Bear Market Barometers
Topics: Bear market barometers, a “Maltese Falcoin” crypto update and a COVID apology
Summary: The slowdown induced by central bank tightening is just starting. Be patient when adding risk to portfolios. Valuations have declined materially but the price paid for high earnings growth is still elevated.
A bottom for equities is likely to coincide with a peak in inflation, since that will signify how much central banks have to tighten. A lot of Wall Street research claims that inflation is peaking now, and a recent IMF report came to similar conclusions1. As per the first chart, the IMF sees US inflation peaking around current levels. Even so, I don’t think we’re there yet. Inflation has already blown past the IMF forecast for Europe, and as shown below, there’s evidence of a wage-price spiral in the US in low wage industries2; US labor markets are still at their tightest levels in the post-war era; and supply chain pressures which spiked last year have yet to abate (some of which is due to the China lockdowns). On top of all that, rising food and energy prices are now feeding into airlines, restaurant and lodging prices3. Bottom line: there’s a lot riding on when inflation peaks. Even if that happens now (which I doubt), the Fed has a ways to go before it can stop tightening.
Inflation, central banks and P/E multiples. As shown in the next chart, when real Treasury yields went negative in 2020 (i.e., Treasury rates fell below inflation), that’s when P/E multiples shot up over 20x. Now that real yields are moving into positive territory again, P/E multiples are declining. And the more positive real yields become, the more equity multiples are likely to fall. That’s why I am less focused on earnings right now; this correction (so far) is all about overpriced multiples finally coming down.
The market barometers on the following page show how valuations have declined. Before we get into that, see the second chart: while the premium investors pay for growth has come down a lot, it’s still high vs history. The barometers tell a similar story: the COVID stimulus boost to valuations has now been unwound, but for the most part, investors are still paying a large premium for companies with high expected earnings growth, at least relative to history. US equity markets are also not pricing in a recession yet: according to Goldman Sachs, S&P 500 pricing for cyclicals vs defensives implies an ISM reading of 49 and GDP growth of 0%-1%.
Economic growth is likely to fall as central banks tighten. Leading indicators point to a decline in manufacturing activity this fall (third chart), and the lean inventory positions of a year ago are gone. As shown in the last chart, rising inventory levels in the US have now converged with falling sales. Large declines in manufacturing and bloated inventory conditions usually result in large earnings declines. For anyone looking to add risk to portfolios this year, more bad news is now in the price for equities (the S&P selloff of 18% from its peak is ~70% of the average selloff during the prior 11 recessions), but still I think you can be patient.
Bear market barometers: equities
This cycle is reminiscent of 2001 and 1987: extended valuations finally coming back down to earth alongside what might be a shallow recession. It’s quite different than 2008 and 1991 when the primary issues were banking sector solvency, overleveraged households and a housing crash. That’s why most of the damage is seen in equities rather than in credit spreads.
Bear market barometers: fixed income
A COVID apology
COVID vaccines continue to yield massive public health benefits. Data from multiple states show a large gap between vaccinated and unvaccinated hospitalizations and deaths during the Omicron variant surge last winter4. These benefits are critical now that Omicron variants are becoming more transmissible, more resistant to monoclonal antibodies and more prone to “immunity escape” (i.e., lower cross-immunity for unvaccinated people who had BA.1)5. Still, some people do not believe that vaccines work based on theories which have been described by my science advisory group as unsubstantiated and false (and those are their kinder words).
That said, I have an apology to make. On two occasions this year in the Eye on the Market, I disparagingly mentioned how someone I’ve known for 20 years has differing views on COVID vaccines based on research he published and some personal correspondence we had. I was wrong to do that; I described his views rather than pointing people to where they could read them for themselves; I did not allow him to articulate his point of view in these pages in a point-counterpoint discussion; and I did not acknowledge that his primary focus was not epidemiology but the impact on markets if the vaccines are as ineffective as he believes they are.
As things stand now, each of us believes that the other is hopelessly lost in a sea of disinformation. I am still not sure how to deal with that, but preserving the relationship has turned out to be more important to me than rupturing it over our inability to see things the same way. As shown in the bar chart, COVID has done this to a lot of people: lost tempers, damaged relationships and a lot of stress. So, no more judgments from me; just the data and the latest research on our portal which everyone can interpret for themselves.
Crypto update since our “Maltese Falcoin” piece: Fortune may not favor the brave after all
Tales from the Crypt: returns since November 2021
|-37%||SANDBOX: Gaming token used by people buying virtual land, possibly to plant tulips on|
|-44%||BINANCE COIN: Token/exchange; welcome to France, global epicenter of entrepreneurship (see p7)|
|-49%||BITCOIN: Store of value? Volatility 5x S&P, 0.8 correlation with NASDAQ, zero inflation hedge|
|-51%||ETHEREUM: DeFi application platform; Ethereum 2.0 is coming, may improve speed/scale and reduce fees|
|-55%||BITCOIN MINER ETF: Each Bitcoin transaction consumes energy to power typical US home for 6 weeks|
|-59%||RIPPLE: Used for currency remittances, also Fred Sanford's favorite drink; SEC lawsuit finally underway|
|-60%||SILVERGATE: Crypto lending bank down more than double KBW Bank Index|
|-61%||DECENTRALAND: Gaming token; Less than 1,000 active daily users according to CoinDesk|
|-64%||BITCOIN CASH: Faster and cheaper than Bitcoin due to larger block sizes, same awful price/volatility characteristics|
|-66%||DOGECOIN: This dog has fleas|
|-69%||ROBINHOOD: Brokerage firm with 25% of transaction based revenue from crypto|
|-70%||CARDANO: DeFi application platform; You could have owned CarMax instead, which is down half as much|
|-72%||SOLANA: DeFi application platform; Seven outages in 2022 as bots crash network|
|-79%||UNISWAP: Token/exchange; its share of decentralized crypto trading activity fell from 80% in Oct 2020 to 30% in Mar 2022|
|-79%||COINBASE: Crypto brokerage; ARK Innovation ETF continues to accumulate shares as its largest holder|
|-82%||TERRA: Algorithmic stablecoin; collapsed when unsustainable 20% yields to holders were about to expire|
|-85%||AXIE INFINITY: Gaming token; how could something ever go wrong with a token linked to digital pets|
|-100%||LUNA: Whatever it was, rest in peace|
Crypto valuation theories
“Store of Value” argument continues to disintegrate given Bitcoin volatility that is 5x the S&P 500, and its 0.8 correlation with the NASDAQ
“Crypto as an inflation hedge” repudiated as crypto prices plummet while inflation rises
Bitcoin as a means of exchange? Not yet; confirmed transactions per day still below 2018-2020 levels
DeFi lending use case also crumbling as expected: since most DeFi lending is collateralized by crypto, DeFi lending activity has declined 25% YTD along with declining crypto prices
Gaming tokens financed by venture capitalists plummet as Metaverse user base falls short of expectations. Decentraland, Axie Infinity and Sandbox tokens have higher valuations and fewer users than non-blockchain games like Fortnite, Candy Crush, etc. Sandbox and Decentraland average daily users were around 1,000 people in late April. I think that’s the number of people still using Lotus 1-2-3
Some crypto collapses can be linked to unsustainably high “staking” yields paid to crypto holders that eventually reset closer to prevailing short term interest rates
Growing list of developing countries with full or partial bans on crypto as a means of payment
Coinbase claimed to have 3 million users on its NFT waitlist but since launch has yet to see more than 200 NFT transactions on any given day
Increase in daily verified Ethereum contracts per day since February report (i.e., a scarce positive)
Stablecoins Tether and USDC continue to trade close to par. As explained in our piece, stablecoin valuations have little relevance for directional crypto prices when they are collateralized by liquid reserves. The adoption of blockchain applications using stablecoins also has no relevance for directional crypto prices. On Tether, the company has reportedly disclosed it holds $40 billion in government bonds and cash out of its $79 billion in total reserves; the rest of its reserve composition is a mix of commercial paper, CDs, money market funds, loans, corporate bonds, precious metals and other digital tokens
Terra’s CEO reportedly founded another stablecoin called Basis Cash (using a pseudonym from the animated Rick & Morty show) which failed when it lost its peg in 2021 and is now trading at 1 cent on the dollar. Some believe that the Terra collapse resulted from a coordinated attack or manipulation, which I find strange since “pump and dump” schemes and other activities that would be prohibited in regular securities markets are by definition not illegal on decentralized blockchains
Cryptocurrency investors are not paying the IRS at least half of the taxes they owe on their virtual-currency trades according to Barclays. The IRS has begun to crack down on tax evasion among crypto investors and in 2023 will begin requiring brokers to report transactions worth at least $10,000
Fidelity announced plans to allow customers to put some of their retirement savings into Bitcoin, which was immediately met by “statements of concern” and reminders of “fiduciary care” by the Department of Labor
Crypto exchange Binance reportedly shared information with the Russian gov’t on its users that donated to imprisoned Putin opponent Alexei Navalny, raising questions about how anonymous crypto holders are depending on where and how they transact. This also raises questions about the decision by France to be the first European country to give Binance a regulatory stamp of approval
Gensler/SEC highlights problems in crypto market due to insufficient Chinese walls across custody, market making and trading at crypto exchanges
Cryptocurrency crime hit a new all-time high in 2021 with illicit addresses receiving $14 billion over the course of the year, up from $7.8 billion in 2020. As of early 2022, illicit addresses held at least $10 billion of cryptocurrency with the vast majority held by wallets associated with cryptocurrency theft
Sources: Bloomberg, Fortune, Forbes, Blockchain.com, Etherscan, DeFi Pulse, TechCrunch, Cointelegraph, Reuters, Chainalysis, CoinDesk, Barron’s, CNBC. “Fortune Favors the Brave” refers to a Crypto.Com commercial which aired during the Super Bowl in 2022. Tales from the Crypt refers to a US television show which aired from 1989 to 1996.
May contain references to dollar amounts which are not Australian dollars;
May contain financial information which is not prepared in accordance with Australian law or practices;
May not address risks associated with investment in foreign currency denominated investments; and
Does not address Australian tax issues.
The slowdown induced by central bank tightening is just starting. You can be patient when adding risk to portfolios; earnings will eventually decline and markets are not pricing in high risk of recession.
FEMALE VOICE: This podcast has been prepared exclusively for institutional wholesale professional clients and qualified investors only, as defined by local laws and regulations. Please read other important information which can be found on the link at the end of the podcast episode.
MR. MICHAEL CEMBALEST: Good morning, welcome to another Eye on the Market podcast. This one is for our Bear Market Barometers piece. We’ve done two podcasts so far on the energy piece. I’ll have a couple more on residential heating and hydrogen coming up in the weeks ahead. But I wanted to make sure and do a quick podcast on this week’s piece.
The bottom line is the slowdown that will eventually be induced by the central banks raising policy rates is just starting. And I think you can be patient when adding risk to portfolios. A good amount of damage has been done in terms of lower multiples in a bunch of different markets, but earnings are going to eventually come down, and markets are pricing in maybe a 30 to 40% chance of a recession. And if you’re looking for a bottom at which to add risk, you’d normally want to do that when the chance of a recession is priced in at least 50 or 60%. That bottom is likely to coincide with a peak in inflation, because that’s going to tell us how much the central banks are going to have to tighten. A lot of Wall Street research and the IMF thinks that’s happening now. They think the peak in inflation is happening now, but I don’t think we’re there yet.
We’ve got a couple of charts in this piece. The US labor markets are at their tightest levels in the post-war era. The supply chain pressures, which are still pretty intense, have yet to come down. And most importantly, there’s evidence at least in part of the US economy, specifically in low-wage industries, that there’s a wage price spiral going on. In other words, wages are going up, companies are passing along those price increases to customers, and that wage price spiral is kicking in in ways we haven’t seen it in at least 30 years, maybe 40. So there’s a lot riding on when inflation peaks. But even if that happens now, which I doubt the Fed has got a ways to go before it can stop raising policy rates. And I think along the way, there may be some better entry points in equity markets even than the ones that we see right now.
There’s a chart in here. Sometimes, we talked about this a lot over the years, and we all knew, you knew that this was going to change one day. The only question is when. And what I’m referring to is negative policy rates, in other words, policy rates and ten-year Treasuries below the rate of inflation. And we had never lived through, I had never lived through a period where we had such sustained low policy rates. And then in 2020, the ten-year went deeply negative in real terms, and that’s when PE multiples really took off and rose.
And now that Treasury rates are on their way towards rising above the rate of inflation, or at least inflation expectations, PE multiples are declining. So I think that process has more to go. And I’m so focused on earnings right now. This correction so far is mostly about overpriced multiples finally coming down, which is why we have a couple of pages showing you what’s happened to PE multiples in a number of different markets.
Before I get into that, I just want to mention that there is a chart in here that looks at two different ways of the value versus growth question. No matter how you look at it, markets are not “back to normal” yet. We’re nowhere near where we were from let’s say 2010 to 2018, where there was some kind of stable equilibrium between value and growth. Growth stocks, even though they’ve come down a bunch on an earnings yield basis, are still pretty expensive. And some of the leading indicators that we looked at tell us that there’s likely to be a pretty sharp drawdown in global manufacturing sometime this fall. And usually when global manufacturing takes a dive down, global corporate earnings do as well.
And the cushion that we had last year in the US was that inventory levels are very low. Well now they’ve caught up, and one of the charts in here shows you that inventories have actually risen quite sharply and that sales have come down to that level of inventory. So some of the cushions that we had in terms of an understocked and undersupplied corporate sector that existed last year are not in place right now.
There’s a page in here that has PE multiples for equities, just some charts and monitors that we’re following. And what you’ll see is certainly amongst the growth stocks and amongst the big mega-cap eight stocks, the largest eight by market cap, the surge in valuations that took place because of COVID stimulus, that’s been completely reversed. So if you’re looking for an entry point that has to do with erasing the premium that was put on these stocks because of all the stimulus from COVID, that’s now been erased and eliminated. But that still puts you at 2018/2019 multiples, which are on the expensive side of history.
What looks a little bit cheaper here is US small cap and Europe, but I don’t have a ton of confidence in either one of those right now as a bottom fishing expedition. The NASDAQ looks tempting. Half of the NASDAQ is down at least 50%, but in the correction that took place in 2001, it was much worse than that. And so it still feels like there could be a little bit to come as well in terms of NASDAQ weakness.
And then there’s a page on fixed income, which is a mixed bag. The opportunities in emerging markets government bonds have gotten pretty attractive, whereas US high yield has only just begun to widen. And there really hasn’t been much activity at all in terms of investment-grade credit spreads, leveraged loans, commercial paper, and asset-backed securities. And I think that makes sense because this to me, this feels more like 2001 than 2008. In other words, this is a multiple and valuation story, and this is not a story about credit risk or the security and safety of the banking system. So I think that’s a pretty important distinction. So bottom line, there should be some cheaper entry points over the next few months because the Fed still has a lot of work to do to catch up to the wage and price inflation that’s percolating in the system.
There’s a couple of follow-ups here. I have some information on COVID, including an apology from me to somebody. You can read about why I’m doing that. And then there’s a chart in here called Tails from the Crypt. I thought it would be interesting to look at an update on what’s gone on in the crypto markets since our Maltese Falcon piece last February. Look, I mean when I wrote this paper, I got a lot of grief for it as an old guy, I’m turning 60 this week, who doesn’t understand the future. All I can tell you is that since I wrote that piece, the value proposition and valuation theories for crypto, in my opinion, just keep getting worse and worse and worse. I’ll tick through a few of them. The concept of a store of value for Bitcoin, I mean, Bitcoin’s volatility remains five times the volatility of the S&P 500. It’s got a 0.8 correlation with the NASDAQ. Crypto as an inflation hedge doesn’t make sense. Crypto prices are plummeting while inflation is going up. Bitcoin, its number of confirmed transactions per day is still below where it was in 2018. So Bitcoin as a means of exchange isn’t going anywhere.
For Ethereum and the kind of blockchain application-based tokens and exchanges platforms, as we expected, DeFi lending is crumbling, because most DeFi lending is collateralized by crypto, and DeFi lending is down 25% along with declining crypto prices. This wasn’t very difficult to anticipate.
And then the gaming tokens, a lot of very smart venture capital people put a ton of money into some of these metaverse gaming things. Decentraland, Axie Infinity, Sandbox, they all have very high valuations and fewer users than the non-blockchain games like Fortnight and Candy Crush and Grand Theft Auto. I read a report that at the end of April, Sandbox and Decentraland were averaging around 1,000 users a day. I mean, I think that’s still the number of people that use Lotus 1-2-3. So as far as I can tell, the value proposition and the valuation theories for crypto have gotten worse rather than better since our February piece. So that’s it for this week. I will be back next week with a part three podcast on our energy paper. Thank you for listening.
FEMALE VOICE: Michael Cembalest’s Eye on the Market offers a unique perspective on the economy, current events, markets and investment portfolios, and is a production of J.P. Morgan Asset and Wealth Management. Michael Cembalest is the Chairman of Market and Investment Strategy for J.P. Morgan Asset Management and is one of our most renowned and provocative speakers. For more information, please subscribe to the Eye on the Market by contacting your J.P. Morgan representative. If you’d like to hear more, please explore episodes on iTunes or on our website.
This podcast is intended for informational purposes only and is a communication on behalf of J.P. Morgan Institutional Investments Incorporated. Views may not be suitable for all investors and are not intended as personal investment advice or a solicitation or recommendation. Outlooks and past performance are never guarantees of future results. This is not investment research. Please read other important information, which can be found at www.JPMorgan.com/disclaimer-EOTM.