Brief Review Of 2019

My track record for my recommended positioning last year achieved somewhat mixed results (Kevin Wilson, 2019a). Based on the 13 separate calls I made on stocks, bonds, yields, the global economy, etc., one could have made some pretty fair money in 2019, but I was proven right on only half (6.5) of them. These luckily included making good money on long bonds, gold, and a long/short fund, to the tune of a 19.92% realized gain in my personal portfolio in 2019. This was mainly the result of selling my bond and gold positions late in the year, but if you’d held on instead of selling, you’d still be sitting on a paper gain of over 19% on gold (SPDR Gold Shares [GLD] or iShares Gold Trust [IAU]), and over 17% or even 20% for two different long bond funds (iShares 20+ Yr. Treasury Bond ETF [TLT] and Wasatch-Hoisington US Treasury Fund [WHOSX], respectively). However, I was profoundly wrong about the performance of the S&P 500 (SPDR S&P 500 ETF [SPY]) for the year, as evidenced by the impressive 31.29% gain it made off the early January low. On a risk-adjusted basis, I still did pretty well (estimated Sharpe Ratio of about 1.45), but buying the passive S&P 500 index (SPY) would have nevertheless beat me quite handily, even on a risk-adjusted basis.

The stock market in 2019 continued its long practice of running up the multiple to all-time high speculative valuations (by some measures; e.g., Chart 1) while blithely ignoring the actual data on total market earnings (down 1.4% year-over-year for Q4, and up only 0.3% for the entire trailing twelve months; cf. Maggie Fitzgerald, 2019; John Butters, 2019). The poorly performing manufacturing and transportation sectors of the economy, which may be harbingers of recession, have also been ignored (Chuck Jones, 2019).

Chart 1: Median Price/Sales Ratio Setting Records


It would appear that for now, the market is not about real earnings growth at all, but rather is only about the continuing supply of easy money from the Federal Reserve. That easy money was once again used by corporate leaders for irresponsible, massive (Chart 2) share buybacks (cf. Kevin Wilson, 2016; Wolf Richter, 2019) and unsustainable dividend increases. I had also suggested that China would slide into an officially recognized recession, but it did not; however, it did continue its steady economic decline. Nor was there the financial crisis in Europe which I had suggested might happen, although there are signs that it still could.

The geopolitical climate did in fact turn out to be very negative, as I had suggested it would, but I was wrong to think that it would actually matter to the markets. The US yield curve inverted fully as I had predicted it would, but once the Fed stepped in and cut rates (as I had also predicted), the yield curve inversion naturally ended; however, this pattern is often seen right before a recession (discussed further below).

Chart 2: Share Buybacks Still Supporting the Markets


There has been a fairly clear descent towards a global recession going on (Yen Nee Lee, 2019; Desmond Lachman, 2019; Sergei Klebnikov, 2019), but it has not yet been officially recognized, as I had suggested it would be in 2019; however, this may well occur in 2020. Furthermore, the global economic slowdown has not yet severely impacted the US economy (Trading Places Research, 2020).

De facto “QE” from the Fed is apparently back in play as I predicted it would be (e.g. Ivan Martchev, 2019), although the Fed insists that technically, since only short-term bonds are being purchased ($300+ billion so far, plus another $60 billion per month), it is not yet true “QE.” This sounds a bit like Fed “doublespeak” and is arguably a false claim, since in effect newly-issued federal debt is being monetized to provide additional reserves to banks, just as previous versions of “QE” did some years ago (Bryce Coward, 2019). This is in part what has really funded the share buybacks that have driven the US market so much higher.

So in summary, it was a good year if you were a conservative investor and followed my 2019 advice, and a really great year if you were an aggressive investor and did the opposite. As famed analyst David Rosenberg has pointed out, there has never been a year in the markets like 2019 (David Rosenberg, 2019).

Questions for 2020

As we begin 2020, are you bullish or bearish on US stocks?

Given my wrong bearish call on US stocks in 2019, now would be the expected time for me to join the late-stage capitulation trade of skeptical bears, based on “FOMO.” Since I’m not much good at timing the market (as might be expected, and as my record confirms), and the market is expected by many to be due for a healthy correction, the easy position to take is to go long stocks by buying the inevitable dips. However, I hesitate to make such an obvious potential error in judgement, because: 1) when a long-term bear like myself finally capitulates, the rally is truly over; 2) the high valuations I feared last year are actually even higher now; 3) investor greed and complacency have risen to very high levels, and since these are reverse barometers, a significant correction is again “imminent”; and 4) political events (a Trade War truce and the acquittal of the president in his Senate trial) will likely further boost the market mildly in the short run, but they can’t drive it very far on their own.

According to many, the trade war may not be an issue at all in 2020, but we still have the prospect of an oil price shock that could arise soon due to severely increased tensions in the Middle East. President Donald Trump will clearly not be removed from office this time around, and his survival will boost his re-election chances in the fall, especially in light of the flimsy impeachment case the House chose to present. It is early going, but it appears to me that the election goes to the Republicans across-the-board unless: 1) an obvious recession is damaging family finances by next November; or 2) President Trump ends up supervising a greatly expanded set of military confrontations in the Middle East. However, either of these outcomes could very well happen before November. Although some econometric models do not suggest anything like a recession is expected in the next twelve months (e.g., Georg Vrba, 2020), other indicators still suggest a recession is on the way. For example, the Fed’s own recession models have long since predicted a recession in 2020 (Chart 3); i.e., once the Fed’s yield-curve-based probability model hits a level of 35%, generally a recession soon follows, and we crossed that level in the fall of 2019.

Chart 3: One of the Fed’s Recession Models Predicts a 2020 Recession


Still, with President Trump raising lots of money in 2019 in spite of a series of scandals and a massive media drive for his impeachment and removal from office, it is possible that he will enter the summer months with a relatively good standing in the polls. That kind of early strength was a very bullish indicator in the year (1984) that President Ronald Reagan was re-elected, and also when (in 1999) the impeachment of President Bill Clinton failed to garner a conviction in the US Senate. Those duel histories might mean not only that President Trump will be re-elected, but also that a fairly good relief rally could arise in the second half of the year. So what do I think will happen in 2020? My guess (and that’s what it is), is that the recession arrives in 2020 but is not officially called until long after the election due to the usual long time lags in the economic data used by the “NBER” to make the call. As a result, Trump will be re-elected easily and the market will soar from its first-half lows in the second half of 2020.

But in the first half of the year, as I just implied, the market’s excesses will have been partially bled off by a substantial first down-leg of an expected huge bear market triggered by the global slowdown, geopolitical tensions, high oil prices, and poor earnings. Predictions of almost 10% earnings growth in 2020 will prove to be about as accurate as similar predictions were in 2019, only this time it will actually matter to the markets. Just as was seen in the long bear market of 2000-2002 (which followed a stock bubble of similar size to the present one), the S & P 500 might be drawn down by around 20-30% in the first down-leg during the first half of 2020, but will likely also enjoy a strong counter-trend rally of about 30-35% in the second half of the year. Ultimately the draw-down in this presumed bear market will reach a paper loss of 60-65% many months from now, perhaps sometime in 2021 (cf. John Hussman, 2019). So my prediction is a small gain on the year, but this would be due to haphazard positioning on the cusp of a bear’s tooth within the early stages of a long bear market decline.

With respect to the energy sector though, I see a bullish trend as far more likely than not. Energy stocks have under-performed for quite a while and are beaten down, with relatively cheap valuations for many of them. For example, the Price/Sales Ratio for Exxon Mobil Corp. (XOM) is 1.14, compared to a near-record 2.60 for the median S&P 500 stock. XOM’s Price/Book Ratio is 1.57, compared to a very high 3.66 for the S&P 500. Likewise, the P/S Ratio for BP plc (BP) is 0.47 and its P/B Ratio is 1.34. These two ratios are 0.66 and 1.30, respectively, for Royal Dutch Shell plc (NYSE:RDS.A) (NYSE:RDS.B); they are 2.06 and 1.48, respectively, for Occidental Petroleum Corp. (OXY). And these two ratios are 2.03 and 2.05, respectively, for ConocoPhillips (COP).

Tension in the Middle East is very likely to rise even higher than at present, and the possibility of additional (limited) military action is very high, even if the possibility of all-out war seems quite unlikely. Oil price shocks are a common denominator in many recessions, so it would not be surprising if the presumed oil price spike that may be in its initial stages now, actually triggers economic distress in the months to come. But in the midst of such a shock, some money might yet be made in energy stocks such as the ones just mentioned.

Which domestic or global issue is most likely to adversely affect US markets in the coming year?

If for some reason during the year, some influential Wall Street analysts change their minds and decide that President Trump is actually likely to lose the election, a major sell-off would ensue based on the perceived anti-business and anti-Wall Street attitudes of many of the leading Democratic presidential candidates. Alternatively, if through some combination of unforeseen events, mistakes, and/or bad luck, the currently tense situation in the Middle East descends into an unexpected large-scale or even full-out war, then stocks will no doubt briefly correct. Or if the current fairly tense situation involving rivalry between China and the US were to descend into a more damaging trade war phase again, we might expect a substantial correction.

There is even an alternative scenario in which a completely unexpected regional Asian war is started by accident, due to naval incidents in the South China Sea (cf. Kevin Wilson, 2017); and in this case, there would again be a short-term market correction, perhaps a fairly sharp one. Longer term, most wars (even including World War II) have not negatively impacted the markets for very long (but with World War I being a prominent exception to the rule).

How does the political climate affect the risks and opportunities for next year?

This one is a very difficult question to answer. As master hedge fund investor Ray Dalio has pointed out (Ray Dalio, interviewed by Nathan Crooks, 2019), the world’s central banks are still madly continuing to provide “free money” to big business and major investors, and this is not a good thing for society. It exacerbates the wealth inequality that has already long-since reached unacceptable levels. This suggests that the recent trend towards populism in countries around the world will continue, or even grow stronger. Dalio has maintained recently that “capitalism basically is not working for the majority of people.” Dalio also points out that government spending is out of control, which in turn sets up a potential conflict over whether to: 1) default on government obligations, 2) raise taxes enormously, or 3) undermine the national currency by printing huge sums of money in the process of monetizing the debt.

I have already written a fair amount about these issues (e.g., Kevin Wilson, 2019b; Kevin Wilson, 2019c; Kevin Wilson, 2019d; Kevin Wilson, 2019e; Kevin Wilson, 2019f; and Kevin Wilson, 2019g). The potential conflict over capitalism and government spending is at the center of US political “discourse” right now, and it will only become more dominant in the national political consciousness when the next recession hits, perhaps later this year (cf. Kevin Wilson, 2018).

This probably means that our ugly tribalism (or political polarization) will get even uglier as the year progresses. But will this actually affect the markets in 2020? I doubt that we will get that far down the path this year. But perhaps in 2021, as a recession again impacts the Middle Class, a national debate on the future of capitalism, the unfunded welfare state, the risks of socialism, and the methods for funding future government spending will actually occur. This debate would only have meaningful effects if some national consensus was reached and a decision was made one way or another; probably a very unlikely scenario in the short run. However, the sooner that the rising tide of populism results in civil unrest or political transformation, the sooner the uncertainty associated with that unrest (or political transformation) will impact the markets.

What do you expect out of the yield curve in 2020, and what impacts will that have on the equity market and the economy in general?

The yield curve inversion only lasted a few months this time, which is not unusual in the lead-up to a recession (Chart 4). Once the yield curve inversion has occurred, a recession usually starts with a lag of about 13 months on average (Barry Ritholtz, 2019). The US 10Y-1Y yield curve first inverted briefly in March of 2019, but did not decisively invert until the beginning of August 2019. So that suggests a recession could begin by September 2020, or even sooner. Since the curve inversion has already ended in response to renewed Fed monetary easing, I would suggest that 10-Yr. and longer Treasury rates will continue to decline over time, as the Fed will ease via “ZIRP” and “QE” until the expected recession has pretty much run its course (cf. Chart 5).

So long bonds might remain a good bet again this year. The only caveat is that if “QE4” is started officially (that is, via the Fed buying long bonds) at some point in 2020, then long bond yields may climb (and prices fall), as they did in previous episodes of Quantitative Easing (Chart 6). This will still support the equity market in the short run (but not in the long run), because rates don’t matter once substantial risk aversion kicks in. This was clearly seen in both the 2000-2002 draw-down and the 2008-2009 draw-down (Kevin Wilson, 2019f; Op. cit.).

The economy will do very slightly better with slightly lower rates and the expected “QE4” than it would otherwise do, but these Federal Reserve actions can’t avert a recession.

Chart 4: History of US Yield Curve Inversions


Chart 5: History of Treasury Yields and Spreads


Chart 6: History of “QE” Indicates That Rates Rise Each Time Instead of Falling as Predicted by the Fed


In terms of asset allocation, how are you positioned as we begin the New Year?

My portfolio now contains 54.4% cash, 13.5% long bonds, 11.5% precious metal ETFs, 19.8% large cap energy stocks, and <1% other stocks. This is of course quite conservative in general, but I think it’s best for conservative investors to hold some dry powder at or near stock market tops. My commitment to long bond funds is much lower than last year because: 1) there is clearly the threat hanging over us of a “QE4” action by the Fed, which will actually raise rates on long bonds for extended periods during a continued secular downtrend (cf. Chart 6 above); 2) the expected oil price spike could cause both a spike in inflation expectations and a sell-off in long bonds; and 3) there is another potential threat arising from the Trump Administration’s stated intention to start selling a 50-Yr. Treasury bond in 2020, which if actually initiated could cause turmoil in the long-term bond funds I have long favored (e.g., Wasatch-Hoisington US Treasury Fund [WHOSX], and the I-Shares 20+ Yr. Treasury Bond ETF [TLT]).

So long-term Treasury bonds are potentially a first half trade only, and perhaps even then quite a bit riskier than they were last year; we will have to wait and see. Much depends on Fed actions involving unconventional policy, discussed further below. Right now, I also favor silver (iShares Silver Trust [SLV]) as a precious metal play rather than gold, but both are likely to make some money. I like integrated mega-cap and large cap dividend-paying energy stocks like Exxon Mobil Corp., Chevron Corp. (CVX), ConocoPhillips, Occidental Petroleum Corp., BP plc, and Royal-Dutch Shell, plc, both as value plays and as geopolitical risk trades.

What ‘surprise’ do you see in the market that isn’t currently getting sufficient investor attention?

There are a number of relatively disturbing ‘surprises’ that could potentially be in store for the markets in 2020 (Robert A. Manning & Matthew J. Burrows, 2019; Michael Doran, 2020; Jeremy Cliffe, 2020). I believe that the real unknowns out there (i.e., with the biggest surprises for markets) would include: 1) a potential brokered Democratic Convention in the summer, 2) the possible forced withdrawal of the US from Iraq now, with a negotiated US withdrawal from Afghanistan later in the year, and a probable massive Iranian proxy war all year against Saudi Arabia, Israel, and other US allies, 3) a possible temporary closure of the Straits of Hormuz by the Iranians, and its re-opening as a result of US intervention, similar to what occurred under President Reagan in 1987, but with significant casualties on both sides this time, 4) the potential failure of the UK and the EU to reach a Brexit Trade deal on schedule could take hold of the markets late in the year, 5) the probable complete collapse of the World Trade Organization (“WTO”) under contradictory pressures from the US, China, and the EU could happen this year, 6) a potentially massive cyber-attack against one of our US regional power grids, conducted by North Korea, Iran, Russia, or China, might have major impacts which could precipitate an economic crisis and even perhaps serve as a casus belli for war, 7) an economically desperate Iran could potentially seek relief from US sanctions by purchasing nuclear weapons from the financially desperate North Korea, using the existence of these weapons to blackmail the US and its allies, 8) China could finally unravel economically, dragging Europe, Brazil, Canada, and Australia with it, and triggering a global financial crisis, and 9) a potential further escalation in the disputes between India and Pakistan could result in a regional war with significant casualties.

A number of these admittedly pessimistic scenarios are quite unlikely, but they are not at all out of the realm of possibility. For example, one of the major factors that inadvertently pushed the Axis powers into starting the catastrophe that was World War II sooner than they otherwise might have (and then later directly attacking the US), was: 1) the imposition of economic sanctions against the Japanese Empire, and 2) while claiming to be neutral, setting up Lend-Lease arrangements with US allies such as the UK, which indirectly harmed Germany. These US actions ultimately antagonized Japan and Germany significantly, and since they couldn’t change their behavior, all-out war resulted when major political crises inevitably arose. These actions were likely only partial causes of, or contributing factors to, the global spread of the war (American Foreign Relations, 2020; Wikipedia, 2019a).

Indeed, in my opinion a major war between the US and the Axis powers was inevitable by 1939, but these US actions likely somewhat accelerated the full globalization of the war. It is therefore important to note that we are currently applying similarly damaging economic sanctions against Iran, North Korea, Syria, Sudan, Cuba, and Venezuela (Wikipedia, 2019b). In several of these cases the ongoing impacts on the intended targets are severe, and since war has always had an economic component, these actions are not without risk. Our economic sanctions are only intended to change the behavior of the targeted regimes, but if they are incapable of change, something else will happen. I am not criticizing these US actions, I am simply pointing out that there may be costs that have not been factored in by either the political system or the markets.

What role will the Fed play in the coming year?

The Fed will attempt something very new in 2020 if I am right about their likely recognition of the looming onset of a recession late in the year. They have already openly stated that negative rates are not going to be an option, and if signs of a slowdown persist, and markets plummet, they could easily hit the Zero Bound by late 2020. That leaves them in a potential quandary about how to apply a counter-cyclical monetary policy that would actually have some efficacy in that situation. They will only have used a total of 250 bp of conventional policy ammo by the time they hit the Zero Bound (Chart 7), but the normal drop in Fed policy rates in a recession is around 500 bp (Willem Buiter, 2019). Their toolbox then will likely only have four tools left: 1) quantitative easing (“QE4”), 2) qualitative easing (cf. Japan’s “QQE”), 3) yield curve targeting (Greg Robb, 2020); and 4) forward guidance.

Chart 7: Recent History of Counter-Cyclical Fed Rate Cuts


Of these, only yield curve targeting appears to have much efficacy; indeed it appears to have already worked both during World War II in the US, and over the last three years in Japan. None of the other three tools has much power in boosting economic conditions because transmission mechanisms for these options are all relatively weak. In any case, Fed members will likely feel at some point like they are “pushing on a string” because of the current output gap and the enormous US public and private debt overhang (Kevin Wilson, 2019g; Op. cit.). They will feel the need to act, and they will try something new like yield curve targeting. That might involve pegging both the long bond rate and the T-bill rate simultaneously (cf. Radha Chaurushia & Ken Kuttner, 2003). This had the effect in 1941-1945 of pushing investors towards long bonds. It is only a short-term kind of measure, and was abandoned eventually because it interfered with more conventional aspects of monetary policy once the war was over.

Fiscal policy might work better, but that is outside of the Fed’s remit. A “helicopter money drop” might be tried as a radical alternative, once Congress and the Fed have sufficiently panicked in the course of a bear market and recession to contemplate such a move. Under this scenario, Congress and the Administration would have to agree to a large (perhaps $1.5-2.0 trillion) counter-cyclical stimulus spending package. The Fed could be induced or cajoled into monetizing the new debt to minimize the impact on the currency. This combination could potentially be useful in federal efforts to boost the economy over the short term, but there is certainly a risk of much higher inflation being triggered if care is not taken; however, there have been other instances (e.g. World War II) in which inflation was successfully limited.

There is also a risk of feeding Congress and the Administration a habit-forming drug (i.e. practically unlimited spending), and there is rarely the possibility of turning back once that route is chosen. How markets respond to all this easy money is more complex than it would seem at first glance. Although every phase of “QE” since 2008 has been met with cheers on Wall Street, nothing the Fed did actually worked during the crisis itself. Easy money has only worked since March of 2009. So we will have to play this one by ear.

What issue is receiving too much investor attention and/or is already priced in?

Several things popped into my mind here. First, the markets have more or less priced in a reasonably happy outcome for the UK stock market in the wake of the Brexit vote. But it is no simple matter to forge new trade agreements, and the EU have shown a certain level of obstinacy in their demands. This may not turn out well, and it may be perceived that a trade deal will not be finished by year-end. This might not be very good for UK stocks (e.g., iShares MSCI United Kingdom ETF [EWU], although they look relatively cheap right now). Another important item might be that the US-China trade war is assumed to be on hold until after the election; however, geopolitical concerns could change that situation.

Disclosure: I am/we are long XOM, CVX, COP, OXY, RDS.B, TLT, SLV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks or other securities mentioned or recommended. This post is illustrative and educational and is not a specific recommendation or an offer of products or services. Past performance is not an indicator of future performance.

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