I was very pleased with the feedback I received after my last Forbes column. I wrote that article after the spread between the yields on the 2-year and 10-year U.S. Treasury notes went negative for the first time in 12 years. While that spread is now once again positive (the 10-year UST is yielding 1.55% today versus a 1.50% yield on the 2-year,) the other main indicator of yield steepness—the 3-month/10-year spread—remains decidedly in the red. As I wrote in my prior column, I considered including a paragraph about the different yield spreads and which is more relevant to the academic arguments surrounding the steepness of the yield curve. Then I realized that would be a waste of time.
The real takeaway is that interest rates are too damn low to indicate a healthy global economy.
As stocks require economic growth to expand in price (in theory, anyway,) that led to the capper of my headline: “And You Should Sell Your Stocks.” We have had the normal volatility in the equity markets since that column posted, but I stand by my conclusion.
The low level of global interest rates indicates a level of risk aversion that is not healthy for the global economy. The extent to which global money managers are willing to incur economic losses to ensure return of principal is staggering, and truly unprecedented.
That's why you are seeing all those yield curve charts in the financial media. If you bought a 2-year U.S. Treasury note today you would pay $100.47. So, in two years you would receive $100.00, and that's a capital loss where I come from. Of course, the interest you would have received on the bond would offset that buy-high/sell-slightly lower loss, but that is not the case in all the world's sovereign bond markets.
That's the important distinction between negative yield spreads (which form an inverted yield curve) and negative yields, which now prevail in Germany, France, the Netherlands, Switzerland and Japan, with Spain and Portugal a few trades from breaking the zero mark.
What does a negative yield mean? It means that the premium to face value paid for a bond outweighs the interest (on a compounded basis) earned over the life of that bond. The coupon rate on the bond is irrelevant. When coupon rates are so low, it is not difficult for the market to price those bonds such that the effective interest rate is below zero.
That's why you have read so many articles about folks in Europe and Japan "paying banks to hold their money." Because those banks fund themselves based on the local bond markets, and when government bond yields go below zero, the banks have to price their deposits that way, as well.
Denmark's Jyske Bank today imposed a rate of negative 0.6% for customers holding more than $1.1 million in assets at the bank. Denmark's central bank is charging Jyske to hold deposits there, and as in so many instances, Jyske's response is, essentially, we're just passing it onto our customers. That is absolutely bonkers. Think about it. An high-net worth account at Jyske would be worth less in August 2020 than in August 2019, assuming no transactions were made. The mattress is actually better than the bank. It really is.
So, that's why Europe is completely uninvestable and why I think that contagion will hit the U.S. Europe doesn’t have enough demand for credit owing to an aging population that isn't forming households and buying houses, etc. At the same time, China has far too much credit, as expressed in the figure I quoted in my last Forbes article: the Chinese banking system is worth $40 trillion compared to the country's $13.6 trillion in GDP. Any slowing in the Chinese economy—and we are seeing that now—makes those debts, at the margin, less likely to be repaid.
And that brings us back to the good ole' U.S. of A. We don’t have a savings glut, consumer spending has been healthy and the draconian restrictions imposed on the domestic banking system by Dodd-Frank have resulted in low leverage in the U.S. financial system versus its overseas peers.
If the U.S. does enter a recession, by the way, it would be a fairly painless way for companies to lower inventories and more easily hire workers. But it would absolutely devastate U.S. stocks, especially the tech titans. That’s why the bond market’s flashing red signals are so bearish for stocks.
The earnings multiples afforded the stocks of the tech titans—with the exception of Apple, which is shrinking, not growing—are elevated versus historical norms. The newer, hotter sectors are even more expensive. I recently read the statistic that application software companies—”cloud plays”— are trading at a multiples of 75x sales as a group, which is absolutely incomprehensible.
But if Europe is dying and China is too levered, don’t the tech titans offer a safe haven? Well for the past 5 years, they have. That performance has driven U.S. equity indices to all-time highs. Those performances have been accompanied by continuous expansion in the multiples investors are willing to pay on cash flows for those stocks, and that's what gets lost in a recession. Amazon doesn’t become a terrible company overnight, but Amazon stock becomes a liability to the indices, something which has not been the case for the past decade.
Amazon needs consumers to keep spending to justify its elevated P/E ratio, currently 75.6x 2019 EPS versus 17.2x for the S&P 500. But Amazon is 3% of the S&P 500. Adding the market values of Facebook, Apple, Microsoft and Alphabet to Amazon’s, we see that the tech titans represent 16% of the value of the S&P 500. Those companies all generate copious amounts of cash flow, but relative newcomers like Netflix and Tesla and 2019 IPOs like Beyond Meat (on which I have a short position,) Uber and Slack have produced nothing but negative cash flows.
So, while Tim Cook and Satya Nadella would barely notice a recession on their balance sheets, I am certain they would in their stock accounts.
Europe is dying a slow death and China is massively over-leveraged. To think that a bunch of bright guys on the West Coast could be producing enough output without making a single consumer product in the U.S. (sorry Tim Cook, but it is true) to offset that global turmoil is just bananas.
What is now being called the Great Financial Crisis of 2008-2009 should have taught us that global markets are interlinked. The bond market is telling the stock market the world is heading for a sharp economic slowdown, but tech stockholders not listening. I saw this movie in 2000 and I saw it in 2008. It does not end well. Lighten up on your equity exposure. The time to act is now.
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