Now that the dust has settled after the Fed’s much-bruited big move, it’s time to take a step back and see what, exactly, happened.
Spoiler alert: We haven’t yet reached the breaking point, and we’re still in a bubble. Markets shrugged off the second consecutive quarterly interest rate hike by the Fed last week while signs of excess abounded in the markets.
And that means individual stock and bond investors would do well to be wary.
Here’s what to watch out for…
Stock Investors: Stay Out of These Sectors, And Keep An Eye on Healthcare
One reason we know stocks are in a bubble is because investors are paying no attention to valuations. How do we know that? Because they poured another $131 billion into ETFs in the first two months of the year. Throwing that much money into these park-your-brain-at-the-door vehicles that don’t require any knowledge of the underlying investments is a sure sign that investors are chasing the rally rather than paying attention to fundamentals. That is the very definition of the bubble. All bubbles pop and this one will be no exception.
Markets appear confident that President Trump and the Republican Congress will be successful in replacing Obamacare with a more workable healthcare system. Such an outcome is essential to the outlook to the big enchilada on which investors are placing all of their hopes and dreams – tax reform. Without Obamacare reform, tax reform is not going to happen. While any new healthcare plan is going to be imperfect, it is essential to setting the table for tax reform. The post-election rally was based on expectations that lower taxes and less regulation would stimulate the economy; any setback on tax reform would deal a hard blow to those hopes and likely push stock prices lower. Whatever their views on Obamacare (which either needs to be fixed to survive or replaced with something that works), investors should keep a close eye on the healthcare debate because it likely holds the future of the stock market rally in its hands.
Despite a big rally after the Fed announced its rate hike last Wednesday, stocks ended flat on the week. The Dow Jones Industrial Average added just 0.1% to close at 20,914.62 while the S&P 500 rose 0.2% to 2378.25. The Nasdaq Composite Index rose 0.7% to 5901. Small stocks continued to lag with the Russell 2000 underperforming large cap indices. Tech stocks continue to lead the market with a 12% rise year-to-date as the FANG stocks (i.e. large cap tech stocks) continue to attract huge amounts of investor capital to build epic valuations. In sharp contrast, the retail and energy sectors (both stocks and bonds) continue to show serious weakness.
A quick glance at the list of new 52-week lows shows a large number of retail names sinking into the mud including Ascena Retail (parent of Ann Taylor stores), BonTon Stores, FinishLine, Fossil, GoPro, Fitbit, Perfumania, SearsCanada, SteinMart, GNC Holdings, Guess, JC Penney, Smart & Final Stores, Target and Vitamin Shoppes. Consumers may be shopping, but they sure aren’t doing it in brick-and-mortar stores. Weakness is also spreading to the restaurant sector and other consumer brands because in reality consumers aren’t doing nearly as well as the pundits would have you believe.
Tesla Motors, Inc. raised $1.2 billion of new capital in the form of $350 million of common stock and $850 million of convertible bonds while another single product company – Canadian Goose Holdings (GOOS) – went public at an exorbitant valuation (38x earnings). While IPO-flippers were goosing their short-term profits, they were probably patting themselves on the back that they won’t suffer the same fate as others who chose to hold on to their Snapchat shares (now trading back down below $20/share) or the even worse fate of other one trick pony stocks like GoPro, Inc. (GPRO) or Fitbit, Inc. (FIT) that lost most of their value since wowing gullible investors on their IPO debuts.
Tesla stands tall as the poster child of today’s stock market bubble and all of the smug Wall Street pied pipers who are leading investors over the cliff to inevitable disaster. But while Elon Musk may think he is very clever by spreading out the inevitable dilution of selling more shares to finance his delusional claims that Tesla will churn out 1 million cars by 2010, he is only fooling those willing to be fooled. The company continues to lose money on every car it makes (as well as every solar panel bailed out SolarCity sells with the help of government tax credits). Cult members are duly warned: keep the car but dump the stock before it is too late.
First quarter growth is likely to be sluggish again as in recent years, but the economy should rebound in the second quarter to somewhere in the 2.5% vicinity. This means first half growth will likely clock in at somewhere around 2% or a little less, nothing to write home about but far from recessionary levels. The difference this year, however, is that the Fed appears more anxious than at any time since the financial crisis to pick up the pace of its rate hikes despite no discernible acceleration of economic growth. If the Fed does what it says it intends to do (a big “if”), it could put interest rates on a collision course with stocks. Before getting too far ahead of their skis as winter comes to an end, investors may want to consider that stocks are already fully priced before following the Pied Pipers of Wall Street over the edge of the cliff.
Bond Investors: Fed Tightening Opens You Up for Serious Losses
Speculation is alive and well in the land of Trump, but the land of Trump is really the land of Yellen and it is peopled by fools. The most interesting reaction to last week’s long overdue 25 basis point hike by the Fed (we do not live in courageous times) was the 11 basis point drop in the yield on the benchmark 10-year Treasury bond after the announcement.
For some reason best left to the geniuses running trillions of dollars of underperforming bond funds around the world, the Fed’s promises to raise rates by 150 basis points over the next two years (which just to be clear would quadruple rates from the levels of a week ago) was interpreted as a good thing. That makes as much sense as Ezekiel Emanuel, one of the architects of Obamacare, telling us with a straight face that his brainchild is not collapsing in front of our very eyes. The only way you can believe these things is through is through a willful suspension of disbelief, which is another way of saying that you have to be an idiot.
Promises of higher rates were shrugged off in the United States, where the federal deficit is $20 trillion with no talk by anyone in the government of making any serious attempt to reduce it. Clearly the bond market either knows something those of us who can still do arithmetic don’t know, or it has shortened its time perspective to that of a fruit fly along with the rest of the market.
In the meantime, one year Treasuries are trading up at 0.98% and 2-years are up at 1.31%, the highest levels in years. In case anyone forgets (apparently everybody forgets), the US finances its deficit with very short term money, so the cost of financing the deficit (and therefore the deficit itself) is going to start feeling the effects of the Fed’s belated boldness very soon.
Many hedge funds are betting on higher short-term rates, which has been a profitable trade in recent weeks. It is also a very crowded trade but it is working. Junk bonds are selling off on rising rates and weaker energy prices. It is difficult to see how fixed income investors can look forward to anything other than pain over the next couple of years with the Fed raising rates by another 150-200 basis points from current low levels. High quality bonds, including investment grade and municipal bonds, are particularly vulnerable to serious losses and should be avoided during the Fed’s tightening cycle.
Outside the U.S., the prospects for bond investors are even more dire. Negative yields in Europe guarantee capital losses for anyone foolish enough to own European bonds (many of these are owned by the European Central Banks and other European institutions who need to meet regulatory requirements). One reason stocks are trading at bubble levels is that bonds guarantee losses. Unfortunately, bonds are in even more of a bubble. And when the bond bubble bursts, it will spell big trouble for bonds and stocks.