The month of July was extremely kind to investors worldwide. This was undeserved, in our opinion, given Brexit, a surprisingly weak second quarter GDP report, the sixth consecutive quarter of earnings declines in the US, an upcoming election in which there will likely be considerable unhappiness no matter who wins, terrorist attacks in Europe, and the turmoil in Turkey. The US stock market posted a 3.65% gain last month, but that was bettered by a 4.16% gain for the world-ex US. See Chart 1. It is as if a fever gripped investors that compelled them to buy bonds before yields fell to 0% and stocks before the Dow hit 20,000. I have a very unscientific contrarian indicator that I use to gauge market sentiment that I call the “right margin indicator”. It refers to the right margin on the internet page where I get some of my market information. It’s generally filled with fear mongering ads designed to prey on investor emotions. During the Dow run up from under 16,000 back in February, every single crank on the right margin was forecasting a stock drop of 50% or more. Now it’s filled with ads predicting Dow 50,000. As a contrarian investor seeing those ads gives me pause.
If it does turn out that we are close to a market pull back, the following is likely to be viewed in hindsight as one of the signposts. Last Friday, the Bank of Japan surprised the market by deciding to postpone the decision to further cut interest rates. That followed by one day the Bank of England doing essentially the same thing. Some observers suggested that world central bankers are close to saying, in essence, “Enough. We’ve done all we can do. Fiscal policy has got to carry us from here”. Central banks have been trying to assure investors and government across the globe that they can keep us all out of global recession, but all that has done since 2009 is give politicians in Europe and United States an excuse to do pretty much nothing of substance. As an example, the United States has not passed a budget in five years. They’ve been using so-called continuing resolutions to fund the government. Central bankers are well aware that recent policy moves have done little for average citizens because the benefits from lower interest rates accrue to investors while hurting savers. They are also keenly aware that a backlash against these policies is behind Brexit and populist movements around the globe. Citizens are demanding an end to policies that they believe, rightly or wrongly, benefit only elite groups of well-connected citizens and corporations.
The risk, of course, is that if there is to be no more quantitative easing or extraordinary monetary policies then eventually the market starts to “normalize”. The pendulum swings back to fiscal policy (Main Street) and away from monetary policy (Wall Street). Legislatures have to spend in order to put people to work to keep recessions from becoming Depressions. Deficits rise, interest rates rise, and price-to-earnings multiples contract. As interest rates rise, companies are forced to “make stuff” to prosper, because financial engineering (borrowing in order to leverage the profits) no longer works. In fact, companies have to reduce leverage. More businesses will fail because the cost of bad decisions rises, but successful businesses are more dynamic and have a greater ability to increase wages.
The bottom line is that the period from the early 1980s through the present has seen great gains for investors but very little wage growth. One way or the other, a reversal of this trend needs to happen, at least in part, and at least for a little while, or the tradition of liberal democracy in Europe and America is in danger. Individuals will put up with the feeling that other people are prospering, but they aren’t, for only so long before they become angry and demand change. The current rise of populism is symptomatic of that. Sometimes those change agents are benign and the changes are positive. Sometimes they are not.
Sector Performance and Risk On
Breaking down the performance of various sectors in July, we saw a dramatic shift to “risk-on’ behavior. Utilities and consumer staples declined while technology, health care, materials, and financials gained. Foreign stocks outperformed domestic stocks, while small stocks led big stocks and growth outperformed value. The trend appears to be moving away from dividend and high quality stocks. As one would expect, higher risk was once again associated with higher return. Bonds peaked with the stronger than expected employment report on July 8th and are starting to break down technically. This is consistent with the notion that investors are giving up on the “yields are going to 0% so you better buy the highest safe yield you can find” fear trade thesis that we saw after the June employment report. It will be very interesting to see what happens with this Friday’s unemployment report.
Gold peaked on July 6th and went into a correction for three weeks. The weak GDP report last week helped restart the rally. While gold bullion is still short of its recent highs, mining stocks have made new cycle highs. It is tempting to focus on the 100%+ rally of the early February low, but the mining stock index (GDX) is still over 50% below its September 8, 2011 all-time high.
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