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True, some of the largest single-day stock market gains come during bear markets. December 26th, 2018 marks the first time the Dow Jones industrial average gain 1,000 point in a single session. Experienced stock market investors know, one big up day does not mark the end of a downtrend.
Investors should also note, Wednesday’s advance was the first day of a rally attempt. If stocks can stage another meaningful advance in the next 7 trading days, preferably on day 4 through 7, the worst of the selling may be behind us. Rally attempts followed by follow-through days are no guarantee, but they often signal the start of a new uptrend.
There were other signs of optimism in Wednesday’s big advance. Stocks from retails, software, internet and consumer spending led the market’s upside. Growth stocks are preferred over mature, defensive sectors when leading the market out of its first bear-market correction in seven years.
The ratio of advancing stocks to declining stocks delivered wide breadth, another positive. Nasdaq winners outpaced losers nearly 4-to-1. On the NYSE, winners led by 5-to-1.
Also of note, there is a tiny but growing group of quality growth companies forming attractive chart patterns. These companies feature strong fundamentals, especially in terms of sales and earnings growth. Often, they are smaller, younger companies introducing new products and services. It is one of the more encouraging signs given the renaissance of innovation and entrepreneurship underway, something we have not experienced to this degree since the 90’s.
If stocks can hold levels this week and deliver a strong rally on any day next week, that would deliver a perfect follow-though day and improve the odds of a new rally as we enter 2019.
The investment environment continues to deteriorate despite the pickup in economic activity in the U.S. the last couple of years. As the Big Four Indicators I highlighted recently show, the U.S. economy continues to move in the right direction.
Despite the U.S. economy doing well, international economies are performing poorly with few catalysts outside of fiscal or monetary policy to drive them higher. Europe is in disarray and in a speech yesterday, China’s Premier Xi, signaled little trade flexibility.
In terms of Monetary Policy (central banks), we are in uncharted territory. On the one hand, market intervention potentially provides a mechanism to avoid financial contagion. On the other hand, it has added a lot of debt to the global economy and relies on globalization to keep the party going. The US and Europe are looking to reduce their exposure to globalization trends.
In terms of Fiscal Policy (government revenue/spending), deficit spending is projected for many years which is a concern after a 9-year economic recovery.
Constant increases in government debt, whether through monetary or fiscal policy, are likely to be a fixture of the 21st century economy. Investors should expect more market intervention going forward. My job is to manage the effects it has on investments and purchasing power. Right now, it is looking like global markets are bracing for another round of asset deflation.
The biggest telltale sign of concern about the potential for further asset deflation is not coming from stocks, it is coming from bonds. With the Fed now selling $50 billion dollars’ worth of bonds every month through Quantitative Tightening (the opposite of QE), analysts expected yields to go up and bond prices to fall. That is not happening. Money is moving to the safety of the 10-year Treasury bond. Money flows to 10-year Treasuries when it is concerned about asset deflation. 10-year Treasury bonds are again yielding less than 3%! Yields on the 10-year would be moving higher, and prices lower, if the bond market was expecting economic growth to continue.
Markets are signaling a high likelihood of ongoing asset price weakness. With each passing day more assets are breaking-down through price support levels. It is entirely possible all of 2017 gains will eventually be erased although stocks still hold on to most of them at this point.
For this reason, I believe it is a good time to be a bit more defensive and raise cash levels. Once the market settles down, available cash provides the ability to purchase growth investments at potentially lower prices. Even if you end up reinvesting at higher levels, that is a price worth paying if it provides peace of mind during a turbulent period in the global economy.
The Dshort website (part of Advisor Perspectives) hosts an incredible about of economic and market data. Periodically I feature some of their work, specifically The Big Four Indicators update. Taken together, these four indicators covering income, employment, retail sales and industrial production are thought to be an excellent monitor of the overall health and direction of the U.S. economy.
The recovery from the Great Recession has been slow but positive. The most encouraging development recently has been the strength coming from industrial production (purple line).
Let’s think about the future for a moment. After all, that is what the stock market is doing constantly. Up to this point in 2018, the stock market has had a very positive view of the future. Why wouldn’t it? Corporate sales and earnings growth have delivered in the strongest economy since 2008.
In addition to an economy that is strengthening, we are also experiencing an innovation renaissance. Quantum computing, space exploration, and organ replacement are just a few of the areas announcing major breakthroughs. If you spend any time following science and technology news, rarely a week passes without a new scientific announcement. Contrast that with the DotCom crash of 2000 where we were at the end of the personal computer revolution of the 1990. The future did not look very bright.
The most important market to watch right now, in terms of what the near-term future may hold for stocks, may be high-yield (junk) bonds. Many commentators point to the increase of debt by corporations as a major risk for the economy. So far it is holding up remarkably well which is not what you would expect if the economy was about to fall in to a recession.
At some point in the future we will see another credit event like the sub-prime debacle of 2008. That is the nature of a credit-based global economy and it will likely trigger a deep recession. Perhaps we are on the verge of such an event but the high-yield market does not seem to think so. It is holding up remarkably well considering how much corporate bond doom and gloom is being reported.
If there were serous concerns in the high-yield bond market you would expect a bigger sell-off, but instead high-yield bonds appear to have decoupled from stocks.
I shutter to think what the global economic environment would be like without the corporate tax, personal tax and regulatory reform recently implemented in the U.S. But I digress, that is the past. What is more important is will these policies allow the U.S. economic expansion to continue?
In its totality this selloff has the character of a grind down to lower valuations; not a panic selloff with no bottom in sight. I think the biggest surprise of this market could be the Dow, S&P 500 and Nasdaq reaching new all-time highs before we actually experience the next recession. There are many things that could go wrong but I continue to believe we are experiencing an adjustment in valuations that will allow this market to resume the bull market rally; not the beginning of the end of the this cycle’s expansion.
While high-yields bonds (HYG) have held up better than equities, there are signs of cracks forming.
Negative developments at GE have caused some to speculate more highly leveraged borrowers are looking at downgrades. The lower tiers of investment grade ratings currently represent a large number of bonds and if we see a series of downgrades pressure could mount on the corporate bond market, both investment grade and high-yield.
I am still viewing this entire episode as a cycle slowdown and not the end of the cycle. The Fed will likely put the break on interest rate hikes in 2019 if credit markets continue to rumble. The real estate market has already broadcast a slowdown and change in buyer behavior attributed to higher interest rates. Weakness in the corporate bond market has their attention. One aspect that may be overlook in the corporate market, however, is the impact of corporate tax reform on the ability of borrowers to service debt more effectively.
The U.S. economy is still doing well and there may be more to come if congress can get together on an infrastructure project. Trade talk with China remains a risk but so far the impact to the U.S. has been limited.
I have set another alert for the high-yield market. Should it trigger I will become more concerned about junk bonds rolling over which would likely represent a negative development for stocks.
After a swift and intense decline in October, U.S. stocks are trying to rally but face renewed selling pressure in November.
One of the current challenges is the performance of international stocks. The economic recovery and central bank policies of Europe, Japan and China continue to lag results in the U.S. This divergence has created a significant valuation gap and instead of international stocks catching-up to the U.S., investors may be looking to revalue U.S. stocks lower.
Here is a look at the Price to Earning (P/E) and Price to Book (P/B) ratios of international (EFA) and emerging market (EEM) stocks compared to the S&P 500 (IVV).
IVV P/E 23.29, P/B 3.33 (U.S. Stocks)
EFA P/E 13.87, P/B 1.59 (Developed Country Stocks)
EEM P/E 11.94, P/B 1.52 (Emerging Market Stocks)
State Street, BlackRock, Dightman Capital as of 11/12/18
As the data above shows, U.S. stocks are trading at a premium to the rest of the world. The P/E ratios above are calculated using 12-month trailing earnings. If 12-month forward earnings estimates were used the P/E ratio for US stocks would be significantly lower. Strong earnings growth projection for U.S. stocks explains why there is such a large difference between trialing and forward P/E calculations.
The risk to U.S. markets is a reduction in the P/E and P/B ratios through lower stock prices despite a healthy U.S. economy and corporate earnings environment. Stocks could trade down another 10-20% from current levels to narrow the gap but U.S. stocks should be able to maintain their independent valuation despite lower growth and valuations in other parts of the world. This would be based on continued sales and earnings growth. High growth environments are often reward with premium valuations. In terms of opportunities in international stocks, eventually they may represent an attractive investment opportunity but as a group they appears to have more economic work to complete before they can stage a strong recovery.
Interestingly, leading growth stocks have held-up pretty well during the selling this past week with the number of stocks reaching new highs for the NASDAQ well above lows back in October.
It will be important for the New Highs-New Lows index to move back into positive territory. The performance of leading stocks is an important sign of when to potentially take defensive action. If high-growth stocks are holding up in a market correction, the likelihood of a bear market is lower.
End of This Cycle
Some commentators are suggesting we are at the end of this cycle. However, they may be failing to recognize that in this cycle we spent the first 8 years in repair mode and only recently began a phase of strong economic growth.
Weak Credit Markets
Another clue to the health of the overall environment can be found in credit markets. Some commentators have suggested the flat yield curve is a sure sign of a pending recession. What they may fail to realize is this is a common occurrence for years leading up to a recession as short-term rates move higher while long-term rates remain somewhat anchored due to a deflationary trend cause by globalization. We are only one-year into a rate rising process and remain at very low rates. Some rate sensitivity has been reported which may help The Fed pause at some point in 2019.
High-yield bonds are holding up well which is something we would not expect if we were moving towards a change in the market cycle.
The stock market had a strong day on November 7th and some observers believe there is a reasonable chance of an infrastructure bill passing which should be well received by the market.
In terms of the international trade, progress has been accomplished. However, China and the U.S. have very different approaches, definitions and attitudes on the subject which could mute economic growth next year if an agreement is not reached.
There are always risks and “what if” considerations when monitoring market cycles. On balance I believe we are still in an expansionary phase economically which could last longer than many people anticipate. There are risks and conditions could change quickly but in total I believe the current selling is corrective in nature, and even if we see additional declines, I believe stocks will resume the current uptrend.
How Stocks Fared Following Midterm Elections
Bob Carey, from First Trust Advisors, provides the following chart on stock market returns for the calendar year following midterm elections.
Back on October 15th in market commentary I wrote, “A scenario is developing which could push stocks further into the red in the coming days and weeks…”
On October 20th I wrote, “I do not expect the current situation to resolve itself quickly.”
To be fair, the stock market could have moved higher from each of those dates, but it hasn’t, the selloff has intensified. There is one primary reason I felt it could get worse before it gets better. This is a mature market. I don’t believe the I bull market is over. I do believe, for it to continue advancing, values need to be reset and that is what is happening.
Those investors with more than a few years of investment experience know that periodically we enter into corrections and occasionally bear markets. The difference between a correction and a bear market has to do with the degree of the decline. Bear market also usually last much longer.
The primary culprit of the current sell-off is interest rate related. The good news is that a statement by the Fed that they are going to review future rate hikes and reconsider their plans could stabilized the market. This is likely to happen if the situation deteriorates any further. A credit/consumption-based economy is very sensitive to interest rates. Like a ballast, interest rates have the potential to tip the stock market if they rise to far too fast. Several real estate reports have recently indicated a slow-down in activity being attributed to higher interest rates.
Corrections are a necessary part of investing. They allow the market to reassess value. Higher interest rates require future cash flows for stocks to be discounted at a higher rate causing them to be worth less. Once the market has revalued stock prices based on higher interest rates the bull market underway should continue. A pause in rate hikes could make this process smoother.
It is possible we could see the situation deteriorate further. If it does investors are best served to hold tight. Often the market overreacts in this type of situation but eventually sprints higher. You don’t want to be out of the market when that happens.
Of course, investments in money markets, bonds and gold can provide some refuge during difficult stock market conditions.
Immediately at the open this morning I had two alerts trigger. One alert was for stock based investment that was under selling pressure. The volume of shares traded immediately at the open was much larger than normal. Overall, the price was down around 2%; firmly below the 200dma (black line). As I suggested in recent commentary related to the current selloff, the additional selling I thought had a good chance of materializing has arrived.
The other alert I received this morning was related to gold. The ETF GLD gapped up at the open and looks poised to continue climbing. This is the type of action you look for from gold in a portfolio. According to ETFReplay.com, the ETF GLD has a correlation to the S&P 500 ETF SPY of +0.08, which is only slightly positive. Correlations have a tendency to change and right now gold appears to be delivering a negative correlation, which is what you what to see during a stock market selloff.