The Case for Bearishness

Even when the equity market falls, it seems to rebound. In the morning, the S&P 500 was down as much as 0.78% before regaining more than half of those losses. Today was the first day the Nasdaq was down this year as technology stocks had been making up for lost ground in this Trump rally. The reason given for this mini-selloff was Trump’s first press conference didn’t live up to expectations. That’s what I mean by expectations being too high. There wasn’t anything surprising about the presser which may have been a problem for the market. It seems to have wanted economic miracles even before Trump is sworn into office. As I showed in a previous article, the last time small business optimism jumped as fast as it did in December, there was almost a 16% jump in GDP growth within two quarters. One possibility for such a large jump in small business optimism may be because there’s hope that the malaise surrounding the country, like was the case in the 1970s, is about to be lifted.

Sentiment indicators don’t always have great records at predicting the timing of major market reversals. I like to look at them for context, so I can compare the current point to past points in market history. Sentiment will never shock you with the direction it is going in, because it tracks the market. When it hits extremes, it’s worth taking note. As you can see from the chart below, the NAAIM Exposure Index’s 4-week moving average hit a new record high. This could mean a correction could be coming shortly. I recognize that this correction could be shallow given the index has gone negative a few times during this current bull market. The only time optimism becomes a problem, is when everyone is of that opinion. However, too much optimism is not enough to mean we’re headed for serious trouble.


The big story for 2017 is supposed to be earnings growth which is something I’ve documented in the past. The biggest contributor to this earnings growth is expected to be energy as oil prices have rebounded. OPEC is cutting production which will limit supply. The economy is expected to rebound which helps demand. Oil firms have cut costs during the downturn. When oil prices go higher some of those cost cuts stick and the firms become more profitable than ever before. The chart below shows this expected profit growth in 2017. The S&P 1500 Composite Oil Gas & Consumable Fuels industry is expected to see 367.82% profit growth. The Energy Equipment and Services industry is expected to see EPS growth of 2,961.95%.


In summary, the market is relying on oil prices to remain high in 2017 so energy stocks can lead the market’s earnings higher. If oil were to crash lower, the narrative of higher earnings would take a hit. Considering oil’s volatile past, the market is on shaky ground by relying on it. While I cannot predict oil prices in 2017, the chart below is very disconcerting for oil bulls. The non-commercial speculators’ net position in crude oil futures is now near the all-time high made in July 2014 which preceded the crash. The speculation will likely come down at some point in the next few months. The only question is how much selling pressure this puts on oil. The profit expectations I mentioned earlier will not come true if oil has a deep sustainable correction.


The total tax receipts are a great measure of economic activity because it is a hard data point unlike surveys. The chart below shows the 12-month summation of total tax receipts is declining for the first time since the last recession. This chart indicates we are already in a recession. There’s two possible counterpoints where this can be misleading. The first is that some people may have tried to put off earnings from 2016 to 2017 because taxes are expected to go lower. If a business is expecting to do a major project which didn’t have tight deadline in December of 2016, it could have been pushed back one month. If you had capital gains in a stock at the end of the year, it made sense to sell it in January instead of December because capital gains taxes may be falling. The second possibility is there may be an increase in people working in the underground economy. Given the substantial decrease in the labor force participation rate is only about half due to an aging population, some of these people may be working, but not paying taxes.


Besides energy stocks, cyclicals in the U.S. are doing well in general. Usually emerging markets and U.S. cyclicals are correlated because they are reliant on similar economic trends, namely strong commodity prices. The difference since the election in these two equities markets is reflective of Trump’s America First protectionist trade policy. The question for U.S. cyclicals is if reversing globalization will counteract the positives that will come from an infrastructure stimulus. China has been behind past rallies in earth moving stocks. Can America now carry the weight for these multi-national power houses? We will see what happens this year, but I’m not betting on it.


The final chart I have is the non-financial net debt to EBITDA ratio. It shows that the debt cycle is about to peak. It’s tough to say when it will happen, but 2017 looks like a prime target. The only way this doesn’t end in a crash is if EBITDA increases like expected.



Positivity is high because earnings are expected to have a great year. However, earnings growth relies on high oil prices which may not be in the cards given the amount of speculative long positions. If earnings don’t improve, the deleveraging cycle will get started as the high yield and investment grade debt are at levels normally associated with cycle peaks. Trump wants to institute a border tax for U.S. firms who outsource. I don’t see how protectionism is the answer to these problems.

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  • Tom Wallace

    January 15, 2017

    Very valuable

  • Jeff

    January 17, 2017

    I find the belief that OPEC will actually cut production this time amusing because OPEC members always cheat and go over their "quotas" because they need the money. Especially Iran and Venezuela. The COT numbers are the most telling. I went short oil last week (long term) just on those numbers. Not only are the large specs at record high long positions, the commercials are at record high SHORT positions. The commercials are almost always right. They have skin in the game. That does not mean oil cannot go higher in the short run, but there is serious overhead resistance at around 54.50 on the futures. Next serious resistance is in the 58-59 range. My belief is that oil will be a great short if it actually gets into that range. As good as the short opportunity in July of 2014. We'll see.