By: Elliot Turner
Recent Events:
Whenever we see a large-scale move one way or the other in the market, traders, analysts and TV commentators alike love offering an after-the-fact rationalization as to the underlying cause. With this January move, it is no more pronounced than the infatuation with blaming “politics” as THE primary culprit. Although a lack of clarity with regard to the future course of policy can and often does lead to trouble in capital markets, in this particular case, blaming politics is an excuse that will lead many to miss the true catalysts.
First and foremost, after a rally of the scale and duration seen since March, it is only natural for the market to retrace some of the move. So far, the stocks down the most since the start of the down-move were those up the most since the March bottom. This chart from Bespoke Investment Group gives a great visual to confirm this effect:
Next, If politics were the source of this move, then why would Emerging Markets and Big Cap Tech have broken down first? Scott first highlighted the breakdown in Big Cap tech on January 11th, over a week before the broader markets cracked.
Why would the Dollar have bounced before the political catalyst?
Why would the long-bond have rallied off of its recent lows?
The Problem:
The confluence of these moves point to an important development. We are still in the midst of a large-scale debt deflation. Deficit spending and aggressive monetary policy have worked to stop the snowballing of the downward spiral in the short-term; however, these signs point to persistent deflation plaguing the economy. We are undergoing a secular shift from an economy expanding its private sector leverage ratio to one now contracting it. Inflation has been the natural outgrowth of each attempt for the U.S. to stall debt-deflation, yet this time around we have taken the most aggressive inflationary policies to date and still cannot inflate.
The damage is far deeper and more severe than any post-World War II crisis and if it keeps heading this way, we will be out of the monetary and/or fiscal policy tools to stop it. Should the TLTs breakout of the $93 area and hold above its 50-day moving average, that would confirm the start of a new deflationary spiral and a flight to safety. Recognizing and anticipating the signs are important in planning how to adequately deploy capital in the near and mid-term. In a debt crisis, companies with significant short-term debts have trouble rolling their debts over to longer maturities, while companies with long-term debt cannot support their interest payments with short-term cashflows. We need to watch for these trends to play out in equity markets.
Just look at U.S. Steel’s (X) recent price action following their earnings release. The company reported a larger than anticipated loss on the quarter. Following the report, Fitch cut the company’s credit rating to junk. When companies with a precarious debt position report large losses, their credit ratings will be questioned. Short-term debt becomes increasingly difficult to rollover to longer maturities and present cashflows cannot support longer-term debt repayments. This spells trouble for the equity values of indebted companies.
What to Look for Going Forward:
It is still too early to say whether this is a pullback, or the start of a new wave down. Regardless, it is never too early to plan. As a trader, I like to take positions on multiple timeframes. I also like to make some investments. In investing, it is important to look for the right time to initiate positions within the context of broader market cycles. Therefore, it is necessary to target areas to attack. Drawing in the Fibonacci Levels off of the March lows, it intrigues me that the 50% retracement level from the lows up to the January 2010 highs sits right near the bottom of the large unfilled gap in mid-July. This seems like a good potential target for a market pullback. That’s not to say we will see the 900 level on the S&Ps anytime soon. These things take time.
On the way down, there was one key development that I will hone in on in any pullback. In November 2008, the NASDAQ and the XLK (tech sector ETF) bottomed. Meanwhile, the broader markets did not bottom until March 2009, at which point it had gone well past its November lows. Tech stocks remained market outperformers through most of the upmove and these stocks cracked before the broader markets in early January. This tells me that the NASDAQ and tech sectors lead the way for everything else.
There is a fundamental reason behind this divergence: companies with groundbreaking ideas and clean balance sheets can survive and thrive through the worst debt crisis in generations. My investment strategy in a pullback is to target companies that have little to no debt, combined with solid business models, in order to scale into long positions at key market support levels. Fundamentally, I will target only companies that have strong cash positions, little to no debt, and a comfortably positive levered free cash flow. A company like Apple (AAPL) with nearly $30 cash per share should trade at a healthy margin above its cash value considering their revenues continued to grow at over 30% year-over-year.
Additionally, I remain bullish on the prospects for biotechnology. These companies also escaped the tech bubble with clean balance sheets and held up relatively well during the financial crisis in 2007-2009. This is an area rich in cash from top-to-bottom. With the pipeline running dry at some of the big players, we are seeing that cash deployed throughout the biotech arena. Add this to the promising drug treatments in line for approval this coming year and you have a predominantly bullish scenario shaping up in the industry.
In sum, my credo at this point is to avoid longs in indebted companies. The worst of the debt crisis is behind us; however, the problems are not. Leverage cycles play an important role in economic cycles and continued deflation points to this negative economic cycle continuing despite the improved GDP number. That does not mean there are not great opportunities. Quality ideas and clean balance sheets will win out in the end. That is how I want to deploy my sideline cash in the coming months.
