This decline in the labor market and stock market hasn’t happened yet. While one can explain the extending of this very weak recovery by saying every economic cycle is different, this would ignore the role the central banks have played. The best way to describe current monetary policy is a grand experiment to see how assets appreciating will affect the overall economy. Even without a nasty recession, the results are not good as the US economy has had a long benign recovery.

The expectations for earnings to rebound in 2017 assume the economy has gone through the weak period and will get back to growing at the 2% it had seen before it started to decelerate in late 2015. Even though Goldman Sachs lowered its 2017 earnings expectations today, it still is projecting 10% EPS growth for the S&P 500. Normally at this point in the cycle the employment picture would be weakening to the point where Goldman would be able to project a decline in earnings which would likely end up having to be revised lower because Goldman is in the sales business and always has to have a positive spin to help its business. In this current case the length of the end of the cycle makes future earnings estimates more disjointed from reality than they would ordinarily be.

While the possibility that the worst is over for the economy and earnings recession exists, I don’t consider it likely. I would go as far as to say that Goldman’s projections for the next few years are virtually impossible as it is projecting earnings growth in 2018 to grow 5% and 4% in 2019. The reason why I see this endless growth phenomena as unlikely is because of the debt the global economy has racked up trying to get growth to re-accelerate after the previous recession.

The chart above shows the global debt as percent of GDP being at its record high. The previous recession was quelled by the big fiscal spending stimulus packages especially in China. There never was a proper deleveraging. The debt level will likely rise higher in the near future as tax payments lower as corporate profits have been declining. Part of the reason for earnings optimism in 2017 is the bet on a fiscal stimulus. Those betting on this possibility must be ignoring the chart above. I don’t see fiscal stimulus as likely. I see a deleveraging finally occurring. This would be healthy and allow for the future recovery to be stronger than this current one.

The best description of the current bifurcation of stocks and economic weakness is Caterpillar. Investors buying Caterpillar are buying into the fiscal stimulus led recovery in 2017 fantasy I explained. The chart below shows how bad sales at Caterpillar are as updated sales were released today. Worldwide retail sales declined 18% in the past three months. Retail industry sales fell 37%, retail construction sales fell 10%, and energy and transportation sales fell 25% (all in the past 3 months). This is while Caterpillar stock is near its 52 week high.

              The one chart which explains this entire situation is the balance sheet of the 10 largest central banks shown below. These asset purchases are what allow the global debt to be at the highest in history and stocks to simultaneously rally. This chart is the only logical explanation for why Caterpillar stock is so high. The question to when this situation will reverse is answered by when the faith in central banks ends. This may come when a fiscal stimulus isn’t enacted and US corporate earnings decline because of the strong dollar and bulls have to admit the only thing holding up equities is the funny money printed at the Fed.

              The final chart I will leave you with is the historical chart of the capacity utilization rate compared with the unemployment rate. Capacity utilization shows the historical production versus demand in the economy. Ordinarily there is a business cycle with growth occurring when demand exceeds production and recessions happening because of over-production. The current cycle peaked in November of 2014. We have experienced a decline in the capacity utilization, but, as I said, I don’t think the cycle has bottomed because of the enormous global debt which has to unwind. A further decline must be paired with an increase in the employment rate. It is almost impossible for firms to not lay off workers with their margins declining so quickly.

Conclusion

            There are a few uncertainties and a few certainties I have about risk assets and the economy. I am certain the balance sheet of central banks will continue to accelerate. I am certain the capacity utilization has peaked for the cycle and that further declines will be met with an increase in the unemployment rate. I am also certain fiscal stimulus would increase the debt which will be terrible for the long term health of the economy. What I am not certain of is how this correlates into asset prices. Junk bonds have ignored increasing defaults and equities have ignored declining earnings. The question is how long this can last.

Well, not entirely, but US traders woke up Tuesday to green screens, a welcome reprieve from two days of mayhem. “Brexit” discussions still dominate the airwaves and headlines, but you can count on the dip buyers and knife catchers for what may or may not be a dead cat bounce.

European bourses were up across the board with the FTSE and CAC up more than 2.5% and the DAX tacking on nearly 2%. We’re seeing strength in all the usual risk-on places. Oil is up, USDJPY is stronger as is GBPUSD. Gold is down as is the VIX.

So are we out of the woods? Has the storm passed so quickly? Not likely. Here’s a bit of technical analysis from BofAML:

“Yesterday’s S&P 500 close below 2025 exposes 1950-1930, which is the February double bottom breakout point and downside projection given the close below 2025. The S&P 500 tested the 38.2% Fibonacci retracement of the early-February to early-June advance at 2001.96 but any bounces that meet resistance ahead of or within 2025- 2050 (prior supports at the May and mid-June lows that now act as resistance) keep the immediate risk to the downside with the 50% and 61.8% retracements at 1965.32 and 1928.69, respectively. Holding this Fibonacci zone is important for the bulls.”

(Chart: BofAML)

In sum: exercise caution.

At this juncture it’s critical not to lose track of two important narratives that the Brexit vote has brought to the fore.

The first revolves around the extent to which European banks are teetering on the precipice. The market has been casting a wary eye at the space for a while now amid possibly reckless ECB easing and generalized solvency concerns in some names. Here’s a look at default risk for Deutsche Bank, Barclays, and also at the spread on iTraxx Sub Fin:

Clearly, there’s a palpable sense of angst. Also, don’t lose track of just how much pain financials have endured over the past two sessions:

As you can see, we’re looking at steep declines across the board. Today’s gains have barely made a dent in terms of recovering levels seen just last Thursday and some European names actually closed red. Indeed, some traders are viewing this week as a kind of live fire stress test. Here’s Bloomberg’s Richard Breslow:

“Banking sector shares have been conspicuous for the hammering they’ve suffered since Friday. There is some understandable and logical rationale why this across the board knee-jerk reaction was so severe. And also that investors may want to be a lot more selective as they reconsider cause and response.”

“Last week, understandably lost in the panic, every big U.S. bank passed its Federal Reserve administered stress test. It wasn’t assured ab initio.”

“Theoretical assumptions are the only way the regulators ever want to have to evaluate the banks. But how the Fed and the banks respond to this real world strain will be a better barometer. It matters because tomorrow there will be an announcement on the approved levels for dividends and stock buybacks. In other words, lowering the amount of capital on hand to help buffer against adverse shocks.”

In other words: this is not a drill.

The second narrative you need to keep a close watch on is the extent to which Brexit exposed the fragility of the market’s increasingly creaky infrastructure. The more interconnected and homogenous markets become, the greater the potential for violent moves. This is exacerbated by HFTs and central bank meddling. Have a look at the response to Brexit compared to previous shocks:

(Chart: BofAML)

Pretty scary, right? You don’t necessarily want to see too many 12-sigma moves. Sure you can make a fortune if you call it ahead of time, but the very fact that it’s a 12-sigma move means you probably won’t be able to predict it. It’s kind of like what any college statistics professor will tell you about the lottery: “sure, someone is going to win, but it aint going to be you.”

This is a bad setup given the geopolitical landscape.

Lots of landmines + fragile markets = potential for “oops” scenarios. Scenarios like that which played out on Friday.

As for Tuesday’s rally, we’ll close with one final chart which should tell you everything you need to know (hint: if this rally were for real, you wouldn’t expect the yield on 10Y US Treasurys and 10Y German bunds to be just flat):

There’s a narrative out there about buybacks that’s been propagated by a variety of outlets over the past 12 or so months that ties ZIRP and share repurchases to equity strength. To be sure, it’s a compelling argument.

Here’s how it goes.

Investors are hurting for yield thanks to seven years of unconventional monetary policy and that’s driven demand for corporate credit, both IG and HY. Companies have taken advantage of a kind of goldilocks situation for corporate debt issuance that pairs strong demand with rock bottom borrowing costs. Here’s a look at the trend in total gross high grade supply:

(Chart: Citi)

Companies, the narrative goes, use the proceeds from debt sales to buy back shares, inflating equity-linked compensation for corporate management teams and, more importantly, artificially boosting the bottom line. It’s financial engineering at its finest; leveraging the balance sheet to manage the optics around earnings and keep the stock price afloat. Further evidence of this dynamic can be observed in beats/misses trends for the bottom versus the top line. This is from FactSet:

“In 2016, US companies have been hurdling EPS targets with relative ease. On average, 68.5% of companies in the SPDR S&P 500 ETF (SPY) have beaten quarterly EPS estimates since 2014. In the prior eight years, however, the percentage of companies in this group averaged 65%. Even when excluding the recessionary quarters from Q1 2008 to Q2 2009, companies averaged only a slightly improved beat rate for EPS (65.8%).

“Revenue expectations, however, have proven to be a harder target. Less than 46% of companies in the SPY ETF beat sales estimates in Q4 2015, with an average of 52.5% beating the Street since 2014. This compares to an average of nearly 57% over the past eight years (again excluding the recessionary periods from Q1 2008 to Q2 2009). In addition, less than half of companies in the fund beat sales estimates for three of the four quarters of 2015 (2015/2C was the exception).”

The implication is clear: companies can engineer beats on the bottom line, but not on the top.

Here’s a look at the trend in S&P buybacks going back two decades:

(Chart: Deutsche Bank)

Clearly, there’s some correlation between debt issuance and corporate buybacks.

But FactSet reminds us that correlation doesn’t always equal causation. Here’s what they have to say about the extent to which share repurchases are driving EPS beats:

“This gulf between companies reporting positive surprises for EPS and sales has widened over time. Within the past 10 years, only the unpredictable recovery year of 2009 featured such a large difference in the two metrics.”

“It might be tempting to explain the divergence in EPS and sales surprises on increased share buyback activity, but the hypothesis doesn’t receive much support from the data. Aggregate share repurchases and buyback participation have stabilized since 2014. In addition, companies missing sales estimates while beating EPS expectations are not more likely to have repurchased shares. One-hundred-sixty-five companies were in this group of the S&P 500 index in Q4 2015. Of those, 124 (75%) also repurchased shares in the quarter. This compares to a representation of 74% in Q4 2007, a period in which the difference in the number of companies beating EPS and sales was effectively nil.”

“Margins, on the other hand, have shown a slow and steady march upward since the recession,” FactSet concludes.

As for Deutsche Bank, they’ve done the math: buybacks have accounted for about a quarter of EPS growth over the past three or so years.

(Chart: Deutsche Bank)

In the final analysis then, it would appear that FactSet may be understating the case. Or at least sugarcoating things.

The question going forward is of course this: what happens to stocks when rising rates make borrowing money less attractive to corporate management teams and the buybacks dry up?

Every week we need to look at the implied volatility and expected move for the week. Comparing the implied volatility and expected move to the previous week will tell us if there is more risk in the market. For next week the oil production report is coming out and the FOMC will make a decision on rates. According to the implied volatility and expected move the market saw more risk in the ECB announcement last week than they do in the FOMC announcement next week. Let's also look at few potential trade set ups. For example, GOOGL is on my radar as a potential candidate for an in and out spread.

You can view your short positions as being short the SPY ETF. Let's review the positions that are on and what to expect next week. There is one big news announcement that is keeping the expected move juiced up in the SPX. That is the ECB announcement as central banks around the world race to the bottom. I'll be sharing one of my favorite iron condor strategies on Wednesday March 9, 2016. For member the class is included with your membership. For non-members - you can register for only the class or sign up for the TotalTheo membership.