It’s Official: Correction is Here

Published at Oct 27, 2018, 8:00 PM in wealth management by Buğra Bakan

“Nature abhors a hero. For one thing, he violates the law of conservation of energy. For another, how can it be the survival of the fittest when the fittest keeps putting himself in situations where he is most likely to be creamed?” – Solomon Short (David Gerrold’s alter ego, a Star Trek writer)

The late September, early October market highs in stocks, may be this year’s all-time high in stock values. This is not due to the US economy doing poorly, or companies reporting dismal results. The stock market is forward looking, and so with rising input, financing and labor costs, along with a slowing down of global trade, European Union troubled with Brexit and Italy, China still on controlled slow down mode, equity investors are having a hard time finding bright spots. One thing is for sure, that the volatility is back and major indexes have touched the correction territory.

It’s a military tactic to know what not to do before everything else, because most importantly, you have to be alive to win battles and wars, and small mistakes can be deadly. In this market environment: don’t try be a hero. Unless you’re a thrill seeker, do not try to time a bottom and get in a concentrated position, because that low may be proven to be not low enough.

General Outlook

The US economy is currently doing well with a 3.5% GDP growth, but the World economy is pointing to a contraction in a year or two. The latest OECD Euro Area Composite Leading Indicator is at 99.6, and anything below 100 signals future negative growth. The US has been the lonely figure on the dance floor and usually when that happens, either the music stops, or more people join the dance. It seems like the former to play out coming into 2020. Or alternatively, growth may slow down to a 2% rate.

In the developed world, unemployment rates are below what would historically create inflation, and the US inflation rate is at 2.1%. Lower inflation rate is attributed to lower commodity prices, technological advancements and globalization, but the signs of a rising inflation have started to appear. This will be truer in the US, especially if the US dollar has peaked and commodities have bottomed.

The US bond prices are in a bear market with yields at current levels. The FED is no longer deemed accommodating, but rather on a neutral position. Combined, this puts pressure on stock prices as relative valuations become less attractive.

A recession in the next 6-12 months is a low probability, but is this good enough? Stocks tend to lead the economy by 6-12 months, so to say that the economy will survive next year may not be a compelling argument for equity investors.

In short, stock investors are confused about the future of corporate earnings. They haven’t given up on stocks yet, but there are serious questions and this doubt creates a tug of war. President Trump’s unwarranted comments on FED actions, and his tariff wars are only making things worse.

For those looking for a silver lining, here is a decent one: stocks typically climb a wall of worry. A case in point, in 1968, Martin Luther King Jr. and J.F. Kennedy were assassinated, USSR invaded Czechoslovakia, there were riots across the country, and the S&P 500 Index had risen 7%. The absence of worry, overly confident investors and frenzy usually is a better indicator of a waterfall decline. When investor worry about a bear market in stocks, that is usually a cause of volatility, but not a full out bear, especially during a time of strong economic growth. As mentioned before, this doesn’t mean go out and try to catch a falling knife, but rather adjust your portfolios for a volatile environment until the dust settles, which may take a few months.

More Warning Signs

There are other concerns for equity investors. The growth sector leaders have also been the leader of weakness, while defensive sectors have shown stronger resistance. This is a typical risk off move. The question is its sustainability. From here, the market usually either sees opportunities in growth areas and this trend reverses itself, or it turns into a bear market.

Rising bond yields, which since 2008 have been associated with a strengthening economy, started to spook stock investors. Globally yields are still low, there is still plenty of liquidity, so one might be skeptical of this analysis. The point I am trying to make, is that higher yields create a double whammy. Higher financing costs and rising relative valuations may have come to a point of hurting stocks.

Usually in a rising rate environment, bank stocks offer a place to hide, as a steepening yield curve translates into higher bank profits. Unfortunately, not this time, not so far. Global worries have been pressuring the long end of the yield curve while FED rates have been pushing up the short end, creating a flatter yield curve, and as a result hurting bank stocks.

Year End Rally and Elections

One action to look forward to in an annual cycle, is the year-end rally. Especially after the mid-term elections, the expectation of political certainty and a stimulus package push stock prices up. This year, the stimulus package, in the form of tax cuts, have already been priced in. In addition, the chance of political uncertainty with a divided government, is also a probable outcome. So, we may see a rather muted Santa Claus this year, if at all.

Tariffs

This is an easy one: tariffs are bad, period. It raises costs for everyone, and hurts economies. If you don’t believe me, ask the people it was supposed to help, like Ford and Harley Davidson. They are forced to lay off workers or go offshore as a result of higher input prices. This, if insisted, can wipe off all the benefits of tax cuts, and we would be stuck with a historic budget deficit with no upside. China is the second largest economy in the world, and the US exports to China is a little less than exports to Germany, UK and France combined. But more importantly, tariffs hurt business confidence, which may lower future capital expenditures, a key driver of economic activity.

Stock Buybacks and Capital Investments

A big supporter of stock prices has been corporate buy backs. How big you say? $560 billion big in the last 12 months trailing June 2018, an all-time high (Source: S&P Capital IQ). The question is, can or will it continue? For reasons shared above, corporations may put a halt to this, or slow it down. With the uncertainty created by tariffs, lower CEO confidence may elevate risk aversion and cash positions.

On the Plus Side

The good news is, a lot of this is already baked in the cake. The question is, how much more bad news is in the pipeline? Usually bear markets follow extreme optimism. Volatility index at 25, and when Nasdaq records daily 4% losses, that’s a hard one to argue for. The recent price action to the downside may be a process of shaking loose ends, creating better valuations and attracting new buyers. Let’s not forget; the FED may not be accommodating, but it is not restrictive either. Its neutral position is accompanied by still easy central bank policies in Japan, UK and Europe. In addition, the credit conditions index, which is probably the most important factor in a debt driven economy, is not signaling capitulation to a level of a looming recession.

The US economy may extend its growth past 2019. The notion that this has been the longest expansion, is looking at the wrong side of the equation, as it also has been the slowest. The longest GDP growth period in the US was during 1991-2001, 120 months of straight growth. The current cycle is 113 months old, but much more importantly: the aggregate GDP growth during the longest cycle, was 42.6%. The current cycle GDP growth is 22.3%. So, there is still a lot of room to grow for a tie breaker.

Summary

Recessions start because of over investment and dropping demand as a result. Bear markets in equities lead recessions by a few quarters, and usually start with very few buyers left to invest. Both conditions occur during extreme optimism. Currently, we lack this ingredient to call for a full-on bear around the corner. But even still, for the reasons outlined above, equity prices may need to go through a re-balancing phase and create even more pessimism before igniting the next thrust to new highs. Until then, there is nothing wrong with playing defense.

Disclosure

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy. The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.