They say its always darkest before the dawn, which seems appropriate as we meet the Winter Solstice today, at the lows of 2018.
There is a lot of commentary out there right now about hos investors are ‘worried’ about certain things like Brexit, slowing economies in China and Europe and if that slowing will seep into the U.S. All these areas of concern have been with us for most of the year. I have pointed out the Chinese credit impulse (slowing) more than a few times. Housing and auto sales have been slowing for months. The only difference is now there is a market decline and all these issues are being discussed. If the market had not been declining these issues would still be with us, only accompanied by the tag line: “Investors shrug at concerns in Europe”.
In past posts I have described the coming year over year comparisons, 2018 v 2019, regarding earnings and GDP growth. Every time I have mentioned that 2019 will look much worse than the stellar numbers put up in 2018, thanks largely in part to the one time cut in taxes. That gave markets a boost and it was hoped that business investment, and wages would go up as a result. Well it’s the end of 2018 and were still waiting.
The Federal Reserve gave a modest tip of the hat towards global economic concerns by reducing its estimate of rate increases in 2019 from 3 to 2. There were even rumors that the Fed would skip raising its rate on December 19th and guide to 0 rate increases in 2019. The Fed NEVER overtly bows to market or political pressures outside of an official recession or panic. The Fed is in the process (as usual) of raising rates into the beginning of a recession. Besides the yield curve, there are several other indicators that make recession in 2019 likely. These indicators have been leaning this way for several months, and finally have tipped far enough that the markets are now concerned and discounting this likelihood.
As this is likely the beginning of a bear market (average -33% post WW2 era), we should expect large rapid moves, both down AND up in the markets. During the bull market, a 2-4% pullback was common and quickly bought. Today we see 2-4% intraday moves that continue to fall to hold support. I expect several more percentage points south before a significant rally in stocks in the first few months of the year. This will be an opportune time to reassess one’s risk tolerance and goals over the next 1-3 years, as well as make sure that one’s portfolio is properly diversified across asset classes. When stocks go down there are often other asset classes that are performing better, the core idea behind diversification.
2018 is sizing up to be a very volatile year. Including today, there have been 11 2% down days this year. There were 0 in 2017, 0 in 2006, and 11 in 2007.
The major indices are currently holding their lows from late October and Thanksgiving week, approximately 2625 on the SP500. The interim highs were just over 2800, a 6% swing.
The big question of the quarter is if the highs or lows will break first. Volume today is extremely heavy, so if the markets can close in the top half of todays range, that should bode well for the next few days.
Looking at the big picture, the 200- and 100- day moving averages are flat, the 50 day is sloping downward. We see the longer term trend is flat while the short term trend is down. The 50 day and 200 day are at the same level and the 100 day is near 2815. The averages are clustered together near current prices while the markets intraday are given to large swings in both directions.
Concurrent news topics are the recent good news item of a 90- day trade war truce, and the bad news topics are the problems with Brexit, and the arrest of the vice-chairperson of Huawei, China’s largest cell phone maker. She is a Party member, daughter of the founder who is also a Party member and has close ties to China’s military. Maybe not the best person to arrest if one is trying to negotiate a Trade Truce.
My forecast from late 2017 was for large swings in market prices and we have certainly seen this play out. When compared to past market tops, 2001 and 2007, one can plainly see plus and minus 10% moves as the market tops out then finally breaks down. Its my opinion that a bear market has likely started, and we have a few opportunities to sell at “high” prices, and get positioned for 2019.
Fundamentally while employment and earnings are good, these are backwards looking indicators. These are the results of a good economy, not indicators it will persist. Housing and autos are slowing; defensive stocks are outperforming growth stocks, and forecasts for 2019 earnings range from 0% to 8%, a far cry from 2018’s +20% earnings growth rate.
So, what to do? Is it more difficult to ‘sell high’ or ‘buy low’? One is fraught with fears of missing out, the other fears of further declines. Selling into market strength and perceived ‘resolutions’ to our economic headwinds might be the best bet. Especially considering the chart below, where in 2019 the global Central Banks will be withdrawing liquidity until further notice, while the Fed insists on raising rates further.
First quarter of 2018 turned out much differently than investors had been expecting at the turn of the New Year. In January’s note, there were many sentiment indicators that had eclipsed their all-time highs. The highest percentage of investors expecting higher prices in twelve months was recorded. Equity markets peaked on January 26 and fell 12%, followed by a large bounce into mid-March then subsequent decline that left us at quarter end about 4% above intraday lows from February. We may be seeing the first stages of the end of the 9-year-old bull market. Looking back at 2007 and 2000, the topping process can be choppy with market gyrations of +/-10%. This is a complete 180 degree turn from the past two years where volatility was non-existent and equity markets went the longest period ever without a 5% decline. Expect continued choppiness as the impact of Tax Reform filters through the economy and if corporations can continue the blistering pace of earnings growth going forward. At the same time for mostly the same reasons, interest rates are likely to be range-bound. Very recently the price of oil climbed on a news release that the Saudis would like to see $80/bbl oil. Rising oil prices would be akin to a tax on consumers and hamper US growth.
Sentiment as seen by the AAII % bullish rolling 8-week average has declined from its euphoric high at 49% in January, down to 33%. At the bottom of the last correction in early 2016 this average was 23%. The current correction may be over and a lot of selling pressure has been exhausted there is room to the downside still. A reading in the mid 20% has been a good area to mark a low in the markets. Sentiment is often a lagging indicator. Investors are most enthusiastic after large price gains. The opposite is true too in that sentiment numbers go low after a price decline. It can be helpful to take a contrarian view as sentiment measures move to extremes.
Blame for the downturn in January was due to a slightly hotter than expected print of Average Hourly Earnings (AHE), and the resulting concern over how quickly the Fed will raise interest rates. The rapid change in AHE has not followed through into February and March, yet stocks remain well off their highs. Analysts have been looking for wage pressures due to very low unemployment numbers for a long time. The lack of wage growth is likely to the re-entrance of discouraged workers back into the labor force. As a discouraged worker, who ‘hasn’t looked for work in the past month’, they are removed from the workforce. When the number of unemployed decreases (the numerator) along with the total workforce (the denominator), the unemployment percentage rate goes down. A low unemployment rate at the same time there is little wage pressure is due to the workforce participation rate being very low. Focusing on the total number of people employed, which is still growing on a year over year basis, may give us a better read on employment situation without looking at the unemployment rate. Any impact from Tax Reform should show up in an acceleration of year over year Total Employees growth.
A more telling chart, and perhaps the real reason behind President Trump’s fiscal stimulus is the following chart. Using the same raw data that created the above chart, the chart below tracks the monthly, year over year percentage change in total nonfarm employees in the United States. There are no seasonal adjustments etc. While we are growing, the rate of increase in the total number of people working, is slowing.
Forward guidance from companies will be critical. Expectations are still quite high regarding full year earnings and end of year price target for the S&P500, currently about 3000, 15% higher than todays price level. During the first quarter, when earnings from Q4 2017 were reported, companies beating earnings estimates were rewarded only slightly, while companies missing earnings had their stock prices pushed down. It seems there is still a ‘priced to perfection’ hurdle that companies must overcome.
The largest macroeconomic driver for the remainder of the year is the now global shift from QE (quantitative easing) to QT (quantitative tightening). This global liquidity spigot the Central Banks have been running on full blast for the past 9 years has begun to end. The US Federal Reserve stopped buying bonds (adding dollars to markets) and began raising rates. These are tightening liquidity. While in 2017 the European and Japanese central banks more than made up for the Federal Reserves actions, both have been broadcasting plans to temper their liquidity injections. China is tightening as now in preparation for increased stimulus to coincide with the Communist Party’s 100th anniversary in power in 2021.
Over the past 9 years global liquidity additions has been the key driver to global asset prices. As these additions slow and become subtractions, one must assume it will impact financial markets. Most importantly global US Dollar-liquidity is the most important as the Dollar is the global reserve currency. Recently the LIBOR-OIS has been in the news, having risen dramatically over the past few months. This index is a rate that compares the overnight cost of interbank dollar borrowing in the US vs Europe. The cost to borrow US Dollars in Europe has gone up dramatically. A low cost would reflect ample Dollars for those who need them, a higher cost reflects a shortage of dollar-liquidity. The TED Spread compares the interest rate on 90-day treasury bills and the 90-day LIBOR rate. The TED spread is 90-day rates and the LIBOR OIS is overnight rates, and they follow each other closely. The crux of it that they both measure the availability of funds in the money markets. If these rates go up, it is seen as a decrease in available funds.
The chart above tracks the TED spread and the US dollar. The relationship is loose but fits well over multiple quarters. If this relationship is correct, the US dollar should dramatically increase in value in the coming months. An increase in the US Dollar will push the prices of non-US assets lower, make dollar denominated debt widely used in emerging markets more difficult to pay back and have further repercussions in debt markets. A weak US Dollar is the underpin of global asset prices, and a stronger dollar, along with Quantitative tightening will be a strong headwind to asset prices in the second half of 2018. If earnings can continue to growth strongly and more workers can be added at a strong pace, both leading to more credit growth, this headwind may be able to be offset.
In addition to international money market rates, the slowing velocity of money has been a constant impediment to economic growth. Or, rather, the low velocity of money is indicative of an economy that continues to languish despite massive amounts of new money put into the system. If the pace of money flowing through the economy slows, GDP can be increased by putting more money into the system. More money moving slowly can be like a small amount of money moving quickly. If money is removed from the system via tightening measure from central banks, and we do not see an increase in the velocity of money, GDP will decline. The slowing of VoM has been a problem since 2000 and is likely directly related to ‘why’ the Fed keeps rates extremely low for very long periods of time. Of course, if VoM were to return to 1960’s levels, interest rates would be substantially higher, causing a re-pricing of all assets—which is a topic for another day.
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The Wall Street Journal had a very good article detailing one of the root causes of the February decline. A classic ‘tail-wagging-the dog’ story about derivatives and how they can impact other markets that are seemingly unrelated. While the outlook for global equities informs the level of the VIX, we have just seen an incident where forced trades of VIX futures impacted futures prices of equity markets. Its as though the cost of insuring against market declines went up so much that it caused the event it was insuring against.
Even with that being known, the impact to market sentiment has been dramatic. Most sentiment indices went from extremely optimistic to extreme fear in a matter of days. This change in attitude by market participants may have a lasting impact. A rapid decline like we saw in February will reduce optimism and confidence (which underpin a bull market rise), and increase fear and pessimism, which are the hallmarks of a bear market. Short term indicators turned very negative and now are more neutral, but longer-term sentiment indicators will take a longer decline to move negative.
Often the end of a bull market is marked by a rise in volatility, with equity prices falling 5-10%, then climbing back up only to get knocked down again, until finally prices cease climbing back up. This can take several weeks or months. We can see this in the market tops in 2000 and 2007. This may be occurring now. Many of the market commentary I follows the approximate theme of ‘markets likely to test the 200-day moving average’. This is the level the February decline found support. This would be about 7% below current prices, and have the makings of a completed correction, finding support once and then retesting.
Since the market highs in late January the major stock indices fell 12%, then gained 6-10% depending on the index. Since that bottom and top; markets moved down about 4.5%, then again up into yesterday (3/13/2018) gaining 4% to 7%. Tech shares and small caps have outperformed large cap along the way, rising more, but falling the same during this series. Recognizing the size of these moves and the time frame can help manage one’s risk and exposure without getting overly concerned with a 2-3% move in prices. But if one is not aware of how the 3% moves are part of the larger moves, one might wait through a series of small declines and find themselves uncomfortable just as a decline is ending—contemplating selling at lower prices as opposed to looking to buy at lower prices. Hedging is a process to dampen the markets impact on a portfolio in the short term while looking for larger longer-term trend turning points. The high in January and current decline and bounce are likely a turning point over the longer term and in the near term provide investors with parameters to determine if the bull trend is still intact.