Guy Haselmann: Humble Opinion and Observations

The S&P is up 6.5% this year. It has risen 4 weeks in a row; more than 1.5% each week. It is higher by more than 10% since Christmas Eve. Yet, in the middle of a Government shutdown, this rally feels unpatriotic to me. Doesn’t’ it? The rally certainly has a strange feel to it. I make an attempt at explaining the rally. If my reasoning is correct, then there is little substance behind the strong move higher, and thus should be faded.

I believe the rally has been driven by changes in expectations in regard to Fed Policy and also in regard to a perceived trade deal with China. No great insight there. But is the market assessing their impact appropriately? Even if the market receives good outcomes with both (i.e., the Fed pauses and a trade deal with China is announced), I believe too much good news has already been priced in as each lacks substance to power markets forward.

Chinese ‘promises’ are typically historically hollow. For instance, does anyone truly believe China will (or can) stop stealing the Intellectual Property of the US? China will likely say they will stop. In addition, the US will not label China a currency manipulator and China will promise to buy more US products.

More hollow headlines. However, another agreement with China in Q1 2019 will likely be agreed upon, simply because both sides need something positive to take other bad news off the front pages. The stock market has reacted 5 or 6 times already to the same headlines....multiple over-reactions.

Furthermore, a Fed pause means little as well. Why? Because real rates are (finally) now positive and the Fed's balance sheet is on a program to shrink by $600 billion in 2019. Policy is economically restrictive and becoming ever more restrictive as the balance sheet creeps lower. In other words, with the Fed’s current path, policy continues to tighten regardless of whether the FOMC chooses to pause or not.

And, a pause merely means a resumption in hikes at a later date; at a “gradual” pace. If the FOMC stops hiking altogether for a longer period of time, it would most likely be due to a looming recession. Either outcome is a lose-lose and something that should not be well-received by the stock market. Again, the market is too euphoric.

In addition, the ECB is no longer offsetting Fed hikes as the ECB QE policy ended in December. And, markets will struggle further when the ECB has to normalized rates from the current UNSUSTAINABLE -0.40% level. A hike just to get to 0.0% will be painful.

In addition, it would be prudent for markets to pay attention to debt levels. Global indebtedness has soared to over $250 trillion which puts it above 300% of world GDP. The US Treasury Market has tripled since 2008 and the CBO is forecasting massive deficits annually for the next 10 years. BBB-rated corporate bonds totaled $700 Billion in 2008, but are now greater than $5 trillion.

The solution to fix the debt crisis of 2008 was to take out more debt. This will have enormous unintended consequences which will begin to be felt as global rates rise from unsustainably low levels. The Fed never talks about how its policies had time inconsistencies.

That new debt simply borrowed from longer-run economic activity in order to support markets (and the economy) in the short-run. It is widely known that a good portion of the proceeds from US corporate debt issuance was used for share buybacks rather than real economy drivers of future economic activity. This spigot has been slowly closing as rates have risen.

In addition, many trillions of dollars of debt are maturing in the next 2 years. Underwriting dollars that are not being invested in stocks. New higher rates also mean debt servicing costs will soar directly hitting earnings and acting as a powerful economic headwind.

Investors should be cautious and adjust portfolios accordingly. The downside is likely much greater than the upside over the next 24 months. Active traders should fade the rally today.