October 2019 Newsletter: Keep Your Eye on the Dollar

October 7, 2019

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The Music is Winding Down

In my previous newsletter, I discussed how U.S. recession risk was rising, but still by no means certain in the near term.

• The yield curve remains inverted (particularly, 10-year minus 3-month)
• The rate of U.S. and global GDP growth is slowing but still positive
• Construction spending has entered a mild contraction
• The manufacturing sector has entered a mild contraction

The year-over-year construction spending and industrial production dual chart gives a quick snapshot of what some of these cyclical “physical stuff” sectors are doing lately:

Chart Source: St. Louis Fed

Construction spending in the U.S. continues to be in a mild contraction for the first time since it went positive after the subprime mortgage crisis, while year-over-year growth in industrial production has touched zero for the first time since it had a big dip in 2016.

The economy is still being held up by consumer credit, consumer spending, and large government deficits acting as a stimulus. Services sectors like healthcare and education are still expansionary.

We have a few new data points since the previous newsletter. Manufacturing has continued to decline based on ISM manufacturing data (the worst reading in a decade), payroll growth is starting to noticeably slow down, and auto sales from many automakers to the U.S. market are in a steep decline in year-over-year terms. ISM non-manufacturing data came in softer than expected, and the latest jobs report showed soft-but-stable results with low unemployment, but potentially setting up a bottom.

Leading indicators measured by my FA Trader colleague Eric Basmajian and others imply low probability of improvement in the cyclical sectors through the end of 2019, but 2020 is more of an open question. CEO confidence, for example, recently hit a 10-year low, and historically their confidence is correlated with low capital expenditures.

Heavy truck sales are down in the United States this past month, which is one of the metrics I watch, because it tends to be a leading recession indicator. Auto sales more broadly have been brutal worldwide.

Manufacturing tends to be one of those all-or-nothing worldwide issues, because it’s so interconnected. One country can have a construction boom while another country has a construction contraction, because they are not very correlated and can thrive independently. With the global manufacturing industry, however, the supply chains are so interconnected and they often rise or fall somewhat in unison. A slowdown in a German auto plant means they buy fewer circuits from Taiwan, which means they buy fewer semiconductor components from Korea, which means they spend less on manufacturing automation equipment from the United States, which means they buy fewer cabling harnesses Mexico, and that butterfly effect cascades through the global supply chain and impacts a couple dozen countries.

During the past three weeks, the United Auto Workers union has been striking against General Motors. The last time they went on strike was late 2007, literally within days of the previous stock market top, and shortly before the 2008 recession. It’s an anecdotal contrarian indicator.

When the economy is weak, workers generally don’t feel confident to push for more, and feel content to have a job when many people do not. When times seem good, unemployment is low, and corporations are reporting strong profits and margins, workers often start to demand a piece of this success. In my previous newsletter, I pointed out that U.S. corporate profit margins are near a record peak, and that such a state has more downside risk than upside potential as we move forward.

Some companies preemptively handle this cycle better than others. In my StockDelver book, I used the example of Nucor, which has historically maintained a strong reputation of being one of the better places to work for in the challenging steel industry. When times are tough, they slash executive pay and cut hours to employees, but try not to perform lay-offs. When times are good, they share profits with workers. This “we’re all in this together” culture has led to low employee turnover, high employee morale and experience levels, and high job satisfaction ratings (4.0 for Nucor on Glassdoor.com compared to 2.9 for U.S. Steel, for example).

IPO Trouble

Lately, a lot of big flashy IPOs have been crushed. In my April newsletter issue, I pointed out that the percentage of initial public offerings (IPOs) that are unprofitable rivals that of the 2000 dotcom bubble and that some of their valuations were out of hand, and listed that as one of my two key concerns for the month. I used Uber and Lyft as examples, and they are down significantly since then.

Silicon Valley and the rest of the U.S. venture capital market, heavily financed by Japan’s SoftBank (which also includes investment money from Saudi Arabia), has been in its own world in recent years where valuations don’t matter, companies don’t even need a clear outline towards profitability, and every type of business, whether it’s a fitness equipment maker or a real estate company is re-branded as a social media tech startup.

The poster child for this era is turning out to be WeWork. For years, they expanded worldwide thanks to external investment, and became a highly-valued startup darling that provides co-working space, became valued privately at $47 billion, and were estimated by major investment banks to IPO with a valuation of over $60 billion. When they filed to do an IPO a few weeks ago, they were laughed at across Wall Street as analysts dug into the details.

Despite being a real estate company at its core, WeWork’s paperwork was filled with phrases like “our mission is to elevate the world’s consciousness” and displayed an almost cult-like adoration of its CEO with 169 references to him in the filings. The business structure was shady, and there were multiple examples of potential conflicts of interest by the CEO. The company was burning through cash at an accelerating rate. Investors started to value the upcoming IPO as low as $10 billion, and sinking from there. The result was so bad that the CEO was ousted from the company and the IPO was cancelled.

Basically, once the company’s numbers and executive culture were displayed for the world to see, it crashed and burned. And without an injection of capital from the expected IPO, they are now turning to large-scale layoffs. That’s how fragile companies are when they rely on external funding with no clear path toward profitability.

Some of these failed IPOs are another log on the recession risk bonfire, because now bondholders are at risk, employees are at risk, investors are starting to tone down their enthusiasm, etc. With manufacturing down, construction down, and unicorn IPOs down, that leaves U.S. consumers holding up the U.S. economy like Atlas.

I wrote an article on Seeking Alpha about why the U.S. consumer is more fragile than people realize. I recommend checking that out. The short version is that the U.S. consumer has record high consumer credit as a percentage of GDP, low median net worth, and problems underneath the headline low unemployment rate that labor participation metrics show more clearly. It’s a risky foundation to rely on. Atlas is getting tired.

For me, the most important metrics remaining to keep an eye on are initial jobless claims and consequentially the unemployment rate. If unemployment starts going up in the coming months, that’ll be one of the last warning signs for a likely recession rather than just a slowdown.

Here’s the unemployment rate (blue line), the Wilshire total stock market index (red line), and recessions shaded in gray:

Chart Source: St. Louis Fed

The difference between economic slowdowns and recessions is partially one of magnitude, but particularly whether the more cyclical parts of the economy get deep enough to pull down the overall employment rate and create a vicious cycle where those unemployed people spend less, leading to more business declines and layoffs.

I’ve been mildly bearish on the U.S. stock market for a couple years now after being bullish for the better part of the past decade, and we’ve indeed had flat and choppy U.S. stock market performance for nearly two years, with better performance from defensive companies, bonds, and precious metals. I partially bought the stock market sell-off during the fourth quarter of 2018, and am looking to buy again on further weakness.

One of the most interesting charts I came across this month was from Pervalle Global. They mapped their proprietary measure of global liquidity (blue line) onto year-over-year S&P 500 returns (black line) with a 12-14 month lead time, and they see a substantial probability of a sharp-sell off into year’s end:

Chart Source: Pervalle Global

The horizontal axis is for liquidity, so adding 12-14 months to that places a potential S&P 500 sell-off in this fourth quarter of 2019 followed by a potential rebound during the first half of 2020.

That doesn’t mean it will certainly play out like this. However, with dollar tightness across the world, some troublesome technical analysis indicators, and the possibility for weak third-quarter earnings reports later this month, I wouldn’t be surprised to see another sharp sell-off like we saw during the fourth quarter of 2018.

I have cash-equivalents on standby and would be ready to pounce on any equity sell-offs if they occur, especially for global opportunities but also within the U.S. stock market. We’ll see.

In particular, I’d like to add some exposure to the SPDR Small Cap Value ETF (ticker: SLYV), which is already down 17% from its 2018 highs (small caps in general never recovered to new highs in 2019 like the S&P 500 did). If I can start dollar-cost averaging into it when it’s down 25% or so from its highs, I’d be happy to.

Chart Source: Google Finance

Longtime readers know that I don’t go “all in” or “all out” of defensive or aggressive assets trying to time the market. Many people write to me saying they went all to cash at some point (many of them back during the slowdown in 2016) and are looking to get back in at some point.

For my low-turnover model portfolio, and for most people who are not active traders in general, I often recommend a “spectrum” approach where, at any given time, I am positioned somewhere on the spectrum between purely aggressive and purely defensive. Right now, I’m firmly on the defensive side, which means although I have substantial exposure to equities, I also have substantial cash-equivalents, precious metals, and so forth.

This spectrum approach of dialing portfolio risk up or down once in a while compared to your baseline allocation, according to market conditions, can work well for disciplined investors, whether you’re an individual stock investor or a relatively passive index investor.

Keep Your Eye on the Dollar

Whether you measure it with year-over-year GDP growth or purchasing managers’ index (PMI), this decade-long business expansion cycle has had three “mini-cycles” within it, where U.S. and global economic growth accelerated and decelerated, but remained in a generally expansionary manner with no employment declines. This chart visualizes the three mini-cycles rather well:

Chart Source: Trading Economics

The first slowdown since recovering from the recession in 2009 occurred in 2012, and the big event at the time was the European sovereign debt crisis.

After a period of growth, the global economy slowed again in 2015 when China started deleveraging its corporate debt bubble, commodity prices dropped, and so forth. China reversed course and stimulated into 2016, helping to give the world another bullish cycle, but is now deleveraging again. Tax cuts in the U.S. also helped push up U.S. equity prices throughout this cycle.

We’re now in the third slowdown, which is shaping up to be the deepest slowdown of the three and might be the one to become an outright recession. China really needs to deleverage its corporate sector, and the trade war is putting further pressure on them, so there are still no signs of a major stimulus from them.

U.S. Bank Liquidity

The biggest subject I’ve been monitoring during this month has been U.S. dollar liquidity, because one way or another this will likely have a significant impact on forward returns for multiple asset classes over time.

In particular, whether this period ends up being just another dip followed by a fourth growth cycle, or an outright recession, may depend in significant part on the strength of the dollar and the underlying liquidity for it.

Investors that have been watching the financial news may know that the overnight bank lending system in the U.S. suddenly broke down in mid-September. Cash was in short supply between banks, and the overnight lending rate spiked to levels not seen since 2008.

Chart Source: Trading Economics

The Federal Reserve has responded by injecting cash into the banking system in exchange for collateral every day for the past three weeks, with plans to continue doing so at least into November.

I wrote a few articles on this subject:

• For a 3-minute overview of what’s going on (suitable for passive investors), I have a Repo Spike 101 article.

• For a quick “repo spike explanation in charts” version I put together on Twitter, see here.

• For a 15-minute deeper dive into my research on the causes and implications of this, and one of my key pieces for the month, see my Seeking Alpha article, The Most Crowded Trade.

During my previous newsletter, I discussed how U.S. federal deficits are large and accelerating at 5% of GDP per year, and are quite an outlier compared to many other countries at the current time. Evidence shows, as I described in those linked articles above about the overnight liquidity issue, that excessive issuance of U.S. T-bills has soaked up all of the available liquidity in the U.S. banking system until the banks ran into regulatory cash limits.

Large banks have run out of extra cash and are stuffed with record high levels of T-bills as a percentage of total assets, in other words.

Although I’ve been cautioning about the U.S. deficit at multiple points this year (which indeed is “different this time” in tangible ways), my base case was that it would start to matter in an acute sense during the next recession. The bank liquidity crunch suggests that the issue is occurring already, ahead of schedule.

The Federal Reserve now is in the position of supplying liquidity (essentially monetizing U.S. federal deficits), potentially for the foreseeable future, which I suggest will likely level off the current dollar strengthening cycle and eventually weaken it as we move into next year or so.

Why Dollar Strength Matters

Chart Source: St. Louis Fed

Dollar strength is a weird thing because causality goes both ways. Historically, investors flee to the dollar as a safe haven when global growth slows. On the other hand, a strong or weak dollar can accelerate or decelerate global growth rates, respectively.

This is partially because emerging markets represent the majority of global growth in recent years, and many of them have high dollar-denominated external debt. Organizations that invest in emerging markets rarely do so in local currency of that nation, and instead prefer to do so in U.S. dollars.

Since emerging market corporations and governments make their income primarily in local currency, but a big portion of their liabilities are in dollars, it can cause significant problems and volatility for them. When the dollar strengthens relative to their local currency, it effectively increases their debts in local currency terms and forces deleveraging and slower growth. When the dollar weakens, it’s like a partial debt jubilee, allowing for faster re-investment and economic expansion.

This hits emerging markets the hardest, but then spills over into developed countries because many of them rely on selling products and services to emerging markets for a big portion of their growth. The S&P 500, for example, receives over 40% of its revenue from abroad. Some is from Europe and Japan, and some is from emerging markets. A strong dollar puts pressure on emerging market growth, but then also means that all of the foreign currencies that S&P 500 companies receive translate into fewer dollars.

Emerging markets, emphasizing China in particular, but also India and others, are representing a bigger and bigger share of the global economic pie over time. As the second largest economy in the world, the biggest importer of raw materials, and a major trading partner with many countries, whether China is stimulating or deleveraging its economy affects growth rates worldwide.

Chart Source: Visual Capitalist

My base case going forward is that, since total liquidity in the U.S. banking system has dried up and the Federal Reserve is forced to provide liquidity injections (and eventually a fourth round of quantitative easing), we’re likely to see the strong dollar level off and probably start to weaken over the next year.

This means that, as 2020 comes, or perhaps 2021 if the timing occurs more slowly than my base case, I believe that being globally diversified will be of significant importance, and I have a positive view towards select emerging markets after the sell-off that we might get later this year. I also continue to view precious metals as offering strong risk/reward potential.

Portfolio Updates

I have several investment accounts, and I provide updates on my asset allocation and investment selections in each newsletter issue.

These include a primary passive/indexed retirement account, two actively-managed brokerage accounts at Fidelity and Charles Schwab, and the account specifically for this newsletter at M1 Finance that I started last year.

I use a free account at Personal Capital to easily keep track of all my accounts and monitor my net worth.

M1 Finance Newsletter Portfolio

I started this account in September 2018 with $10k of new capital, and I put an additional $1k into it before each newsletter issue, totaling $19k so far.

It’s by far my smallest account, but the goal is for the portfolio to be accessible and to show newsletter readers my best representation of where I think value is in the market. It’s a low-turnover multi-asset globally diversified portfolio.

I chose M1 Finance because their platform is commission-free and allows for a great combo of ETF and individual stock selection with automatic and/or manual rebalancing. It makes for a great model portfolio with high flexibility, and it’s the investment platform I recommend to most people. (See my disclosure policy here regarding my affiliation with M1.)

After adding $1,000 in fresh capital in October, here’s the portfolio today:

Here is the full list of holdings within those various sections:

Changes since the previous issue: 

• Added some extra money into defensive segments (cash/bonds/precious metals).
• Replaced Aflac with Johnson and Johnson in the dividend segment.
• Tweaked the weighting of the international equity segment a bit.
• Added Rio Tinto and Total SA to the commodity segment, replacing the GUNR ETF.
• Switched to the Aberdeen gold ETF from the iShares version.

Primary Retirement Portfolio

This next portfolio is my largest and least active. It purely consists of index funds that automatically rebalance themselves regularly, and I rarely make changes.

Here’s the allocation today:

From 2010 to 2016, this account was aggressively positioned with 90% in equities and enjoyed the long bull market.

Starting in 2017, in order to preserve capital, I dialed my equity allocation down to 60% (40% domestic, 20% foreign). This was due to higher stock valuations and being later in the market cycle more generally. If the U.S. economy encounters a significant sell-off, I would likely increase equity allocations to upwards of 90% once again.

Related Guide: Tactical Asset Allocation

For my TSP readers, this is equivalent to the 2030 Lifecycle Fund. One reason this is so conservative for my age is that my active portfolios below are more concentrated and aggressive, so I consider them together when determining how to allocate assets.

This is an example of a portfolio strategy that takes a rather hands-off approach but that still makes a tactical adjustment every few years based on market conditions. This employer-based retirement account is limited to a very small number of funds to invest in, so my flexibility is limited compared to my other accounts. I would, for example, have some precious metal exposure in this one in place of some of the bonds if I had that option.

Active Portfolios

My accounts at Fidelity and Schwab are mainly for individual stock selection, single-country ETFs, and selling options:

Changes since the previous issue: 

• Bought shares of Sberbank and Sandstorm.
• Sold SunPower for a significant gain. Part of the position was called away via covered calls, and the rest I sold. I would potentially buy back in at a lower price. I wrote about it a year ago on Equities.com and it more than doubled since then, and now is retracing a bit.

____

I spoke at the Philadelphia Money Show about value investing this past weekend, and had the opportunity to meet some readers as well as other writers.

In particular, I want to give a shout out to Swen Lorenz, author of Undervalued Shares, who happened to be in town all the way from the Channel Islands and attended the presentation. He does very deep dives into specific stocks each month, and I suspect that these sorts of global value plays are the style that will pay off in the years to come. His call on Gazprom has already been quite successful.

For those that want more frequent updates from me, I increased my activity on Twitter this month, sharing a lot of charts and other research about these liquidity issues pretty much in real time as they occurred, along with other topics and links to my various articles within a day of writing them. Normally I’m not a big social media person but there is a big financial community on Twitter that has been very interesting to engage with. So, feel free to connect with me there if you’re on that platform.

I’ll be traveling internationally during the rest of October which is why I sent this newsletter out a week early. I’ll be slow with emails but I’ll likely be on Twitter here and there in small amounts.

Although nothing is for certain, market risks are elevated at the moment and could get rough this quarter, so make sure you know what you own and that you’re comfortable holding it through periods of volatility. Look for bargains and stick to your process.

Best regards,