Making Hay Monday - April 3rd, 2023

High-level macro-market insights, actionable economic forecasts, and plenty of friendly candor to give you a fighting chance in the day's financial fray.

Apr 03, 2023

Special Message:

Because my view that energy stocks are in the midst of a long-term bull market has been a key and recurring theme of Haymaker editions, I felt it advisable to make some relevant comments on it apart from this week’s main topics. To that point, OPEC’s announcement over the weekend to cut production by another one million barrels per day (bpd) is a very big deal, in my view. Based on the powerful rally by crude this morning, I think it’s safe to say the market agrees with me.

A critical point I’ve made in recent months, as oil has continued trending down, is that financial (basically, futures contracts) trading of oil is some 30 times the physical market. No doubt, a considerable amount of that is driven by computers, including the infamous AI algorithms. The price action this year strongly suggests these financial players, both human and computer, have been laser-focused on weakening economic data. The recent banking dislocations only reinforced that tendency. Selling, or even shorting, oil became the knee-jerk reaction.

Amplifying this weakness was the Biden administration’s decision to release even more oil from the Strategic Petroleum Reserve (SPR). Ironically, it may have been that announcement which catalyzed OPEC’s additional output cut (beyond the two million bpd reduction announced last year).

What the market in its infinite (AI-enabled?) wisdom failed to appreciate is that even during the Great Recession, oil demand only fell by 1½ million bpd. China’s reopening alone should offset that amount of potential consumption erosion… if it happens. In actuality, demand has been running stronger than expected for months, if not most of the past 2½ years. This, combined with the increasing difficulty of finding new oil reservoirs, has left inventories dangerously low. Only the ~~reckless~~ persistent SPR releases have obscured this reality, at least to unsophisticated observers… or computers.

One expert who doesn’t take the data at face-value is Cornerstone Analytics’, Mike Rothman, often quoted in these pages. Based on OPEC’s latest squeeze-play, he’s now upped his year-end Brent Crude forecast to $160. (U.S. oil tends to trade at a $5-$10/barrel discount to Brent.) He’s also anticipating a one million bpd shortage through the balance of the year. Suffice to say that both of those are shocking numbers, with profound economic and financial implications. The “don’t worry, be happy” stock market does not, by my reading, appear to be factoring this in even as a remote possibility. Despite that — or perhaps because of it — I’m strongly encouraging Haymaker readers to not indulge in that type of dangerous complacency. As they say, forewarned is forearmed…

Not Quite Ready for Prime Time

"In my view, it's not a banking system problem. It's actually way bigger than that. It's a US Treasury, G7, sovereign debt balance of payments problem. Because look, treasuries underpin everything, it's the collateral for the whole system. So if we're going to have a treasury problem, we're going to have an everything problem.” -The Forest for the Trees author, Luke Gromen

“We know our oil balance forecast (and the implications for energy share prices) have been way way way out of consensus for 2 ½ years. That’s OK, but for those that have continued to stay out of this space (and missed the huge move since our October ’20 call) there’s still significant upside potential to be captured.” -Mike Rothman, founder of Cornerstone Analytics and (for my money) America’s savviest oil analyst.

Truth be told, I cringe a bit when friends arrive to stay over a weekend at our Indian Wells, CA home. This is where we spend time away from the long Pacific Northwest winters… at least until California’s increasingly hostile and avaricious policies chase us to a different warm weather place of refuge. (Admittedly, this year the warmth has been notably absent.)

It’s not that I don’t love seeing friends and family. Rather, my mixed feelings stem from Saturdays being when I try to get most of our Making Hay Monday (MHM) editions pretty much put to bed.

This weekend, we were visited by a friend of over 40 years who entered the securities industry even before I did — yes, I realize that’s one for Ripley’s Believe It Or Not!. Though I don’t think he reads either of my weekly notes, he is aware of how much time and effort I put into them. On Saturday morning, as I was ramping up to write this edition (nursing a nasty night’s non-sleep due to a reaction to a root canal a few days earlier), he proffered what he hoped would be some helpful advice. He opined that I should use ChatGPT to assist me in writing my newsletters as so many college students are apparently doing these days with their term papers, etc.

My friend went onto wax euphorically about how accurate this new AI app was versus search engines like Bing and Google — even with their updated and enhanced versions. Appreciating my need for some quiet writing time, he wanted to go on a hike. We used ChatGPT to identify the trail, one I’ve been on a number of times. The only problem was that it stated the trailhead was in the wrong city. He did admit that often happens and you can’t put too much trust in the answers.

That statement caused me a bit of bewilderment. If AI can’t be relied on for such a basic item, what good is it for someone like me who constantly needs to do serious fact checking? To put it to a more relevant test for this MHM, he and I submitted another basic question to this digital version of Carnac the Magnificent:* “Is Morgan Stanley forecasting an earnings recession?” Since my pal was at Morgan, and its predecessor firm Dean Witter (where we both started out), it seemed an appropriate query. The answer back was that it did not; it was too early to come to that conclusion, in its matter-of-fact opinion. (Usually, technology doesn’t have opinions, but in the brave new world of AI, that no longer seems to apply.)

Fair enough, I thought, because there are a number of different strategists and economists employed there, with differing views. To dial things in a bit tighter, I entered: “Does Morgan Stanley’s Mike Wilson anticipate an earnings recession?” Once again, the answer came back in the unaffirmative. However, since I read Mike’s work every week, I knew that to be inaccurate. It would have saved me some valuable time if it had been able to do a rapid search of his publicly available recent research, but that was not produced. So, I had to do it the old-fashioned way — pulling up his reports from an e-mail inbox.

Fortunately, for my still somewhat-addled brain (it turned out I had a massive abscess that was leaking toxins into my sinus cavity), I didn’t have to search too far. In fact, I went to his March 27th research note and quickly came across the following section:

“We believe it's underappreciated how significant the negative operating leverage is going to get before this earnings recession is over. More importantly, it doesn't necessarily require an economic recession to play out, although that risk is now elevated, although not our base case.”

First, note that he wrote: “…before this earnings recession is over.” In other words, he clearly believes one is underway right now, which ChatGPT told me was not the case. Moreover, it wasn’t a new view by Mike; he’s been saying this for months. As I’ve relayed before, David Rosenberg asserts the earnings recession has been ongoing for a year though I lean toward the Mike Wilson view that it began in last year’s fourth quarter.

Second, please pick up on his point that a profits contraction isn’t contingent upon a broad economic downturn when he writes the latter is “not our base case”. This implies that the economics forecasting team at Morgan has not yet called for a recession. It’s my understanding they have not, and they have a lot of company. Most of “The Street” doesn’t see one coming either, nor does the Fed (there’s a big red flag, as it’s missed every one of them since it was founded 110 years ago).

Coincidentally, last week I read the latest Felder Report from my great mate, none other than Jesse Felder himself. As you will see, he’s on the same scent as Mike Wilson and he’s taking his concerns to a higher, longer-lasting level: “A precipitous fall in small business optimism, rapidly rising labor costs and a significant tightening in lending standards all point to a high probability of a cyclical decline in corporate earnings, something the stock market has not yet priced in.

What perhaps is even more troubling is the fact that, beyond these cyclical headwinds to profits, there are reasons to believe that the reversal from record high profit margins could come to represent a secular peak, as well, to be followed by a long reversion back to historically normal levels — in short, the bursting of a massive earnings bubble.”

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Lest you think that is too gloomy, consider his well-reasoned arguments. These largely hinge on the Four Horsemen of the Profits Apocalypse: interest rates, labor’s income share, tax rates, and monopolistic pricing power. Jesse’s eminently defensible thesis is that the last 40 years have seen a remarkably beneficial combination (at least for Corporate America) of ever-lower interest rates, a declining share of the pie for workers, tax rates cut in half, and lax anti-trust enforcement. He believes all of these are in the process of reversing. To his list, I would add my big bugaboo of “greenflation”, the rapidly rising costs from the Great Green Energy Transition.

Mike and Jesse are in a Vulcan Mind-Meld state when it comes to the U.S. stock market trading at a “no-worries” valuation. This is despite the recent banking spasms which portend most negatively for economic vitality and, hence, corporate income statements. Relatedly, with bank deposits falling at the steepest rate since the early 1980s, it strongly suggests an exceedingly negative flow-through to credit conditions.

To learn more about Evergreen Gavekal, where the Haymaker himself serves as Co-CIO, click below.

Private Wealth Management

Perhaps that’s a big reason why my Gavekal colleague, Will Denyer, has found that what he calls “True Financial Conditions” are much more restrictive than most other similar studies. Will includes loan standards which are tightening to a degree similar to what was seen on the brink of recessions past.

To close this macro section of today’s MHM, I thought it appropriate to point out a tendency that once attracted intense focus at this time of year: seasonality. As those of you with some gray in your hair may recall, for decades stocks displayed a recurring pattern of rising from October to April and then flattening out, if not swooning. However, that changed during the era of the Fed’s serial QEs, which ran from 2009 until early 2022, with some brief pauses. Based on trillions being injected into the financial system from the Fed’s Magical Money Machine, the market went up pretty much constantly, even during the previously adverse months.

Now that the Fed is QT-ing (tightening) instead of QE-ing (easing), that crutch has been snatched away. Stocks will need to stand on their own two legs. But with profits in a clear downtrend, despite what ChatGPT says, at least one of those legs — profits — has been seriously injured. Should the other — which right now appears to be liquidity-driven momentum — also crumple, millions of investors might wish they had dusted off that old Wall Street saw: “Sell in May and Go Away”.

Champion

As most readers are now aware, SEC rules restrict my ability to comment on individual stocks. That’s unfortunate because I believe presently it’s a classic case of “It’s a market of stocks, not a stock market”, to use another old Street saying. Pursuant to that ditty, despite my general negativity toward equities, there are a number of situations offering intriguing risks/rewards.

One of those involves telecommunications equipment stocks, in particular those that compete directly with China’s now-emasculated Huawei. As you may be aware, U.S. government sanctions have been in place against it for nearly four years. Over time, they have become increasingly punitive.

Because it is one of the primary suppliers of 5G (fifth generation) telecom equipment, necessary for high-speed wireless networks, this has created a major opportunity for its Western competitors to gain significant market share.

Even prior to Huawei’s neutering, it was pretty much a triopoly; ergo, now it’s just a duopoly. Obviously, though, there are competitors of much smaller scale. There are attractive elements to both of these leading rivals, as well as, of course, negatives. One in particular has a had a rough go of it over the last year. Ironically, that includes its own run-ins with the U.S. government. The various blunders caused its stock to break multi-year support, which was also its pandemic panic low. (In my opinion, it also makes sense to view support levels for most stocks exclusive of the Covid crash troughs because that was such a brief and precipitous decline. Looking at it this way, the support break was even earlier.)

Since then, the downtrend has continued. Lately, though, it has been showing signs of stabilization. Its valuation is also extremely compelling. This includes throwing off copious amounts of excess cash flow. As usual, this can be used to pay down debt, raise dividends or buy back its bombed-out shares. That’s likely to be winning trifecta in the years to come.

The comic clairvoyant mischievously played by Johnny Carson in his classic The Tonight Show Starring Johnny Carson*.

Champions List

Telecommunications equipment stocks

Select financial stocks

For capital appreciation:

U.S. Large Cap Value

U.S. GARP (Growth At A Reasonable Price) stocks

Oil and gas producer equities (both domestic and international)

U.S. Oil Field Services companies

Japanese stock market

S. Korean stock market

Singaporean stock market

Gold mining stocks

Physical Uranium

Swiss francs

Copper-producing stocks

For income:

Top-tier midstream companies (energy infrastructure such as pipelines)

BB-rated energy producer bonds due in five to ten years

Select energy mineral rights trusts

Mortgage REITs

BB-rated intermediate term bonds from companies on positive credit watch

ETFs of government guaranteed mortgage-backed securities

Contenders

For virtually my entire career, whenever the economy was late in an expansion, and the yield curve was seriously inverted, I became a bond bull. This time, though, I’m having a hard time jumping on the “buy long-term treasuries” bandwagon. The distinct possibility of crude oil going bonkers from here is just one reason, but another big one is the fact that the federal government is, once again, beginning to hemorrhage red ink. An actual recession, of course, will only make this worse.

My attitude with long-dated Treasury bonds is to buy them as trading vehicles when they’ve been pounded. Frankly, I was leaning that way earlier this month, but the twin bank failures of SVB Financial and Signature Bank, with First Republic on the ropes, happened before I could suggest some maturity extension.

For now, I’m reinstating U.S. government debt in the Contender category. Should there be another sharp selloff, I’m inclined to focus on the two- to seven-year maturity range for buy recommendations. My overarching belief is that the yield curve is going to normalize — i.e., un-invert — via a dramatic decline in short-term rates as the Fed belatedly reacts to what I believe is a highly probable recession. Due to the considerable odds of a massive supply of new debt — and a reluctance on the part of banks and overseas investors (such as foreign central banks) to hold longer term U.S. government IOUs due to inflation risks — I’m not sure long bonds will rally as they usually do. In fact, I fear yields might actually rise in a recession. That would also be a shocking development right up there with the potential of oil in the mid-100s.

Intermediate Treasury bonds

European banks

Small cap value

Mid cap value

Select large gap growth stocks

Utility stocks

Down for the Count

One trick I’ve learned with corporate bonds is to look very closely at those whose stocks are breaking the aforementioned multi-year support levels. For my team and I, three years is the significant interval, but the longer a downside resistance has been in place, the more meaningful is the violation of that level. In other words, if a stock has repeatedly bounced off 20 over at least a three-year period and then it decisively breaks below that, an urgent warning is being conveyed.

Accordingly, my advice to those do-it-yourself subscribers — and I know there are a plethora of you reading this — is to do a review of all of your corporate bond holdings right now, checking out each of the underlying stock charts. In my view, this is particularly important presently with an intensifying credit crunch unfolding — notwithstanding the stock market’s present disregard of that threat. (Further, my inability to offer guidance on previously recommended bonds has led me to worry you’re flying a bit blind on them at this point.) This is not to say any bonds where this is happening are an automatic sell. However, it is advisable to revisit the story to make sure you still feel comfortable with the issue in question.

Bonds where the relevant common stock has broken multi-year support.

Long-term Treasury bonds yielding sub-4% (per the Contender comments up above)

Profitless tech companies (especially if they have risen significantly recently)

Meme stocks (particularly those that have had sharp recent rallies)

Small cap growth

Mid cap growth

Haymaker