Bear markets, defined as stock market declines of more than 20 percent, are very confusing. They unfold very quickly, create tremendous volatility and do not have to make intellectual sense. Bear markets do not necessarily lead to a recession but are often precursors to one. Between September 21st and December 24th, the U.S. S&P 500 declined 20.5 percent but then rebounded 7 percent into early January (Figure 1). Europe, Japan and Emerging Markets are all well into bear market territory. Bear markets rarely correct overnight. They typically need to find a bottom first and then build a base and find reasons to recover.
In the past few months, we have systematically reduced client equity risk exposure to account for the increased volatility. We have moved to our core portfolios, composed of proven U.S. and international investments, and plan to ride out the volatility until further notice. There are too many major unknowns to be fully invested in equities.
Figure 1 – U.S. Equities Bounce from a 20 Percent Correction, Trend is Lower
By most conventional economic measures, U.S. stocks are currently cheap relative to the past few years and can justify being purchased.
- Corporate earnings are expected to grow by 5 to 7 percent in 2019, down from 20 percent in 2018, but still strong by most standards.
- U.S. Economic growth is expected to continue at 2.0 to 2.5 percent, down from 3 to 4 percent.
- The P/E multiple for the S&P 500 has contracted from 16.5x to 14.1x, low by many historic measures.
- The Federal Reserve is likely to reduce the trajectory of rate increases in 2019, becoming more reliant on current market data. The current Fed Funds Rate is 2.5 percent and could remain there all year.
- The U.S. consumer continues to increase spending, a result of near full-employment and lower energy prices.
- Inflation remains benign at 2.1 percent, although wage growth has increased to 3 percent.
Based upon recent economic performance and projected corporate earnings, U.S. equities look reasonably priced.
What Concerns the Bears
Why did the S&P 500 crash 20 percent from September 21st to December 24th? In my opinion, it was because of key changes in market perception. Investors moved from a mindset whereby “tax cuts will solve every problem,” to concern about global growth, trade wars, higher interest rates and the stability of the administration. Key concerns include:
- Market technicians turned bearish. After nine years of a bull market, a bear market is seen as long overdue. Key technical support levels for the bull market were breached and many chartists suggest that a 30 percent pullback from the Sept. 21 high is likely, with a DJI target of 18,800 or so.
- Global economic growth has slowed substantially, with trade wars appearing to be the primary cause. Trade wars have been started, but not finished, with both our allies and adversaries.
o Disputes with Europe and Japan over steel and cars were expected to be wrapped up prior to the election; they were not.
o Trade wars with China have escalated from a focus on trade deficits to difficult cultural disagreements.
- The stock market finally reacted to the gradual rise in interest rates and increased government borrowing.
o The Federal Reserve has increased the Fed Funds interest rate from 0.75 percent in 2017 to 2.5 percent in December 2018.
o The U.S. Treasury funding need exploded from $546 billion in 2017 to $1.3 trillion in 2018 and is projected to increase to $1.8 trillion in 2023. Increased Treasury borrowing raises the cost for corporate borrowers.
- Political disagreements have derailed the pro-business Republican agenda for the foreseeable future.
o The Democrats won the majority in the House of Representatives during the November 4th election, paving the way for challenges to Trump’s agenda.
o There is a perception of chaos in the White House as President Trump lost senior staff that did not agree with his policy views. Many believe that without a strong staff, President Trump can create problems but not solve them.
- The positive impact of tax cuts on the stock market appears to be ending much earlier than expected.
o The rate of change of earnings growth is slowing faster than expected.
o The wave of corporate stock buybacks, approaching $1 trillion in 2018, is likely to diminish in 2019 and beyond.
o Tax reductions, designed to repatriate corporate-held overseas funds, have been disappointing.
- Several leading U.S. industries faced substantial pressures, impacting their stock prices.
o Since October, oil prices collapsed from $75/barrel to $45/barrel due to worries of slowing global growth and overcapacity. Oil sector stocks and bonds were decimated.
o Several major global technology companies had their privacy policies challenged in Congress and around the world, with subsequent concerns about corrective legislation and declining product usage.
When combined, these issues changed the overall market perception from tax-cut induced “happy days” to a new reality of multiple market concerns affecting both specific industries and global economic growth.
Comparison of U.S., Europe and Emerging Market Charts
Below you will find five-year price charts for emerging markets, Europe and the U.S.
- The emerging markets chart shows a clear high on January 26th and, starting in June, an acceleration lower as the first 25 percent trade tariffs were announced. By the end of the year, emerging markets were down 26 percent from the high.
- The European chart shows a clear high on January 26th which accelerates lower in October due to Brexit concerns, populist party wins in Italian elections and trade war issues. By the end of the year, European markets were down 25 percent from the high.
- The chart of the U.S. S&P 500 Index (on page 1) also shows the January high but the markets recovered over the summer to make a new high on September 21. The Index then declined by 20.5 percent into December 24th but recovered 6 percent by year end.
Figure 2 – Emerging Markets have led lower and may be building a base
Figure 3 – European Markets Should Continue their Decline into Brexit
As an avid chart-watcher for more than 30 years, I have several observations:
- None of the chart patterns look completed to the downside. There is an old saying in stock trading: ”do not try to catch a falling knife”. Rallies in bear markets can be especially strong but often fade away over the next week or two. We have had several of these faded rallies since September. In most cases, a period of base building is needed before the market can move substantially higher.
- Bear markets do not necessarily lead to recessions. Bear markets without a recession are much milder, typically a 20 to 26 percent correction lasting 8 to 14 months. Bear markets with a recession (2002 and 2008) are very scary and typically decline by 38 percent to 42 percent and last 17 to 21 months. It is premature to determine which of these we are in.
- As global markets are generally interconnected, the U.S. appears to be trying to catch up to the declines of Europe and Emerging Markets. This is often related to strength or weakness in currency exchange rates.
- Economic facts have not yet caught up with the market action and charts. The business of Wall Street is to sell investments, not buy them back. The marketing machine is very powerful and convincing.
Investment Themes for 2019
The recent market action and charts are advising me to be cautious. Accordingly, I have reduced client equity exposure to below normal levels, in some cases approaching the lower range permitted in each client’s Investment Policy Statement.
Our exposure to fixed income has improved in quality as our largest positions are now in two- and three-year U.S. Treasury bonds and high-quality corporate debt. The size of the potential federal budget deficit and corporate refinancing needs necessitates keeping maturities short and waiting for higher interest rates.
Overall, I am hopeful that we are in a non-recessionary bear market which will dissipate over the next few months as trade wars ebb, borrowing costs stabilize and politicians agree on new solutions. I will be looking for opportunities to add to portfolios on significant market weakness.
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