The Macro Market Wrap Up With The Mad Genius, Vol. 28

A couple days ago I left off my 2018 forecast review at stocks and bonds. And it was a pretty rocky year, regardless of the 7% gain over the last 4 trading days.

When I published my forecast in January 2018 , stocks were overvalued by every measure known to man. I mentioned Warren Buffet’s favorite valuation method, which is total market cap to GDP, and total market cap normally tracks around 50% of GDP. At the beginning of the year it was 143%, and at the highest reading it was close to 150%, or three times the normal reading.

I also mentioned that the reading should have been higher, because the government changed how it calculates GDP. That is because they added research and development to GDP, meaning GDP (the denominator of our ratio) was higher.

As an aside, GAAP accounting rules require companies to expense R&D because it doesn’t add anything to the bottom line. So it shouldn’t add anything to GDP either because it doesn’t produce any final goods or services to the end user.

Regardless of how the government miscalculates GDP, in January I said that S&P companies had strong balance sheets and profitability, and that would translate into some staying power for valuations. Based on the momentum at the time as well as the tax cuts, I said the DOW could go to a range of 26,080–26,580, and the S&P could land in a range of 2825–2880. The high on the DOW was 26,951, and on the S&P 2940. So I was off by 371 points on the DOW, or 1.4%, and 60 on the S&P 2.08%.

The indices peaked in 2017, at 24,837 for the DOW on December 28. The S&P peaked at 2690 on December 18. I said stocks could run 5–7% from there, and that I would rather sell a significant position to take profits, missing the blowoff top and that extra 5–7%, rather than risk losing much more. Excluding the last 4 trading days of the year, the DOW bottomed so far at 21,792, for a peak to trough of 19.1%. even if you sold in January that would be a peak to trough of 12.26%. For the S&P, excluding the last four days, the trough is 2351, meaning the peak to trough is 20.03%, and if you calculate from the peak last year it’s 12.6% peak to trough.

I don’t know about you, but I think missing the last 7% rise in stocks worked out much better than mounting losses of 12%-20%.

Now it’s also important to note that I said that as interest rates rise, and the Fed Target Rate is now 1% higher than one year ago, as interest rates rise, the balance sheets and income statements at corporations would begin to deteriorate. Also with a rising interest rate, the yield on government bonds would become more attractive. Whereas the yield on stocks was 1.83% a year ago, that is now 2.09%, and the 3 month treasury yield by comparison has moved from 1.39% to 2.45%…making treasuries look more attractive just based on the yield, because not only is the yield now higher, but you can de-risk your portfolio with a 3 month treasury and get a better yield than stocks with better tax treatment as well, and puts further pressure on equity prices, just like I said would happen.

Dividends have not fallen yet, even though some companies like GE have made cuts. All else equal, with falling stock prices the yield is now rising. We clearly haven’t hit bottom yet, but I did say that even if we only revert to the mean while maintaining the current level of dividends, that spells out 1100 on the S&P. Because dividends are now beginning to fall along with equity prices, that 1100 mean reversion target will begin to look more and more pricey, translating to equities falling much lower than even that. Since we haven’t bottomed out yet, you will be able to pick up the S&P on the overshoot to the down side with a yield of 7%. Not to worry because that is yet to come.

Moving to bonds, in my forecast I noted strong outflows in bond funds could be attributed to bond investors worrying about the loss of principle. Consider a municipal bond issued by the NYC Municipal Water Finance Authority in November 2017, with pricing at issue from 98–117. As recently as 12/20, that same bond was priced below 90, and December 12 it was as low as 88. And the same pattern can be found in all long term bonds.

My recommendation on bonds was to short a treasury bond mutual fund or ETF, but to make sure it was a long term bond fund. Short term bonds of 6 months or less would remain very stable in price. Shockingly, the longer term funds have done pretty well and held up; the biggest funds were off by only 2–4%. However, the junk bond and high yield funds haven’t fared as well, so if you shorted a junk bond fund, you’d have profited.

That’s it for today. Let me know what you think or ask your questions in the comments. Thanks for reading Volume 28 of The Macro Market Wrap Up With The Mad Genius. Until next time remember that there is always a bull market somewhere in the world, and on the opposite side of every crisis, lies opportunity.

#economics #stockmarket #bonds #crash #recession #investing #yearinreview2018