Market Peak?

The market has settled into a tight range after spiking higher in November and December. It’s tough to say why the market would rally when it is already so expensive. It tends to want to hurt the most investors when they are all leaning in one direction. There were a lot of shorts betting against the market throughout its two-year period of being range bound. With two corrections occurring during this period, the market looked like it would finally fall. The chart below shows previous examples of markets having what chartists call a blow-off top formation. It’s the last hurrah of the bull market which has the least basis in fundamentals.

blowofftop

One of the best representatives of this market is Netflix. The chart below shows the operating cash flow. The lower the operating cash flow has gone, the higher the stock price goes. Speculators are telling Netflix to increase its subscriber count even if it’s at a loss. If you read the comment sections or tweets about the company, traders are claiming valuation doesn’t matter. It is now conventional wisdom that shorting a stock based on valuation is a direct road to the poor house. This scenario of ignoring valuations reminds me of early 2009 when stocks were falling indiscriminately. A retailer called Jones New York was trading at a market cap near the amount cash it had on hand, but investors were too worried to take the plunge in these cheap stocks because they could fall another 20% in a week. The stock ended up rallying soon after trading near its cash position. Valuations will always matter. The conventional wisdom about it tells you what phase of a bull or bear market we are in. However, this non-quantitative metric has been saying the bull market is in its maturation stage for quite some time, so its timing has been off.

netflixcash

It grows exhausting going through each metric which shows stocks are expensive because it hasn’t led to any major correction. Most of this rally has been caused by multiple expansion. Usually it’s better to have stocks rally based on earnings improvements, but this rule of thinking hasn’t been accurate in this bull market. Valuation is supposed to matter in the long run, but when traders are able to make money in a hedge fund hotel like Netflix for years, it makes you wonder if you can be the lucky one who is able to get in and get out without losing money. You are banking on someone greedier buying the stock from you. This has been a winning bet in the past few years. I find the chart below astounding because it shows that the current market is one of the most expensive peaks ever and we aren’t necessarily at the peak. If the market rallies further, it can become the most expensive market ever in even more categories than it is in today.

overvalued

Junk bonds had a great rally following the winter of 2016 crash. It happened even while ex-financials net debt/EBITDA leverage is near the highs. The reason why this hasn’t led to the declines I expected is because of the grey line below. It shows how resources were the main cause of the corporate leverage spike. The two ways this can end badly is if either oil prices fall back down or other late cycle industries start seeing more sales weakness. Another possibility which can lead to trouble is if yields start increasing as is shown in the chart on the right. This is how situations can go from OK to bad quickly. Right now, debt levels are elevated, if sales fall slightly, it could cause a domino effect where it becomes more expensive to borrow money and impossible to issue new stock because of market volatility. The biggest question is if the next change in sales growth is higher or lower.

corpleverage

Today Trump was inaugurated as the 45th president of the United States. It’s important to keep your biases in check when you analyze the possibilities of what his presidency will bring. The market sold off part of its morning rally because his inaugural address appeared to have protectionist tones. The market likes when he talks about tax cuts and regulatory cuts, but not when he talks about tariffs. The question is whether Trump’s presidency is part of a larger trend towards increasing trade barriers. Trump claims to be in favor of free trade and just wants to renegotiate deals to make them more fair. The answer to whether trade will thrive is if foreign leaders are willing to appease his wishes in order to trade with America. The chart below shows global trade improving while tariffs decline. Obviously if the tariffs start moving higher, trade will be hurt.

tariffglobe

The reason for this trend against free trade is because wage growth as a percentage of GDP has lagged behind profits as a percentage of GDP. The people aren’t sensitive to minor changes, but when they see it happening over many years, it starts to become an issue. Politicians attempting to piggyback off the frustration repeat the statistics which make the people become even more angry. They have focused their negative energy on the wrong policy as free trade helps goods become less expensive. Correlation doesn’t equal causation. Just because free trade has expanded doesn’t mean it’s the main reason wages have stagnated. There appears to be a skills gap among millennials. They have college degrees, but they don’t have the proper skills to fit into the jobs employers are seeking.

wagevsprofit

Conclusion

The market is ignoring valuations and is focusing on performance and momentum trades. It’s tough to argue in favor of focusing on the long term where profits matter again because momentum has reigned supreme over an extended period of time. Netflix’s operating cash flow has been negative for almost two years, yet the stock continues to hit new all-time highs. On another note, President Trump was inaugurated today. He may potentially spring a new trend towards higher global tariffs and slower trade growth. This would throw another wrench into the bull thesis. We will see how his rhetoric matches his governing style. Past leaders who have used the term ‘fair trade’ favored increasing tariffs, but it doesn’t necessarily guarantee Trump will do the same.

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