End of the Cycle?
Featuring Kevin Smith
Published on: April 26th, 2019 • Duration: 15 minutes • Topic: Valuation, Macro, EquitiesKevin Smith, founder & CIO of Crescat Capital, joins Real Vision for his first Trade Ideas interview to discuss his bearish bet on the stock market. He reviews a variety of valuation metrics, highlights the flashing red signals from his macro indicators, and discusses how to make the trade, in this interview with Jake Merl. Filmed on April 24, 2019.
JAKE MERL: Welcome to Trade Ideas. I'm Jake Merl sitting down with Kevin Smith, founder and CIO of Crescat Capital. Kevin, it's great to have you on the show for your very first Real Vision interview.
KEVIN SMITH: Thank you, Jake.
JAKE MERL: So before we get into your actual trade idea for today, can you please go over your background, who you are, and what you do at Crescat Capital?
KEVIN SMITH: Sure, I'm the founder and CIO of Crescat Capital. Crescat is a global macro asset management firm headquartered in Denver, Colorado. I have degrees in economics and finance from Stanford, and the University of Chicago. And I'm a CFA charter holder with about 20 years of portfolio management experience.
At Crescat, we are about developing tactical macro themes to time the business cycle. And they derive from our fundamental equity and macro models. Our macro thematic investment process applies to all three of Crescat's strategies. Our Crescat large cap, our Crescat long short, and our flagship global macro hedge fund.
JAKE MERL: And so with that in mind, today, we'll be talking about the S&P 500. And I want to get your thoughts, Kevin. Are you bullish, bearish? What's your take as we're breaking out to new all time highs?
KEVIN SMITH: Well, we really believe what's going on today is really a triple top pattern, if you will, in the S&P 500, that is really retesting all time highs at record valuations and record late in the economic cycle.
JAKE MERL: So I understand the market is expensive. But how expensive is it, really?
KEVIN SMITH: Well, when we look at the market, we look at about eight or nine different valuation factors. And across all of these factors from price to sales, the price to book, EBITDA, free cash flow, the market is at record all time high valuations or very close to it. Really, it peaked out in September of last year across all these valuation metrics. Market cap to GDP is another one.
And at Crescat, we have a 16 factor macro model that we use to time the business cycle and the stock market. And the model really has a great track record of timing the peaks of the tech bubble and the bottom of the tech bust. The peak of the global financial crisis, the housing bubble, and the housing bust, if you will. And today, that model is near the 100th percentile for record late cycle and record overvalued. And so we think that's just another set of indicators that tell us that we're at the top of a business cycle.
Another metric we look at is PE ratio. And a lot of people will say that P/E ratios are actually reasonable today. And so we've looked at GAAP P/E ratios going back into the 1800s. And what we found is that before recessions, if you look at the market peak before every recession that we've had going back into the 1800s, this is the second highest PE ratio that we've ever had today. It's higher than the that it was ahead of the global financial crisis. It's higher than it was ahead of 1929. The only PE ratio that was higher was the tech bubble in 2000. And so I challenge anyone to show us a valuation indicator that shows that the market is cheap today.
JAKE MERL: OK, so Kevin, I think we can all agree that based on the metrics you've just laid out, that the market is overvalued. But how does that help with timing? How relevant is valuation with timing? And what are you looking at, what tools, what indicators, what markets are you looking at that's helping you with timing this market?
KEVIN SMITH: When we look at some of the macro timing factors that signal that we're at the top of a business cycle, one of them that's really important to us to look to include, and it's in our 16 factor macro model, is consumer confidence. And consumer confidence, like the unemployment rate, it tends to be at record good levels near a market peak or at the top of a business cycle.
And consumer confidence recently has reached record all time highs. But how do you know when consumer confidence is starting to falter? And this is kind of a hat tip to John Hussman who discovered this, but there's two components of the consumer confidence indicator-- the future expectations component, and the present situation component. And when you see the future expectation component start to diverge to the downside relative to present situation, it's been an uncanny timing signal for the peak of the business cycle and an oncoming recession that worked in all seven of the prior recessions.
The second timing indicator that I'll talk about today is what we call the battle of safe havens. And it's really when you start to see utility stocks, which people think of as a safe haven, start to diverge in a negative way for the 10 year Treasury bond. And the last two times that utility stocks started to move to the downside while treasuries were going higher was again, the peak of the tech bubble, and then the peak of the housing bubble. And so they were great timing indicators ahead of both of those bear markets.
Today, we're seeing it once again, where the correlation is almost ready to start to turn negative between utilities and in treasuries. Utilities actually, when you look at Crescat's fundamental equity model, they're the worst scoring sector in our model today. And they have the most debt that they've ever had. They have negative free cash flow in aggregate. And they have the highest valuations relative to their own fundamentals. A lot of the same valuation indicators that we were talking about earlier.
The third kind of macro timing indicator that I'll talk about is yield curve inversions. And there's about 50% of the US treasury yield curve that's inverted today. But when we look at the shorter end of it, the three and the five year yields relative to the federal funds rate, when those spreads turned negative, once again it was the peak of the tech bubble and the peak of the housing bubble ahead of the global financial crisis.
But what's interesting, we think, if you're looking for a pair trade to go along with our short SPY trade, is a long gold trade. And when you look at the goald to S&P 500 ratio in the tech bust, it went up 200%. In the global financial crisis, it went up 300%. So you can see in this chart that it's a great setup today, again, for the gold, the S&P 500 ratio. And it's a great pair trade that we also have on in our hedge funds with respect to our S&P 500 short.
JAKE MERL: So it sounds like you're saying we're at the end of the cycle. We're at a market top. Do you see a recession in the cards for this year?
KEVIN SMITH: You know, we are record late in the business cycle. It's longer than the 1990s business cycle. And the Fed has paused its rate hikes late in the cycle. And everyone's bullish about this. And you look at every recession, the last nine recessions have all been preceded by a Fed pause in rate hikes, ultimately to be followed by a decline in rates. And the yield curve, as we showed, is starting to price in that it's more likely that the Fed's going to be dropping rates than continuing to hike them in the next year.
And so nine of the last recessions were preceded by a Fed pause. It's not a bullish indicator at all. But there were three soft landings, where the Fed paused its rate hike cycle, and then ultimately decreased rates. But those all happened early in the business cycle, just three years into the business cycle on average, those three times. This is the record longest business cycle ever.
We also have the record highest rate of change of Fed funds increased during the rate hike cycle. And you can see that in this chart on a log basis, how it's been the steepest, just going from close to 0% to almost 250 basis points on Fed funds. That's the steepest rate hike cycle that we've had late in a business cycle ever.
Another bullish narrative that's been going around is that the Fed's pause is somehow bullish, and that there's a lot of liquidity that central banks are creating. Actually, when you look at global central bank liquidity in terms of global M0, the global monetary base, or global M2, the global total money supply, global liquidity has actually been contracting year over year for the first time in the history of these series.
A lot of people think that liquidity is driving this everything rally that we've had in this market top retest. But liquidity is actually drying up. So that's bearish. But it's not just that liquidity is drying up. It's that even when the Fed ultimately-- when central banks ultimately come to the rescue, the big bullish narrative is that central banks coming to the rescue is going to be positive. It's going to keep the stock market up.
Well, if you look at in 2007 and 2008 on the same chart, the global central banks increased the money supply in 2007 and 2008. And it coincided with the housing bust and the global financial crisis. So it's hardly a bullish sign at all.
JAKE MERL: So taking all this information into consideration, how long do you think we have until we're in a recession?
KEVIN SMITH: Well, on average, when you look at when the Fed pauses its rate hike cycle, the top of the bull market actually happened on average, of two months before that final pause that turned into a reversal or a drop in rates. And the average recession started an average of five months after that rate hike cycle.
So if December was the final rate hike, the recession could be starting next month. Now that's average, it can take longer. And some of the longest recessions took two years, like in 2006. But even in 2006, when the Fed stopped its rate hikes and ultimately reversed them, there were still bombs going off everywhere. I mean, that was the peak of the housing bubble, and there were great short opportunities, even then. But on average, just five months to a recession.
JAKE MERL: So how would you position in the current environment? Would you be going short the market here?
KEVIN SMITH: So are trade idea is a short SPY, short the SPDR S&P 500 ETF. And right here around 293, which is this kind of triple top retest from the January, September, and current market peaks at record valuations, we think you should enter the trade here around 293. We're looking for about a 20% drop over a six month time frame. That would get us to around 234.
It's a retest, basically, of those December lows that we had in the market that we think was just the beginning of the bear market. And we would like to use a stop of maybe 310 on this trade. So that gives you about 6% to go against this, and truly breakout to a new high. So that's kind of the setup that we're looking at in our global macro hedge fund.
And in our long short fund, we haven't even a lower target for the S&P 500. On average, when you get into bear markets, particularly ones from record valuations, it would take a 40% correction just to get to median valuations, historically. And bear markets don't tend to stop at the median, either. They tend to go much further. So in our hedge funds, we're using a risk model to manage our risk. And we have an even lower target than this.
JAKE MERL: So what would you say is the biggest risk to this trade?
KEVIN SMITH: Well, the biggest risk to us, really, is we would look to our macro indicators. And it's hard for us, I think, to be shaken out of this trade, because we do so much fundamental and macro work. Really, this is a theme that we're committed to. And we've been committed to it now for a couple of years. And it's been challenging, because you can have pullbacks like we've had in our hedge funds.
But then like in the fourth quarter, when the market starts to drop as much as it did then, it can really lead to some strong performance. And it led to two our hedge funds being two of the top hedge funds in the world last year. And so we think that was only the beginning. That there's still much more to play out for this trade.
JAKE MERL: So with all this in mind, Kevin, are there any other charts indicators or market that you'd like to discuss that we haven't already mentioned?
KEVIN SMITH: There's a few more I'd like to highlight. And one is an economic divergence that we're seeing an underlying economic indicators relative to this market top retest in the S&P 500 year to date. And if we look at the city US economic surprise index for instance, it's been in continuous downtrend all year. In fact, just went to a new low the other day with some of the housing data that came out. Now this is an alligator mouth type of a divergence that we see. And usually, those alligator jaws tend to snap shut.
The next chart I'd like to show is the S&P 500 earnings estimates relative to the market itself. Year to date, analysts' estimates for the S&P 500 earnings for 2019 have been coming down consistently all year. We're looking at basically flat year over year earnings growth for the S&P 500 at best. And that's after a huge earnings growth year last year on the tax cut. And so it's just another alligator mouth divergence that we see.
And then the third one I'd like to highlight is a record bullish sentiment today. And it's across a number of different indicators. But here's just one indicator that we look at, the VIX futures. And there's a record speculative short interest in the VIX futures, which is even more so than it was ahead of the market top back in September of last year. So just one of many indicators that we look at that signals that we're near a record top late in the business cycle at record valuations.
JAKE MERL: Kevin, that was great. Thanks so much for joining us.
KEVIN SMITH: All right, thank you.
JAKE MERL: So Kevin is bearish on the stock market. Specifically, he suggests shorting the SPDR S&P 500 ETF, ticker symbol, SPY, at 293 with stop loss at 310, and a target price of 234 over the next six months. That was Kevin Smith of Crescat Capital. And for Real Vision, I'm Jake Merl.