Morgan Creek Capital Management – Welcome To The New AbnormalVW Staff
Morgan Creek Capital Management letter for the first quarter ended March 31, 2016 – Welcome To The New Abnormal.
Welcome To The New Abnormal
1. Welcome to the New Abnormal. We coined this phrase a few years ago as we thought there was nothing normal about the equity market environment since the extremes of 2000. From 1983 to 1999 the MSCI World Index almost never went down (2/17 negative years), compounded at an impressive 14.8% and the intra-year drawdowns were a not so scary (10.5%). From 2000 to 2015 the World Index has gone down often (one third of the years) and has only compounded at 3.5% while experiencing average drawdowns of a gut wrenching (17.3%).
2. Post-Crisis Deleveragings are measured in decades. There have been four great unwinds, the U.S. in 1873, the U.S. in 1929, Japan in 1989, and the U.S. since the 2008 trough, and it takes 14 years on average to reach trough long-term interest rates which tend to settle between 1.5% to 2%. We are currently in year 9, so 2021 looks like the likely trough.
3. Global Trade has not grown since 2008 and the pace of its decline has recently accelerated. Low levels of global exports have historically been an early warning signal of global Recession.
4. Industrial Production always turns down ahead of Recessions and has now declined for seven consecutive months (and fourteen of the last sixteen). We have never had six consecutive monthly declines without having a Recession follow within a year.
5. Even if the next Recession were a shallow one like 2001 (two slightly negative quarters that weren’t even consecutive) the market impact would likely be significant given the level of current valuations and the average correction during a Recession is (38%).
6. ISM ticked down in April to 50.8 and now is slightly above the contractionary sub-50 zone. Historically, an ISM of 50 indicates a 65% chance of a Recession within the next year.
7. Leading Economic Indicators ticked up slightly, but still point to the ISM dropping below 50.
8. Q1 GDP growth (first estimate) came in at a very disappointing 0.5% (likely will be revised even lower) which points to an ISM reading well below 50.
9. Regional Fed Surveys have been consistently bad and are now all pointing to a lower ISM.
10. S&P EPS and Cash Flow growth rates remain solidly negative, which points to an ISM below 50.
11. The Durable Goods Orders growth rate has collapsed back below zero (2.5%) pointing to an ISM in the 40s.
12. When S&P 500 EPS Forward Estimates peak (as they did in Q3 last year), and continue to decline (as they have in Q4 and Q1), there historically has been 100% probability of a Recession within the following year.
13. Consumer Confidence has rolled over to levels normally found in Recessions.
14. Retail Sales growth is trending down at an accelerating pace, heading toward Recessionary levels.
15. There is barely a whiff of Inflation anywhere with both Headline CPI and PCE (Personal Consumption Expenditures) currently well below the Fed target of 2% (Core Inflation is at 2.2%, but turned down again in April).
16. PPI is at levels (1.9%) only seen in the depths of the Global Financial Crisis in 2008.
17. U.S. GDP continues to be weak with Q2 currently trending at 1.7% (and falling) according to the Atlanta Fed GDPNow indicator (versus a 2.35% consensus).
18. Extremely high Inventory levels could become problematic and have historically been a Recession trigger as the inventory cycle turns from destocking to restocking.
19. Forward Inflation Expectations (5 yr./5 yr.) have recovered slightly to 1.7%, but remain at levels where past QE programs were initiated (in sharp contrast to Fed jawboning about raising rates).
20. Long Bond rates have fallen to 2.6%, signaling that Deflation is a much larger risk than Inflation.
21. History actually indicates that the Fed should raise Fed Funds to 3% (historically, FF equals nominal GDP growth rate). Fed must believe the economy is much weaker than it was historically to keep rates at a near zero level.
22. Contrary to popular belief, the Fed has not eradicated the Business Cycle and there are many indicators lining up to say we closer to the end of the current cycle than the beginning.
23. Fed tried to leave ZIRP (Zero Interest Rate Policy) too early in 1937 and we had a bad outcome (respectfully called the Great Depression). There is actually a case to be made that the Fed has lost control and there is no way out, just like in the 1930s.
24. When the Fed is not expanding the Balance Sheet, U.S. equities have struggled (actually made no return) over the past five years. With no more QE, where will equity returns come from?
25. It is looking increasingly likely that faith in the global Central Banks is waning. European and Japanese stocks have fallen dramatically since the last rounds of QE/QQE by the ECB & BOJ.
26. U.S. equities remain at extreme levels of valuation, 83% above their long-term regression.
27. U.S. equity TTM P/E and Adjusted P/E ratios are the third highest they have ever been.
28. The Buffett Indicator of the ratio of Market Cap/GDP is second highest ever, only worse in 2000.
29. The Q Ratio (valuation vs. replacement cost of corporate assets) is near record levels.
30. Margin Debt (the rocket fuel for the rally since 2009) has begun to roll over and when it turns down it tends to decline very rapidly, leading stocks lower.
31. Inflation Expectations levels have historically been highly correlated with forward P/E ratios and the collapse in inflation expectations argues for much lower equity multiples (lower by 35%).
32. GMO Forecasts poor returns for traditional assets over the next seven years including an approximately 2% nominal compound annual return for U.S. equities.
33. Another longer-term equity model used by a number of asset managers (created by Butler-Philbrick) also predicts a slightly negative real return for U.S. equities over the next decade.
34. The December 2014 Barron’s cover could be an example of Front Page Syndrome. When comparing the 2009 to 2014 move in equities to the move from 1995 to 2000, the current rally should have ended last spring (April 2015).
35. The Strategas Equity Trend Model turned negative in Q3 2015, just like it did in 2000 and 2008.
36. Market Crises are highly correlated with Dollar surges like the one we have just experienced in 2015. The question is whether we’re more likely to see an environment like 1998, 2000 or 2008?
37. Equity market cycle highs usually occur in Q4 of the 4th year of the Presidential Cycle (this year) and cycle lows usually occur in Q1 of the 1st year (Q1 2017) or the Q2 of the 2nd year (Q2 2018) which aligns nicely with the #2000.2.0 playbook of a Recession and market trough in 2017 matching up nicely with the 2001 to 2002 period.
38. Small-cap weakness (lagged large-caps badly in Q1) has historically been a sign of deteriorating market fundamentals.
39. There is huge dispersion in valuation and margins across equity market sectors, which has historically been a target rich environment for long/short investing. 40. The current equity market advance is becoming increasingly narrow (without FANG: FB, AMZN, NFLX and GOOGL, the S&P 500 was down (5%) in 2015).
41. Only the largest Technology and Consumer companies are rising within their sectors.
42. The trend in the Consumer sector has deteriorated dramatically in the past year and only two sub-segments still have positive momentum.
43. Energy sector fundamentals remain weak and there is real risk of rising bankruptcies in the sector (despite higher oil prices) as overleveraged companies are shut off from additional capital.
44. The Healthcare sector remains under attack and is an example of how fragile equity markets are in the current environment.
45. Biotech, in particular, has experienced a meaningful down draft as valuation questions surfaced.
46. The Four Horsemen of the #Growthpocalypse (copper, Korea, oil and interest rates) are all pointing to slower growth and potentially lower stock prices. Dr. Copper, in particular, remains sick, recently giving back all the Q1 gains, and falling copper prices have been a leading indicator of slowing growth.
47. The KOSPI Index rallied along with other EM in the second half of Q1, but has declined back below the 2000 level. KOSPI has been a good leading indicator of slowing growth in the U.S. (and lower equity prices) given high tech components weighting.
48. The rapid recovery in oil prices over the past few months has the potential to reverse some of the stimulus provided to consumers as gasoline prices rise.
49. The 10-year Treasury rate has been stubbornly low at 1.76% (in stark contrast to predictions they would rise above 3%), likely a sign of deflation risk and slowing growth.
50. Unemployment numbers have begun to plateau and are at levels which have been associated with ends of economic cycles in the past.
Welcome to the New Abnormal
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