Market Optimism Ending

While optimism exploded after the election, it has slowly started to revert to the mean. If you’re only focusing on equities, you wouldn’t be able to see the unwind because the S&P 500 is within less than 1% of its all-time closing high. The Dow is still making its attempts at reached the heralded 20,000 level. As an aside, it will be interesting to see if the Dow reaches 20,000 before the U.S. debt reaches $20 trillion; the debt is $19.57 trillion and will reach $20 trillion in about a month. Equities have been in a sideways correction, but the dollar and 10 year bond yield have fallen off more.

The 10-year treasury yield is down 3.69% year to date and has fallen from its 52-week high of 2.64% to 2.35%. The dollar has fallen 0.79% year to date and has fallen from its 52-week high of 103.82 to 101.40. Given that the dollar and bonds yields rising had been part of the Trump trade, it may mean equities are next to fall. The biggest declines should be seen in the regional banks and small caps. The Russell 2000 is already down 2.08% from its high and the KRE regional bank index is down 2.21% from its recent high in December. I expect them to fall further with accelerated selling starting on January 20^th as traders ‘buy the hype and sell reality.’

It’s interesting the Trump trade is unwinding because at the end of the year, short interest plummeted. The rally was driven by short covering, especially after the election, as many traders were position for a Trump election to cause the market to crash. As you can see from the chart below, short interest in the NYSE fell 5.3% to a 2-year low and the Nasdaq short interest fell 1.5% to the lowest since January 2014. If the rally is to continue early this year, it will need to rely on buyers instead of short covering. This will be tough because buyers will likely want to see more clarity on the economic policy front before jumping into the market with both feet, especially since valuations are already stretched.

There is much evidence to cite which conflicts with the bullish narrative. The chart below is just one factor which I will review. It shows net equity issuance as a percentage of cash flows has be rising. This measure of leverage usually increases during times of crisis because firms need to raise capital and have little profits. It is currently higher than the peak of the dot com bust. Investors are ignoring this leverage as the U.S. high yield spread is low. In the 26-year history of this chart, the net equity issuance as a percentage of cash flow has never been this much higher than the high yield spread. In other words, there has never been this much unbridled optimism.

As I showed in the dollar and 10-year chart, the optimism has been waning noticeably. The question is not whether Trump will get some of his agenda passed into law, but whether the expectations were possible to be met because they are so high. Some consumers in these surveys may simply be happy the election is over because of the vitriol which surrounded it. The Bloomberg Consumer Comfort Index shows the initial post-election positivity retracting. There was no economic reason to be positive for most workers. As I previously discussed, the praised wage hikes were met with decelerating hours worked, so there was not a big boost in take home pay.

Going back to the way the economy and consumer spending was before the election is not a good thing. Bank of America has internal debit and credit card data which it uses to track consumer spending in various industries. Retail sales seasonally adjusted ex-autos declined 1% month over month in December. Millennials are starting to drive the data more and more as they get older and have more disposable income. They spend money on experiences instead of goods. This could be why lodging spending was up 6.5% year over year and home goods spending was down 5.6% year over year. I understand this thesis because as a millennial I have a similar perspective.

However, if experiences are valued by this demographic, you would think going out to eat at a restaurant would fall under this category. I think we will need a full cycle of data to determine what this means for the restaurant industry. The chart below shows spending at restaurants decelerating to levels not seen since the depths of the last recession and right after it ended. The data would seem to be cyclical because millennials didn’t suddenly start having an acute impact on sales trends in late 2015. Based on this chart, you’d assume the economy is already in a recession.

The final chart I have is seasonally adjusted monthly credit data. As you can see, right when restaurant sales started to decelerate, consumers started using more credit. My theory is consumers are putting normal expenses on credit cards because their personal savings are dwindling. Usually credit spending is good news for the economy, but it’s not this time because it’s being used as a last resort. If my theory is correct, there will be a deceleration of restaurant sales to the point where they go negative when lines of credit get extended to their limit. Maybe consumers gained hope after the election because the economy has been very bad for them personally throughout this recovery.

Conclusion

            If restaurant sales and net equity issuance as a percentage of cashflows are viable economic indicators, then the consumer optimism will soon wain as the economy falters. The equity market will follow the dollar and bond yields and head lower. When Obama came into office, it marked a bottom in stocks. When Trump comes into office, I expect it to mark a top. Obviously, these indicators can be wrong, so take this advice for what it is; it isn’t a guarantee.