For the first time since 2009, the market gets ‘paid’ to be short US equites. With the S&P 500 Forward Futures curve moving from backwardation to contango, equity shorts start to earn positive carry. This may not mean an automatic reversal of the strong positive equity trend in US equities but it does remove one of the fundamental pillars of CTAs, momentum-driven and some algos in executing long S&P 500 Futures strategies.  

1.       Trend followers will tell you that the most powerful combination is when you are paid to be in the momentum. i.e. when you are not only riding the momentum but you are also getting paid to do that (you are earning positive carry).

2.       This is exactly what has happened in US equities since 2009: if you have been long US stocks through US index futures, this has been a positive carry trade in addition to being also a very powerful long-term momentum trend.

3.       This is actually quite unusual: the dividend yield was lower than the 3m TBill rate between the late-1950s till 2008 and long stocks through futures (early 1980s) had been a negative carry trade. In fact, the negative carry was around 2.5% pa during that period.

4.       Since 2008, however, the opposite has happened: with the dividend yield climbing above the 3m TBill rate, the carry of being long stocks through futures has flipped to an average of around +2% providing massive support to the stock market positive trend.

5.       (When the dividend yield is lower than 3m TBill rate, the SPX futures curve is in contango, and is in backwardation in the alternative scenario).

6.       Since last year, though, things have changed: with the Fed rising rates and the 3m Tbill yield moving up, the SPX futures curve first flattened out about 6 months ago and is now in contango.

7.       With the Fed continuing to raise rates, the SPX futures forward curve is likely to continue to steepen (3mTBill 1y fwd went above SPX dividend yield last December) and thus the negative carry of long equities through futures will also start increasing.

8.       Timing the market is a sucker’s game. People have been calling the end of the equity bull market the moment SPX reached the previous 2007 peak again in 2013. They have thrown everything at this call: valuations, flows, sentiment…

9.       I have no idea if 2018 will be the year when this trend will break but being long equities has lost an important pillar of support: the carry. All of a sudden, for the first time since 2009, the market is ‘paid’ to be short SPX futures!

One would think that US corporate profits and the S&P Index should move closely together. And they do… most of the time. But when they diverge, should we be buying/selling US equities?

1990-2017

The chart above shows that since the 1990s there have been three such divergences where the S&P Index ‘outperforms’ US corporate profits by a large margin followed by a subsequent crash in equities: Dotcom Crash, the 2008 GFC, and whatever we have now (WWHN). The Dotcom crash was indeed an equity bubble with US equities starting to diverge already in the mid-1990s.

The 2008 GFC crash did not have much to do (if anything )with equities. However, US corporate profits started declining already in Q3 2006 while the S&P Index continued to rise well until the summer of 2008. Nevertheless, the divergence between the two was not that stark as the in DotCom crash. Still, the declines in the S&P Index during the Dotcom and 2008 GFC were similar.

The bounce back in US corporate profits after 2008 GFC was rapid and extreme, just like the decline was. This was again in stark contrast to the Dotcom crash which was preceded by flat US corporate profits since the mid-1990s. Their rise post the Dotcom crash, thus, was gradual. The 2008 GFC was such an extreme event that caused US corporate profits to ‘outperform’ the S&P Index between 2008 and 2013, a very rare event indeed (see Chart below).  

However, since Q1 2012, US corporate profits are more or less unchanged while the S&P Index continues to power higher. Still the divergence between the two now does not seem that extreme as in the Dotcom crash.

1947-1990

The only other time when US corporates ‘outperformed’ the S&P Index was between the mid-1970s and the mid-1980s. After being flat for almost 10 years priors, the rise in US equities after 1983 to ‘catch up’ with US corporate profits was extreme which might have contributed to the sudden crash in 1987. But one could think of that event as just a sudden stop to regain one’s breath after running a 100m sprint. The S&L crisis that followed, similar to the 2008 GFC, had almost nothing to do with equity valuations which, this time, was reflected in the performance of the S&P Index (no crash).

So where do we go from here?

Another way to look at the relative performance of US corporate profits and US equities is to index them to 1947 when data for US corporates started to be available (Chart below). What is obvious here is that ‘something’ happened in the early 1980s: The Great Financialization of the US economy started. Moreover, US equities got an extra ‘artificial’ push when the SEC introduced Rule 10B-18 which gave safe harbor for US companies to buy back their own shares.

The DotCom crash, 2008 GFC and WWHN (TBC) are much more visible and it seems that the divergence between the S&P Index and US corporate profits now is at least comparable to the Dotcom era. So, when is the ‘crash’? All this tells us, is that US equities are running ahead of US corporate profits and that they are on the expensive side when using traditional valuation methods. But there are other things that one should consider before making any conclusions about potential setback in share prices. And even when all things are lined up for that crash that everyone has been waiting for now years, there is still the trigger – leverage.

…followed by a de-financialization of the US economy.

I am not talking about a correction in this bull market, whether a one-off (1987, for example) or a cyclical one caused by a financial/economic crisis (1998, 2000, 2008). This can happen any time leverage is too high. I am also not talking about a structural bear market either, like the one we had after the Great Depression between 1930 and 1950, for example. For that to happen, if ever (given that it did not happen after the Great Financial Crisis of 2008 thanks to the authorities’ help in restoring the financial plumbing of the economy), we need much more than a regulatory change: we need an economic and financial crisis coupled with a failure of trust in our institutional infrastructure.  What I am talking about is a sustained structural change in the dynamics of the market, something more reminiscent of the more “sideways” market between 1960-1980. The latter can happen without any economic and financial reason; it can happen just if the SEC revokes Rule 10B-18 which allows US corporates ‘safe haven’ to buy their own shares.

The SEC introduced Rule 10B-18 in 1982. The rule greatly simplified the procedures which US corporates must follow in order to buy back their own shares. This resulted in a big spike in US corporate share buybacks. For example, before 1982, there was very little US corporate buyback activity for fear of insider trading prosecution and the likes. Since the rule came into force and especially since the financialization of the US economy in the 1980-90s which spurred M&A and hostile takeovers, and the change in management incentives towards more equity-based remunerative structure, US corporates have become the dominant buyer of US equities. They are a fundamental structural force, and one that is greatly underappreciated, in the equity bull market that followed.

The chart at the top of this post illustrates the financialization of the US economy that took place in the early 1980s and it is ongoing now. Non-financial corporations have been net buying back their own shares (negative equity issuance) while financial corporations have been issuing new shares.

Supply of US equities

Overall US equity issuance can be broken down among three sectors: financial, non-financial and foreign (ADRs, for example). Though the financial and foreign sector have been generally net issuing shares throughout the history of the data, there is a break in the pattern of equity issuance for the non-financial corporate sector (chart below). While between 1945-1982 the latter has been a net supplier of equities, after, it has been a net buyer of equities (negative net equity issuance).

We can see that more clearly if we factor US corporate net equity issuance by GDP (chart below). While before 1982 there were only five years when there was a negative equity corporate issuance, after 1982 the opposite happened: there were only three years when US corporate issued more new shares than they bought outstanding ones.

Or another way to look at the changes which occurred in the early 1980s is to break up the periods (chart below). The positive net supply of corporate equities between 1945-1982 dwarfs the negative corporate issuance thereafter. I have broken the 1982-2016 period into two. For the 8 years between 2008 and 2016 US corporates bought (negative net issuance) as much of their own shares as for the 26 years which preceded (1982-2008): this is the power of corporate share buying since the 2008 financial crisis!

The financial sector, however, has been a net supplier of equities. This is not because banks and other financial institutions have been issuing equities (even though they have as part of their financial restructuring after 2008) but because of ETF shares supply. The two charts below show the breakdown of total US equity supply by the three main categories and the rise of the ETF respectively.

That’s how the supply side of US equity looks. What about the demand side?

Demand for US equities

The chart below shows a breakdown of the cumulative demand form the main traditional buyers of equities. Households have been the largest seller of equities. However, what they have done is basically sold their direct holdings of equities but bought equities through mutual funds (and ETFs –  included in that number) and pension funds. Nevertheless, even taking this indirect ownership of equities, US households have net divested of equity shares as pension funds (both public and private) have also net sold equities since 2013. The other big traditional buyer is foreigners but they have also recently started divesting of US equities.

So, how is it possible that the demand for equities from the traditional market players seems to be on a decline relative to history but we have had this amazing bull market in US equities since 2009? It is the supply. I have included in the chart above also US non-financial corporates buying of equities as a positive number (this is the same as negative net supply – the opposite of the line in the chart on top of the post). This is especially so after the 2008 financial crisis, when cumulative US corporate share buybacks overtook buying of US shares by foreigners. In fact, looking only at the 2008-2016 period, US corporate net share buybacks far outstrip any other equity demand (chart below).

Reality is that US corporates sit in both the demand side -through buybacks of outstanding shares – and the supply side – through IPOs – of US equities). They are in a unique position to affect both: the act of buying back your own shares affects positively demand for them but it also affects negatively their supply (the shares are retired and they do not come back to the market). This simultaneous increase in demand and decrease of supply makes US corporates the most important player in the US equity market. That is why, any change in their dominance position would have huge repercussions on the equity market trend.