. 

Firstly, they likely will decline less than their overlevered brethren and the risk of a bankruptcy is smaller. If a repeat of 2008 really beckons, capital preservation may turn out to be the key metric of survival, no matter the drawdown.  Secondly, buying equities with zero, or very low, leverage is also a free option. If we are wrong, and the debt finance buyback and dividend party goes on, a portfolio of equities with zero leverage eventually will join the party too. In all likelihood, that means excess returns for your stocks.  

Once leverage has increased you can sell and go looking for another batch of firms with no leverage, primed to lever their balance sheet to hand out money to shareholders. We concede that this latter rationale partly is a contradiction. But we would rather buy firms with a clean balance sheet, than the alternative of buying equities that have already maxed out their potential for debt financed shareholder gifts.  


Confusing charts; no directional clarity

Meanwhile, looking at the macro, strategy and technical charts has left me confused, a bit like Macro Man I suppose.

Macroeconomic leading indicators have stabilised based on the most recent data. The year-over-year rate in the U.S. and EZ headline indices have climbed marginally, and risen strongly in China. In Japan, however, the message from the headline index is grim. Global money supply growth has turned up further, helped by the U.S. and China. It is particularly encouraging to see that M1 growth has accelerated slightly in the U.S.  

On on the contrary, my short-term charts of the market are sending a very unclear message. In the U.S. put-call ratios point to further upside despite the recent rally, while the adv-decline ratio continues to roll over. My equity valuation scores point to a slow grind higher in coming months, before a sell-off takes over towards the end of the summer. In sovereign bonds, I remain bearish.