Jan 22 2019
Is Recent Stock Market Strength a Sign of Safety…or Danger?
Since early October there has been a “bear market” in stocks, both here and abroad. Though some indexes declined approximately 20% from their highest point, most stocks were down much more until just recently. In the past few weeks, stock indexes have rallied about 10% providing some relief for investors, but far from the peak reached in late September.
This is a good time to explore if the recent strength in indexes is the beginning of a better stock market or just a short-term advance leading to further trouble ahead. As you know we have kept your portfolio defensive during this period, with less stock exposure and less volatile stocks. Though this is effective during market declines, it can be a bit trying in the face of the recent market strength.
How can we determine if there is further downside ahead or if the recent rally is the beginning of a real recovery? Let’s review the data points that were the cause of the tough market. In my view, we need these data points to stop trending downward or to become more clarified, before we take a more “risk on” growth posture.
The economy and stock market are co-dependent. The first sign of economic weakness at the end of the third quarter is what sent stock prices into the downward trajectory. Since that time most leading economic indicators continue to be in a downtrend. Investors need global economic growth to stabilize stock prices to stage a meaningful long-term recovery. If economic growth can stabilize – albeit at a lower rate – stocks could still do very well and better than most investment alternatives. However, we need to see clearer signs of stability on this front.
Corporate Profit Growth
Economic growth is directly tied to the profitability of companies both here and abroad. We are now at the beginning of earnings season and need to see companies meeting or exceeding the lowered expectations that analysts have adjusted downward since the fourth quarter. Some of the most recent warnings and reports have not been positive, including Apple, JP Morgan, Macy’s and Ford – all of which have been negative.
However, the earnings season has just begun and we have some big bellwether companies reporting over the next few weeks including domestic heavyweights Boeing and Caterpillar. These upcoming reports should shed further light on the sustainability of the market’s recent advance.
Lastly, when it comes to earnings reports, it is very important that investors realize that these reports are about what happened last quarter and are not a precursor to what may happen going forward. This is why we also want to consider the following three policy challenges. These policy issues need to be better clarified before markets can be on more sound footing.
Federal Reserve (Fed) Policy
The Fed has raised rates nine times over the past two years in an effort to prevent the economy’s growth (inflation) from accelerating too quickly. As we have written before, this effort comes with the risk that the Fed can mistakenly “overshoot” their estimate of interest rate increases versus growth and turn an otherwise sound economy into a recession.
This concern is real and is one of the reasons investors have been selling shares. Fortunately, the Fed has recently backed away from being so adamant about further rate hikes. In the short run, this has soothed investor’s fears. However, I would like to see further clarity in the Fed’s message and a willingness to reverse course if necessary. The next Fed meeting at the end of this month may provide this.
Global Trade Policy
Tariffs and other impediments to trade with China and other global trading partners are a negative for global and domestic growth. On this front “no news is bad news.” Economic data from China is slowing and they remain an important trading partner for the US and global economy. A trade deal that turns out to be better than earlier perceived would go a long way to alleviate investor fear and support both economic growth and global corporate profitability. We will be watching these negotiations carefully.
Government Shut Down
Though short-term government closures have been stock market nonevents in the past, we are now in uncharted waters. Previous government shutdowns have been measured in days while this one is now more than a month old. This has a negative effect on a number of sectors of the US economy and some of our country’s largest corporations. Investors would be wise to consider the shut down as a further risk to stock prices. As with the other policy challenges, any sign of improvement or positive outcome to this standoff would be supportive of a better stock market environment.
Clearly, there is no shortage of bad news and challenges on the domestic and global front – for the sake of brevity, we left Brexit and US debt levels out of the discussion. At times the stock market “discounts” all of the bad news by lowering the price of shares. We are not sure that the stock market has fully priced in some of these current risks, particularly given the more recent elevated level of share prices. However, if it turns out that the recent strength is the beginning of the recovery – coupled with some clarity on the issues described above – a re-test or normal correction from these levels would be expected, allowing us an opportunity to invest at more attractive prices in the very near future.
Keep in mind that bear markets often demonstrate periods of short term strength which are followed by declines back to the old lows or even lower. This was the case with the market rally in November that resulted in a further 10% decline in indexes. If this recent strength is just another temporary rally in the bear market – given that all major indexes still remain in long-term downtrends – I want to make sure your assets are safe. In that spirit, I continue with my recent, ongoing mantra of “better to be safe than sorry” when it comes to the bulk of your liquid net worth. Keep in mind that historically bear markets last just 6-8 months and this one is already entering its fourth month. Over the next few weeks and months I will be continuing to monitor the data points and view any pullback in stock prices as a possible re-entry point, but one that will need to be validated by better fundamentals.
I am excited about the prospect of re-investing in a significant global stock market recovery.
Jan 02 2019
2018 can best be described by Charles Dickens who wrote, “It was the best of times, it was the worst of times.”
Within the backdrop of strong economic data and corporate profitability, global equity markets advanced well into September, only to give back all of the gain – and then some – ending the year with all major indexes in the red.
The media quantifies a bear market as a decline of 20% or more, and most major indexes have either surpassed that threshold or are within striking distance. For all intents and purposes, I would classify this as a bear market. The question investors should be most concerned with is: is it a gentle bear market or a more aggressive grizzly? Let’s take a look at some data points.
As I mentioned in my last Strategy Update, the market is approaching a fork in the road and the direction it takes will be dependent on economic data. The road to the left (gentle bear) goes in a direction where we find that most of the decline in stock prices is behind us.
This road will be full of signposts that argue the global economy will continue to grow, albeit rather slowly, and avoid a recession. These economic data points released in the coming weeks will allow me to get some verification. One of the mile markers will be stronger than expected earnings. Earnings season starts this week, so I will be paying close attention to these reports.
Finally, a more constructive stock market environment requires significant policy expertise. This relates to a more accommodative Federal Reserve, progress in tariff negotiations and lastly, but not least important, getting our government turned back “on.”
From my perspective, the data points on earnings and the economy are easy to judge. However, I think the market’s biggest problem is the unknown of potential policy missteps. I am hopeful economic and earnings data are supportive and that policy makers can successfully navigate these issues. If some or none of these data points yield positive results, we are more than likely going to be traveling down the other, much less forgiving, fork in the road (grizzly bear).
In the absence of supportive economic data and/or policy success, I believe that global stocks could easily decline further. If one considers that the average bear market decline is approximately 38%, it is easy to see how much worse this could get for investors. Down this road are signposts that earnings are worse than expected and the economy is teetering on recession.
That alone could be enough to send stocks down another leg, but combined with a policy error could really solidify the grizzly bear case. Though bear markets can be difficult, keep in mind that they are not long affairs – usually just 6-9 months – which means we may be a good way through this one. The best thing about a bear market is that when they end there are tremendous bargains to take advantage of if investors have the cash and capital to do so.
It is impossible to know which fork in the road the market will take. Anyone who says they know for sure would be mistaken. To quote Jack Bogle, the veteran Vanguard CEO, this week in Barron’s magazine, “This is no time to take significant risk and if anything investors should reduce risk at these levels.”
I strongly agree with Mr. Bogle.
If at the present time the bulk of your assets are in fixed income, they will be generating better than money market return. I do not see this as a long term investment strategy, but a very good safe harbor until we get better clarity on the issues ahead of us.
In your taxable account, you may have taken some significant capital gains from selling some of your big stock winners in recent years. These sales on balance were timely as many stocks are much lower today and now your portfolio is more defensive. However, with the gains come capital gains taxes. Keep in mind my thoughts that it is better to pay thousands in taxes, than to lose millions in market value. Your tax liability will be about one-third of the total realized capital gains, which for most amounts to about 2-3% of their total portfolio value – a small price to pay for portfolio protection.
I wish you and your families a very Happy New Year!
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