Are The Bulls Giving Up?

The stock market fell slightly on Tuesday as it prepares for the Fed to hike rates on Wednesday. In this article, I will discuss the latest changes to the macro environment, namely the decline in sentiment surveys and the increase in the producer price index which may soon reverse because of falling oil prices. Bull markets usually end when they run out of buyers, not because of bearish short sellers. The shorts have been claiming stocks have been overvalued for a while. The bearish case may have been reasonable, but the bulls always had a counterclaim why stocks should rally in the short-term. Their arguments are now starting to wear thin. The Fed is hiking rates, the ECB is about to start tapering its QE program in April, fiscal policy won’t be there to save the economy because the GOP is stuck on healthcare, and corporate profits aren’t going to grow that fast.

Even buybacks won’t be able to save the market. As you can see in the chart below, the last 12 months of the top 500 net buybacks excluding financials has plummeted since 2015. Buybacks stopped increasing when earnings stalled in 2015; they’ve fallen recently because interest rates have risen which means firms can’t borrow money cheaply to buy back their stocks. This will hurt EPS growth, putting more pressure on revenues to drive profit growth.

Besides the Fed and ECB taking their feet off the gas pedal, Chinese corporate leverage is also declining. The Chinese economy has been built on an unsustainable expansion of debt. The debt metrics have become so unbelievable, it makes you wonder if the rate of increases can defy gravity. It turns out the debt Chinese firms can take on does have a limit as it has been falling quickly since 2016. As you can see in the chart below, the correlation between Chinese corporate leverage and the MSCI World Index is 0.74. The Chinese debt has been the fuel for the bubble. The chart has the MSCI Index lagged by 12 months meaning the latest crash in Chinese corporate leverage is predicting a decline in the future.

Before the NFIB survey was released, I was expecting another solid result because small businesses are very excited for fiscal stimulus and deregulation. My expectation was met as the survey showed more good results. However, its slight deceleration is disconcerting because the surveys have been the lipstick which has been put on this piggish economy. As you can see from the chart below, the outlook for expansion fell from 25 in January to 22 in February. It’s probably going to fall more as small business owners realize the tax cuts and infrastructure plans the GOP promised will not be coming in the next 6 months. Looking at the breakdown of the outlook for business conditions, 12% said economic conditions made it not a good time to expand business and only 8% said economic conditions made it a good time to expand business. As I said, it was mainly a good report as the outlook for general business conditions only fell from 48 in January to 47 in February.

Besides the slight weakness in the NFIB survey, Gallup has also seen an increase in economic discomfort from consumers. The weekly economic confidence index fell from 16 last week to 9 this week. The reason for the decline can be seen in the breakdown in the chart below. The economic outlook index fell from 15 to 3, meaning the number of people who think the economy is getting better and the number of people who think the economy is getting worse are virtually identical. It turns out hope doesn’t spring eternal!

Giving fuel to the argument that the Fed is behind the curve of inflation, the producer price index came in hot today. The chart below shows the non-seasonally adjusted 12-month change in producer prices. This is the highest growth in prices since March 2012. It’s tough to say the Fed needs to raise rates now since it didn’t raised rates when the PPI was above 4% in 2011. The Fed’s policy is clearly inconsistent with many economic reports.

In my opinion, the Fed was behind the curve a few months ago and is now raising rates to catch up with its mistake. Just as it tries to catch up to inflation, inflation will fall again as oil prices fall. The PPI increase was driven by final demand goods prices increasing 3.9% on an unadjusted basis. This was driven by oil price increases. The chart below shows energy final demand prices increasing. The chart is slightly wrong as the actual increase was 19.2%; I used it to show the change visually. With oil prices at a 3-month low, final goods prices won’t be driven higher by oil anymore. This means the PPI won’t be driven higher by final goods prices and the Fed doesn’t need to raise rates three times this year anymore.

I still expect oil prices to fall further from the current price of $47.90 because of shale production. The EIA expects U.S. shale production to increase 109,000 barrels from March to April. Even though OPEC isn’t happy with oil in the low $50s, shale loves it. This means OPEC will either cut production further or capitulate. It looks like Saudi Arabia may have already capitulated as it increased production by 263,000 barrels in February compared to January. This is one month after the production cuts were supposed to start. If OPEC fully capitulates on its cuts, oil will fall to the $30s. Currently, the OPEC cut is subsidizing shale oil profits. Energy firms’ earnings will decrease if the cuts end.

Conclusion

The Fed, ECB, and corporate buybacks cannot hold the stock market higher. It makes you question if the bulls are running out of ammo. Adding to these negative headwinds, the GOP’s healthcare proposal is looking like it won’t pass soon which means fiscal policies can’t bail out the market. Possibly because of these issues on the horizon, Gallup’s consumer economic expectations survey weakened. Oil’s weakness means energy earnings estimates will be cut; the 9.8% consensus growth estimate in 2017 S&P 500 earnings won’t be hit if that happens.