The best view is always from the top of the mountain

US stock markets are riding high, with valuations in the 95th percentile since 1881. But the US economy is in trouble, with growth expected to be in the 4th percentile.

Oil

We focus on Brent as the global benchmark.

The market crept up a further 40c/bbl on the week to close at $44.84, but was again unable to regain the ‘flag shape‘ highlighted earlier this month. And as the chart from Reuters shows:

• “The second half of June and first half of July marked the peak of optimism about a rapid drawdown in excess oil stocks and a rise in prices. In the weeks since, positive sentiment has been ebbing away
• “On the futures side, Brent’s six-month spread peaked in a contango of 48c/bbl on June 19 and has since slipped to about $2.33, again signalling that traders expect inventories to remain plentiful”

Similarly, the International Energy Agency’s August Report comments:

“We reduce our 2020 forecast by 140 kb/d, the first downgrade in several months, reflecting the stalling of mobility as the number of Covid-19 cases remains high, and weakness in the aviation sector”.

The autumn is a traditionally weak period for oil markets, and it looks as though 2020 will be no exception.

S&P 500

We focus on the US S&P 500 Index as the world’s major stock market index.

The market rose 21 points last week to 3372, again failing to make a new all-time closing high. It’s problem is highlighted in the chart from Nobel Prizewinner Prof Robert Shiller. This measures the price/earnings ratio over a 10-year period, to remove short-term wobbles up or down:

• Currently the ratio is around 30, and only 1929, 2000 and 2018 have been higher
• Put another way, it is at the 95th percentile of market valuations since 1881

Yet as respected analyst James Montier of GMO notes:

• “Valuations on a Shiller P/E basis are in the 95^th percentile (right up there in terms of one of the most expensive markets of all time)
• “Economic growth measured as real GDP is in the 4^th percentile based on pretty generous assessments of this year’s growth (which is one of the worst economic outcomes we have ever seen)”

This is not to say the market can’t move higher in the short-term, given the stimulus support being provided by central banks. But it does suggest that we are much nearer the top than the bottom of the recent rally.

Interest rates

We focus on the US 10-year rate, as this is the “risk-free” benchmark for global markets.

Last week was a wonderful week for traders in the US Treasury market, with the 10-year rate jumping from 0.56% to 0.70%, after peaking at 0.72%.

The reason was that the US Treasury decided it needed to sell a record $112bn of debt, including $38bn of 10-year debt during the week. This was most unusual, as liquidity is always low in August with most senior traders on the beach. But they clearly decided to stop building sandcastles for a moment, given the opportunity for an outsized profit.

Their carefully-timed selling ahead of the auctions drove yields higher and prices lower (bond prices are the inverse of yields). And now they can sit back in their deckchairs and wait for yields to fall again.

In due course, they will then be able to sell at a handsome profit, and bank their Christmas bonuses. Nothing, after all, has changed in the economy over the past week to justify such a large move in bond prices.

Market speculators dominate

There was a time, as the Refinitiv chart shows, when investors were genuinely investors. Average holding times used to be 8 years, when fundamentals such as earnings and management ability used to matter:

• But holding times had dropped to just 8 months by the end of last year, as the high-frequency traders (HFTs) began to dominate
• They are effectively legalised highwaymen, as Michael Lewis noted in Flash Boys
• “From 2006 – 8, HFTs share of total US stock market trading doubled from 26% to 52% – and it has never fallen below 50% since“

The holding period dropped still further to just 5 months this year, as the RobinHood traders bet their furlough money on worthless stocks like Hertz instead of sports.

But now, of course, the furlough money has stopped. And company bankruptcies are rising, and large company bankruptcies are already rivaling those seen in 2009.

Wall St hasn’t yet woken up to the fact that the furlough money has now stopped – and with it the funding for the 20%-25% of trading being done by the RobinHood bettors. Nor, as Montier warns, has it noticed that US economic growth this year is expected to be the weakest 4th percentile since 1881.