As we reach the culmination of the holiday season and as the Santa Claus rally continues, greed has replaced fear in the markets. Will this continue into the new year? The Financial Sense Newshour talked to John Kosar of Asbury Research to find out what’s in store for 2020. He looked at the broad swath of rising indexes not just in the U.S. but around the globe. Kosar also explained how rising interest rates are hinting at a stronger 2020 economy. Danielle DiMartino Booth discussed two industrial recessions we’ve had, the Fed and what she sees in 2020. Financial Sense Wealth Management’s CIO, Chris Puplava looked at what’s happening in foreign markets.
See Rally Built on 'Hopium', Says Danielle DiMartino Booth for the full podcast.
Risk-on Mode
Risk appetite has substantially shifted, and markets have given up on fear. Kosar uses Asbury Research’s correction protection model and the Asbury Six model to provide an accurate reading of market conditions. The Asbury Six has been positive since Oct. 15, and CPM went to risk-on Oct. 17. Both caught the market coming out of a period of congestion around May 1.
This strongly suggests we have moved into a risk-on phase. After choppy August market conditions, the S&P 500 sat on its 200-day moving average. Steel and copper prices were both down, along with commodity prices. Energy has also been weak. However, in the middle of October, Kosar saw his models turn. Both steel and copper turned on a dime, and foreign markets have shown signs of improvement. The U.K., South Korea, Taiwan, Brazil, China and Russia are all improving, among others.
“From the end of September to the middle and latter part of October, things turned,” Kosar said. “There's an undergirding here that has taken place. It's not just a Santa Claus Rally or the market getting happy in the fourth quarter. Something tangibly changed, and the risk appetite globally made a noticeable shift during that period.”
What’s Up With Treasury Yields?
Ten-year Treasury yields have headed lower to 1.4 %, almost back to the lows of August 2016, though they’re now close to two percent again. Rates have behaved unusually over most of 2019. Kosar uses several strategic indicators—including break-evens and relative performance between Treasury bonds and Euro bonds—to track rates out one to two quarters, but these have not worked well as indicators in 2019.
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Instead, 2019 rate movements were driven more than usual by Fed watching, Kosar said. The Fed has put its thumb on the scale more than usual to keep rates down, which is continuing now. Since Aug. 30, 10-year rates had been near 1.70, and they’re creeping higher, currently at 1.91. This is an indicator the market has stabilized. We seem to have a sense of what the Fed is doing now, he added, and it appears it will be on hold for much of 2020.
The next move higher may see rates fall between 2.05 to 2.16, which is the big level to watch in the next one to two quarters. Kosar’s next target is 2.60 on the 10-year. Alternatively, if rates head lower—which Kosar does not think is likely right now—his target range is between 1.50 and 1.37.
“I think in order for us to get that high, globally I think the economy would have to get even stronger,” Kosar said. “I think interest rate markets have stabilized. They're starting to go higher... It just looks like the world has stabilized and is starting to improve economically.”
Strength in the Tech Sector
The tech sector has been a juggernaut through much of 2019. Kosar has been watching Apple, with a target of 291 on the stock. His 291 was a technical target based on the resumption of Apple's larger trend that started years ago. Now, Apple is trading near 284, as of December 24, 2019. Also, the PHLX Semiconductor Sector Index has taken off, as has biotech.
While Apple broke out at the end of August, biotech only broke out a few weeks before the Christmas season, Kosar noted. It’s now up nine or 10 percent, both of which signal less fear of risk.
What Could Rattle Stocks in 2020?
This risk appetite isn’t dissipating anytime soon, Kosar said. Several major large cap stocks that tend to drag the market around with them still have upside targets. He explained if markets were a game of baseball, the U.S. would be in the seventh or eight inning. There could be a pullback into typical seasonal weakness for the middle of January through February, but after that, Kosar believes there will be a resumption of strength.
While tech has shown strength, retailer stocks have also moved higher. Walmart broke out at the end of August and resumed its larger trend that started in mid-2015. Kosar’s price target for Walmart is 130, and the stock is currently trading near 120. Target and Costco also have charts that almost look like Apple’s, Kosar said, adding that 2019 has been an odd year overall. From May to August, the market couldn’t get its legs, and then something shifted and its shot higher.
Commodities Showing Strength
Steel prices have exploded and the industrial metals, as indicated by action in the XME, which is a metals and mining ETF, have taken off. Asbury Research recommended buying the XME at the middle of November and it's rallied three to four percent since then. Currently, it’s trading near 29, while Kosar has it heading to 32. Asbury also put out a call to buy copper miners at the beginning of November and that trade has already hit Kosar’s target price.
The company made a similar recommendation for the steel ETF, SLX, which is trading near 38.5. Kosar sees that heading to between 40 and 50. Some of the commodities still have legs to play out in the first quarter of 2020, he added.
“We actually put out a short idea in natural gas, looking at UNG, the ETF for natural gas, at about 19,” Kosar said. “It's trading around 17.30 now, and I've got it going to 14.25. So that’s the fly in the ointment, in the commodity space.”
Will 2020 Show a Repeat of 2019’s Strength?
While Kosar doesn’t like to play the prediction game, he does have his eyes on some areas of the market going into 2020. The U.S. is in the eleventh year of its bull market, the longest expansion in history, and interest rates are still historically low. He suspects we will see some kind of pullback between January and February due to seasonal timing, which will partially be fueled by the current appetite for risk.
Around April or May, when we get into that seasonal low through the summer, Kosar will be looking for any indication that we could be in for a scary second half of the year. If we are, Kosar expects market participants will attempt to shrug off what could be something more substantial.
“What I'd say to investors next year is, get some tactical tools and have an exit plan. Because when the market goes up for this long, interest rates are this low, and geopolitics are what they are, I'm afraid one of these days we're going to get a bear market here and it's not going to be three percent. It's going to be 30 percent. And I think we have to be aware of that.”
Why Did the Fed Shift Focus in 2019?
At the end of 2018, it seemed as if the Fed was set on continuing to raise rates in 2019. Instead, 2019 saw three rates cuts. What caused this change in Fed Policy? According to DiMartino Booth the Fed was caught off guard by what happened in the overnight lending market and decided to take a different approach.
A big part of this shift is because Jerome Powell is not an academic, as many former Fed chairs were. Instead, he’s a businessperson, and he appears to be approaching policy from a position of pragmatism. In October 2012, when Powell was a rookie on the committee, he noted that the Fed was blowing a fixed income duration bubble across the entire credit spectrum, which could turn into a problem when the Fed attempted to normalize rates.
Powell also has ties to the hedge fund community, and has a deep understanding of credit markets, DiMartino Booth said. We recently saw what many are calling Repo Madness in mid-September, she added, where repo rates spiked to nearly double digits. Powell likely wasn’t as caught off guard by this as some others, she said. The Fed has been expanding its balance sheet at a rapid rate, such that, if it keeps going, it will be as though quantitative tightening never happened at all over the last 21 months.
With Repo Madness coming into play, overnight lending rates spiked as a result of excessive reserve depletion. Powell’s status as a market veteran likely allowed him to be aware that, if the Fed just resolved the debt ceiling, the issues with Treasury’s “checking account” with the Fed being depleted would be resolved.
The Treasury was about to bounce a check, DiMartino Booth said, and Fed officials were aware that its account with the Fed needed to be restored. As a result, every quarter corporations have to make quarterly tax payments to help. What caused the reserves drain in the first place?
“We've had currency in circulation rising for years,” DiMartino Booth said. “We've had foreign central banks dealing with negative interest rates in their homelands, parking increased amounts of deposits at the Fed to get that uptick in yield. And in the background, we also had quantitative tightening. All three of these separate factors drained reserves to a level that we found out in mid-September was too low.”
The Fed’s New Approach
With the Fed’s about-face, markets appear to be doing very well. Typically, the perception is that the Fed kills bull markets by being too aggressive raising rates. That’s not what we’re seeing play out right now, DiMartino Booth said. This time around, markets seem to be aware that the Fed is taking a different approach. The Fed is behaving preemptively to deal with apparent bubble formations, where past iterations of the Fed haven’t dealt with bubbles until after they pop.
We may also see the Fed take action in 2020, despite the coming elections in the U.S., DiMartino Booth explained. She doesn’t believe that Powell will risk credit markets if he sees weakness forming in the real economy. There are too many unknowns right now to know where the Fed will go and that uncertainty may be an issue in 2020.
“Right now, financial markets are trying to digest this completely different approach of trying to be preemptive and get out in front of what Powell knows darn well is a huge credit market bubble,” DiMartino Booth said. “We don't know exactly what the trade deal … is going to accomplish, mainly because the Chinese have never been capable of buying as many agricultural products as what's been promised. We don't know if the damage that's already done to the European economy can necessarily be undone.”
Proceed With Caution?
DiMartino Booth recommends investors proceed with caution. There are some troubling trends brewing in markets right now. Looking at the rally starting in 2009, 68% of it is directly attributable to earnings growth, and 32% has come from valuation expansion. Looking at 2019 in isolation, only eight percent of the rally is attributable to earnings growth, which is negative over the last four quarters.
Instead, 92% of stock gains have come from valuation expansion, a lot of which began in mid-September and then again on Oct. 11, when Powell announced that the Fed would be conducting overnight repo operations to ensure market liquidity, and that it would actually start to grow its balance sheet by $60 billion a month going forward.
Economic expansions don't die of old age, DiMartino Booth said, citing the common trope about bull markets. However, they do tend to be driven by secular forces, which are as driven by cyclical patterns as anything else in the markets.
Concerning signs are beginning to form, she added. We've endured two industrial recessions in the course of the current expansion, DiMartino Booth said, which has never happened in post-war history. What has likely happened is, quantitative easing and massive liquidity meant to support financial markets bled through to the real economy.
“Because so much of this rally has been built on valuation and what I call ‘Hopium,’ it has left us that much more vulnerable to any kind of financial event,” DiMartino Booth said. The U.S. has doubled the size of the bond market to $10 trillion and has increased non-financial business debt to a record 74%. She said anything can happen with that much leverage in the background, and added that investors need to be very careful, understanding that fundamentals aren’t driving the market.
We’ll likely see the melt-up in stocks continue in the first half of 2020, she said. Then economic fundamentals may come to bear. At that point, it’s easy to imagine the Fed reacting with more quantitative easing, potentially growing its balance sheet above $4.5 trillion.
“Powell understands how dangerous the situation is in the credit markets, and how easy it is to unleash systemic risk,” DiMartino Booth said. “However, this time it's in corporate debt. If we manage to make 1998 a parallel year with 2019, and therefore 2020 a parallel year with 1999… we'll have that much further to fall with double bubbles in stocks and bonds.”
Foreign Equities Lead
In Smart Macro, Financial Sense’s CIO Chris Puplava, made the case for foreign stocks based on recent developments and signals. Global leading indicators are showing a bottom in global growth around the August to September timeframe, Puplava noted, and are continuing to show improvement.
Commodities, and notably leading-indicator copper, have been performing well, he added, and as copper has been moving higher, steel prices, which took a hit earlier in the third and fourth quarter, are starting to move back up. Another notable signal can be seen in global interest rates, such as those in German bund yields and Japanese interest rates, which are starting to move up. This confirms the world economy has cleared the trough in in global growth seen earlier this year and is likely to continue higher.
At the same time, Puplava said, the U.S. economy is likely going to fall behind further, playing catch up on the downside. U.S. growth peaked much later than the rest of the world in the September to October 2018 timeframe. Since then, the U.S. has been decelerating, and he expects to see growth rates to trend sideways or head lower. He doesn’t see an upturn in U.S. growth until the first or second quarter of 2020.
“This leads me to believe that with U.S. growth starting to underperform global markets, we should see some improvement in global equities relative to the U.S.,” Puplava said. “If you look at the European stock market, it really hasn't gone anywhere for close to two decades. And we just saw a new high in that market, which means that we could probably see some significant movement ahead.”
Looking Ahead to European and Japanese Markets
In addition to Europe, the Japanese economy has underperformed for years. A lot of the improvement in European stocks is apparent in small- and medium-sized companies, with large-cap stocks yet to break out. Puplava expects Europe to start preforming well over the next six months, as internal strengthening in European stocks continues. He also believes the same dynamic will play out in Japanese stocks.
The Nikkei index has seen a surge to 52-week highs, the highest in a number of years. Based on Japanese stocks making new 200-day new highs, the Nikkei is showing a lot of strength right now.
“There's tremendous value in Europe and in Japan,” Puplava said. “We might even have a more significant breakout in Japan. … We're starting to see improvement this year in the Nikkei, where I would not be surprised if the Nikkei breaks north of 25,000 in 2020.”
To listen to this podcast see Rally Built on 'Hopium', Says Danielle DiMartino Booth, or for a full archive of past shows, visit the Financial Sense Newshour page.
Written by Ethan D. Mizer
