Interesting, no?
Via Advisor Perspectives, November 30:
By the end of the summer I became convinced that the United States equity market was setting itself up for a powerful post mid-term election rally. The economic fundamentals were strong: unemployment was at a 40-year low and real growth was better than 3%; the Federal Reserve was raising rates, but that was only a noble attempt to creep back to normal levels for the later stages of a business cycle. The yield curve was likely to remain positive, inventories were not excessive and leading indicators were still rising....MORE
Offsetting these positives was market valuation. My model indicated equities were fully priced and sentiment indicators suggested that investors were dangerously optimistic, emboldened by the favorable fundamentals above. The Fed was shrinking its balance sheet and slowly draining the economy of liquidity, the lifeblood of rising equity markets. There were signs that the economy was decelerating. Earnings increases were slowing from a rate of 20% year-over-year in 2018 driven by the tax cut to an estimated 10% year-over-year in 2019. Two traditional drivers of growth, housing and capital spending, had yet to gather momentum, leaving the work of expanding the economy to the consumer and government spending. There were a number of aspects of the Trump administration’s policy agenda, like healthcare and immigration, that were unsettling to investors. In addition, the United States was in conflict with China over tariffs and trade policy.
There were also problems emanating from abroad. China, which had orchestrated a modest slowdown at the beginning of the year to try to reduce the non-performing loans on the books of its banks and shadow banks, had slowed down more than expected and, in response, policy makers had to cut taxes, depreciate the currency, step up fiscal spending and engage in monetary accommodation. European growth had been negatively impacted by Brexit. The rise of populism in Europe had weakened Angela Merkel’s leadership in Germany and boosted authoritarian rule in Eastern Europe. Military conflicts continued in Syria, Yemen and throughout the Middle East. These issues all have an indirect impact on the economic stability of the United States.
For these reasons I thought the equity market would have to go through a correction to improve valuation and sentiment. In October, the sharp decline in the market wiped out all of the gains in the indexes from the beginning of the year. Major investment advisors changed their view of the outlook from positive to negative. Sentiment moved into pessimistic territory. The S&P 500® is only selling at 15.6 times 2019 projected earnings. Conditions became favorable for the year-end rally I had been expecting.
Then the mid-term elections took place. There was nothing really surprising in the outcome. The Democrats seized control of the House of Representatives and the Republicans gained some seats in the Senate. The significance of the shift in Congress can be debated. I expect to see the President begin campaigning for a second term immediately. I also believe it will be hard to get major legislation enacted, but there may be some adjustments made in the tax code and the Affordable Care Act. Both sides recognize the need for improving our infrastructure, but little progress has been made on this front so far in spite of talk of a trillion-dollar program. With the annual budget deficit increasing from $800 billion to $1 trillion because of the tax cut and spending programs already in place, there might not be much enthusiasm among either party for expanding the deficit further.
One hope I have is that the Democratic majority in the House doesn’t waste its time on an impeachment effort or any kind of investigation of President Trump. It would further exacerbate the polarization that already exists in Congress and reduce the likelihood of cooperation on legislation where both sides have a common interest, like infrastructure. The Mueller investigation of Russian involvement in the 2016 presidential election is going to release some of its findings over the next month. I expect some members of the Trump inner circle will be embarrassed by what is revealed, but the President himself won’t be directly impacted. Mueller’s report will be dismissed as a “witch hunt” or “fake news” and only intensify Trump’s reelection efforts. It will have limited market implications. We now have new leadership in the Justice Department. Let’s hope the Mueller investigation is permitted to run its independent course toward completion.
After the uncertainty of elections was removed, markets briefly rallied before the inevitability of a tougher earnings environment in 2019 set in. It seems like the 27%+ year over year earnings gain reported this quarter is being completely discounted by markets as the tougher future comps are dragged into the spotlight. Perhaps companies won’t get any credit for their strong 2018 results because those numbers are viewed as the result of earlier tax cuts and stimulus, and hence “artificial.” But lower corporate tax rates will continue to have an impact beyond this year. In the second quarter of 2018 S&P 500® companies had a tax rate of approximately 19.6%, the lowest tax rate since 1993, with the exception of the fourth quarter of 2008 when GAAP earnings were negative, according to analysts at S&P Dow Jones Indices. Fourth quarter earnings, which won’t be reported until early 2019, should also show close to 20% earnings growth. Over the long term, earnings and interest rates drive stock prices, but day to day that message can get drowned out.
Clients keep asking, “What is the catalyst that will enable the bull market to resume?” They also wonder how the U.S. economy and its equity market can continue to do well when the rest of the world is slowing. Will the United States pull up other economies because of its growth or will they pull us down? The market seems to shift back and forth on this point.
The debate is whether the market requires a positive catalyst to resume moving higher or if the absence of any further negative catalysts will prove to be enough. In the darkest days of the Great Financial Crisis, when the economy was in a recession and financial firms failed, it was outsized acts of stimulus that arrested the market declines, eased investors’ psyches and placed a floor under global equities. Today there isn’t any major economy in the world in recession, and markets are nowhere near witnessing declining earnings. Even though earnings growth might get cut in half in 2019, earnings will still move higher.
The natural trajectory of the market should be higher given the combination of earnings growth with only moderately higher interest rates. If 2018 marks the end of the bull market and the earliest signs of a recession, that would mean a lot of fundamentally strong indicators are broken. Investors should consider these three: the yield curve, the Conference Board Leading Economic Index and Average Hourly Earnings. These indicators have among the strongest predictive power of any indicators we’ve ever tested, and all three say that no recession is in sight.
The traditional yield curve hasn’t produced a bad signal (i.e. inverting with no recession, or a recession without inverting) since the 1960s. The yield curve has inverted seven times since then, and seven recessions followed at an average of 17 months later. One might argue that the analysis is only based on seven data points, but we struggle to find a forecaster with a better track record.
The Leading Economic Index published by the Conference Board has a track record almost as good. Historically a recession follows about 22 months after the last peak in the LEI. Finding that peak can be somewhat subjective as it requires one to look back in time to plot the peak, but nevertheless the LEI has been falling at the onset of nearly every recession since the 1960s. There was only one case where the LEI was rising at a time of recession, and that was the second half of the double-dip recession of 1981–1982....
note: the above was written before the 2's/5's or 3's/5's or whatever the fashionable bit of the curve that makes the inversion case, inverted.
At the moment the curve doesn't matter, if and when we think it does, you can rest assured we'll go "curve, curve, curve" 24-7.
For now, as a commenter—I forget where—said: "I think the pundits just like saying 'inversion'".
Inversion. It's almost soothing, in a paradoxical kind of way.
Personally, I like paradoxical. More consonants.
