S&P 500: There’s Still Something Ridiculously Wrong
Featuring Michael Gayed
Published on: June 12th, 2019 • Duration: 13 minutesMichael Gayed, portfolio manager at Pension Partners and author of the Lead-Lag Report, revisits his “Spring Crash” thesis for the stock market, and discusses how a dovish Fed could impact the situation. He notes the flashing signals from the bond market and small caps, discusses the binary outcome of a crash or melt up, and considers how to play the reflation trade through emerging markets, in this interview with Jake Merl. Filmed on June 11, 2019.
JAKE MERL: Welcome to Trade Ideas. I'm Jake Merl, sitting down Michael Gayed, portfolio manager at Pension Partners and author of the Lead-Lag Report. Michael, great to have you back on the show.
MICHAEL GAYED: Pleasure, thank you.
JAKE MERL: So you were here in both March and April, making a pretty courageous call on the S&P. You said stocks were due for a spring crash. And those were your exact words. And you said the word crash. You said the market could retest its December lows, and your thesis started to play out. We sold off to around 2,730 or so. And then, right on cue, the Fed came in. And we've seen this rally back to 2,900. So given the recent pop, has your spring crash thesis changed at all?
MICHAEL GAYED: So let's revisit the entire argument. I was making the case you'd have a spring crash really based on a few things that were happening at the time I was talking. All right, one was lumber, which had been notably weak. And funny enough, after that segment I did with you guys last month came out, when I was really emphasizing lumber, everyone seemingly on Twitter tweeted me at Lead-Lag Report, was referencing lumber. And lot of people were showing historical relationships that did validate the idea that lumber weakness tends to precede periods where markets tend to collapse or break down significantly afterwards.
Utilities were strong. We've seen the yield curve all over the place, not just in the US but overseas; not just collapsed, but in some cases, invert. And I would argue to you that if you were a Martian coming from outer space, and you didn't look at stocks, and you saw that bond yields were pushing at the 10-year to almost under 2%, you were seeing some inversion of the 3-month thing and the 10-year, you were looking at negative rates getting more negative, you'd probably say market probably already did crash, right? The only thing that didn't get the memo, of course, was the S&P so far.
Now, I still think there is a real risk. I think the risk has lessened. And I think the risk is lessened, because right on cue, with that very poor jobs report and all the global PMI manufacturing data, which is getting worse and worse, forcing some rhetoric changes from central banks, you may now have a situation where there's a panic move by the Fed, panic move meaning what we're seeing now. We'll just talk about the Fed cutting rates, as opposed to hiking rates. Cutting rates-- I think now the expectation is three times this year, no different than the Pavlovian dog's response to the bell.
That alone could cause some kind of residual, bullish movements here buying, that probably explains why the S&P is up 5% in 5 days, why you're now back towards the highs, at least on large caps. You haven't seen that on small caps. You haven't seen that in emerging markets. A lot of other weakness is still there.
Something is still ridiculously wrong, though, right? Because the fact that we're even talking about the Fed cutting rates with the unemployment rate at 3.6%-- I wish people would step back and just say, how fragile must we be, if you can't even handle a momentary blip in the economy, a momentary blip in markets, that it results in monetary policy changes that are longer-lasting than now? Right? So there is something, I think, that's very crazy with the way the rhetoric is playing out here.
JAKE MERL: So lumber is still weak. Small caps are still weak. We see bond yields still downloading near the 2% level. Do you think stocks are still going to crash?
MICHAEL GAYED: Look. When you have this kind of behavior, I think there is absolutely a possibility. Now, there are always false positives in every signal. I talk about this all the time on the road. There's nothing that's a holy grail. You have to, at the end of the day, slow down entering a storm. You hope that the crash doesn't happen. You get to your destination slower, but you're out there safer.
So the question then becomes, well, if you don't have a crash, what happens? And I think that there is a possibility, that if that scenario has played out, that you don't have that now-or-never moment, that markets don't really break down further from here, that probably emerging markets are the place to be. When you look at emerging markets relative to the S&P, around mid-May actually, that started to stabilize. In other words, you started seeing emerging markets keep in pace with the S&P as all this trade war talk was happening. So it seems like there might be some kind of leadership shift happening there.
And I suspect that the dollar is due for a pretty meaningful decline. I think a lot of what's happened with this rhetoric around cutting rates is really more about trying to target the dollar, try to cause a depreciation in the dollar, as these trade wars continue. Because as much as you may want to put a tariff on some country, at the end of day, if the currency adjusts by the same amount of the tariff, then net-net, you haven't gone anywhere. Right?
So I think that there's some argument to be made that the dollar is likely to be weak, that maybe why you're staring to see gold rally strongly-- because dollar-denominated assets would benefit from a weaker dollar-- may be why you could start seeing some movement in broader commodities and reflation trades. Again, all this is hypothetical. These are just starting to show sort of the whites of the eyes of some trend changes in those areas.
JAKE MERL: And what would be the catalyst to get those higher?
MICHAEL GAYED: It could very well be just that-- we've seen that sometimes, the most powerful monetary weapon is not interest rates, but its words. It's talk. I am certain that the Fed knows what words at what time to release into the marketplace for algorithms to just jump on it and create a self-fulfilling cycle of some kind of trend. So it wouldn't surprise me if it's just purely discussion that starts the trend lower in the dollar, that then has all these now other knock-on effects. But I will maintain what I said. Bonds still suggest there's some severe risk here, so tread carefully either way.
JAKE MERL: So you mentioned emerging markets. Are you bullish on emerging markets on an absolute basis or just relative to the S&P?
MICHAEL GAYED: Yeah, I mean, look. I mean, absolute and relative get to be the same when your relative is high enough. In other words, if the relative outperforms emerging markets is 2,000 basis points-- it's 20%-- that's a pretty big absolute move, too, most likely, right? I just think that there's so much negativity towards emerging markets. And listen. Emerging markets have been dead money for over a decade. You talk about volatile cash like this, it's been the worst investment from an opportunity set perspective, relative to, obviously, US markets, right? At some point, hopefully that will change, hopefully. Hopefully, in my lifetime, emerging markets start running.
But I think, from a contrarian perspective, you start saying, well, there's so much negativity towards emerging markets. People are assuming that all these trade wars are only going to affect them negatively. Maybe there is a positive outcome, and maybe there's some kind of potential investment to be made there.
JAKE MERL: And how much outperformance do you actually see?
MICHAEL GAYED: Yeah, interesting question. So look. I mean, we've seen historically, when emerging markets run, they run pretty strong. And it depends, obviously, on your time frame. When emerging markets are this compressed, they can converge against large caps fairly quickly. I mean, emerging markets, when we look at them on a weekly basis, can have 10% moves, if you look EEM or VWO or some of the other emerging market ETFs. So if it were to happen, it probably could happen not only very aggressively, but maybe 1,000, 2,000, basis points against the S&P, just a catch-up trade, effectively.
JAKE MERL: So it sounds like you're saying there are two binary outcomes. So you could either have the crash you were suggesting could happen last time, or we get this reflation trade, due to the Fed easing, the Fed dovish pivot. And therefore, you should be short the dollar and you should be long emerging markets. Is that right?
MICHAEL GAYED: Yeah, and I know that sounds like I'm talking from two parts of my mouth. But I don't think the two are unrelated. And I'll use some history for that. Go back to 1999. Greenspan lowered rates, because he was concerned that Y2K was going to cause a crash. So he liquefied the markets. And a lot of historians will argue that that was what ultimately caused the true blow-off and move in the tech bubble before the collapse.
So it could very well be that, given that lumber has been correctly telling you that there's weakness in the economy, we're seeing that. Given that utilities have been telling you there's weakness in the economy, we're seeing that. Given that treasuries have been rallying, telling you weakness in the economy, we're seeing that. The Fed overreacts, causes a tremendous amount of liquidity rush suddenly, to avert the crash that could be coming, because these other areas are telling you to be careful, and then cause a blow-off move. It is very possible that is the scenario, that the central banks create an overreaction to the potential of things really breaking down meaningfully.
JAKE MERL: If the Fed were to cut rates in the coming months, and stocks do rise, wouldn't that be a long-term sell signal? Wouldn't that signal at the top?
MICHAEL GAYED: Yeah, this is always what's curious to me, right? People always say, don't fight the Fed. Well, if you don't fight the Fed, then why do we ever have any bear market, to begin with, when the Fed had rate-cutting cycles? I don't think a lowering of rates itself is going to do anything for the economy.
Let's go back to lumber. Lumber is tied to housing. Housing is tied to the 30-year mortgage rate. It's clear that cutting rates is not necessarily causing the long end of the curve to respond. The 30-year, which is tied to mortgages, which ultimately will drive housing, typically, and drive lumber demand, how is cutting short rates going to help with that? The only move we're really seeing from the Fed, in terms of effectiveness, is asset purchases, is the balance sheet expansion. That's a very dangerous thing, if they start to go back to that. Because again, then where does it ever end?
JAKE MERL: So I understand that the rate of change for the Fed funds from 25 bips is one of the greatest in history and that we have tightened significantly. But unemployment is 3.6, and there are some other factors that suggest, why are we cutting rates now? And it suggests that the whole monetary experiment from 2008 was a bit of a failure regarding quantitative easing and XRP. What do you think of that?
MICHAEL GAYED: Listen. I think there's a lot of validity to the idea that, if the Fed does lower rates, it's an admission of failure on their part. And it's an admission of failure, which they don't want to do. Because if they do, I think it means that we're probably in the Japan trap with all this debt, $22 trillion or so of US government debt.
Yeah, it's funny. People always say, where's the bubble? Where's the bubble? The markets are-- PE is this, and price of sales-- where's the bubble? The bubble is clearly in government debt. And all this tremendous amount of easing and lowering of interest rates and normalizing rates to an ever-lower level has ultimately created, I think, an environment where, at some point, the piper has got to get paid, in terms of all of this tremendous borrowing against the future.
And by the way, it's not just US governments. It's also large cap equities, large cap companies, which use these low rates to ultimately buy back stock, as opposed to reinvest in something that's truly productive or enhancing in growth. That's a whole nother discussion of itself. I do worry that we may be entering sort of a no man's land for monetary expectations, expectations because, if the expectation was that the Fed's going to keep on raising rates, and you can't even keep doing that at this point, how are they ever going to raise rates?
JAKE MERL: So Michael, can you please summarize your view in 30 seconds and give some recommendations how we should play the current environment?
MICHAEL GAYED: So again, is the risk still there of a big decline? Unequivocally yes. Lumber still has not turned. But by same token, if all of these signs are there, and the central banks are paying attention to it, it could be an overreaction to liquefy in advance of what could be a big breakdown. And that could cause a conceivably meaningful melt-up in reflationary trades, especially emerging markets, cause the dollar to break. So I think anybody that's looking at markets here, inherently, if you're bullish, you're going to be betting that the Fed is going to overreact and actually cut, I think.
If you are bearish, nothing much has changed. The S&P is probably still likely the place to target most of your attention. And if you're bullish, you want to probably bet on anything outside of the US and anything that would be tied to a weakening dollar.
JAKE MERL: Well, Michael, we'll see how it plays out. Thanks so much for joining us.
MICHAEL GAYED: Appreciate it.
JAKE MERL: So if the Fed continues to be dovish, Michael thinks the iShares MSCI emerging markets ETF, ticker symbol EEM, to S&P 500 ratio could rise 10% to 20% over the next three months. That was Michael Gayed of Pension Partners and author of the Lead-Lag Report. And for Real Vision, I'm Jake Merl.