Looking back over the last six months, with perfect 20/20 hindsight, we can now see that the 4th quarter mini bear market was effectively a technical decline based largely on fear. But as of today, the fear is gone, prices have returned to their pre-crisis position and the whole episode appears to be in the rear-view mirror. Now that the brief cycle of action and reaction has been given a little exercise, investors will turn back to the longer-term drivers of price. With the new quarter, market direction and general price action will highly depend on earnings, fundamentals and trends in global economies.The burden is now on the bulls as we enter the “Show Me” market.
Markets are by nature speculative. They are simply a basket of expectations based on future earnings, dividends and interest payments. As investors, we speculate that a stock or a bond or any security will be worth more or pay us something in the future otherwise, we wouldn’t own it. That is logical and time-tested investor theory. Along those lines, the period we just completed which included a 19{1de7caaf0b891e8de3ff5bef940389bb3ad66cfa642e6e11bdb96925e6e15654} loss and full recovery in six short months, was also speculative. Last fall investors speculated that the wheels were coming off on many fronts (The Fed, trade wars, political chaos, China melt down, Brexit) and they decided that the future “value” of stocks was not attractive.Prices fell. Then in December, the Fed recognized global and domestic economic weakness for what it was and took their foot off the rate accelerator.That’s all they did, and no, they did nothing wrong or different than any other Fed in history who recognize that rate hikes are no longer warranted given changing economic conditions. Investors suddenly recognized a rich oversold condition in the markets as we did (“Calling All Cars” on December 26th) and put money back to work. But I will tell you a few things about the psychology of those investors who bought aggressively in December and January, counting ourselves among them. None are in it for the long term. Far less money was deployed in buying back than was sold in the fall. And finally, investments were made for one purpose and that was to make a quick buck on an easy trade and high probability to rebound back to today’s price level.
So that happened.
So, what’s next?
Now that the fear and greed cycle has played out completely, stock price action will now turn to actual financial and economic evidence for direction. The evidence will need to “Show Me” that prices should continue higher or even remain where they are. That evidence begins in two short weeks with the new earnings season and a full slate of economic data.
For prices to move sustainably and substantially higher from here, we’ll need to see the following:
- Strong earnings from US cyclical sector stocks
- Stability in non-US global economies which includes a bit of calm from France and the UK, some direction on Brexit, and better news from China. I’d like to see the Canadian housing market stop falling at a rate of 15{1de7caaf0b891e8de3ff5bef940389bb3ad66cfa642e6e11bdb96925e6e15654} year over year (what? You didn’t hear?). I like to see Emerging markets show good numbers and some new price highs.
- Credit market expansion. High yield corporate bonds will begin climbing their massive mult-year “maturity wall” that Sean spoke of recently. Will credit handle it well and continue higher or buckle as bond repayments become DUE!
- Trade negotiations with China need to find a deal – Trump has already pushed out any talks again to June.
If all or most of this can happen in the coming months, there is the potential for us to see the S&P 500 push all the way up to 3000 as it already trades at full value today at 2840. A move to 3000 is about 5.6{1de7caaf0b891e8de3ff5bef940389bb3ad66cfa642e6e11bdb96925e6e15654} higher and would mark an all-time new high for the index (marginally).
However, the market will also be evaluating and watching the increasing evidence associated with recession risk as we receive new economic data. These are as follows:
- The shape of the yield curve which remains inverted on the short end but still ok on the long end.
- Continuing increases in Jobless Claims that indicates we may be pulling away from full employment and angling toward higher unemployment.
- Increases in wages that cannot be passed onto consumers which pinches profit margins and earnings. Earnings growth for the S&P 500 peaked in the 2nd quarter of 2018.
- Stability in the Citi Economic Surprise Index for global economies. This index effectively measures a weighted pool of economic data and aggregates their trends as up or down into a single line. Pretty neato index but the chart doesn’t look so great (Bespoke.com).
If these “trends” toward some form of recession or even a continuation of the global slowdown persist in the months ahead, we would expect to see the S&P 500 trading down closer to 2500 by year end. On a percentage basis, that’s roughly -13{1de7caaf0b891e8de3ff5bef940389bb3ad66cfa642e6e11bdb96925e6e15654} downside from where we are today.
Classically, after a near vertical run higher from the lows in December in the last 90 days, investors are just now starting to feel that anxiety of wanting to be more aggressive, to add more risk exposure, to reach for returns. With an upside of maybe 5{1de7caaf0b891e8de3ff5bef940389bb3ad66cfa642e6e11bdb96925e6e15654} and a downside of -13{1de7caaf0b891e8de3ff5bef940389bb3ad66cfa642e6e11bdb96925e6e15654} or more, the risk to reward ratio isn’t great.
Things that do look GREAT
To finish on an optimistic note, there are things that we like with much better opportunity than any broad US stock market index. We like Europe and Emerging markets still. The former has been lagging the world in various rounds of price decay for almost four years and may be pulling out of that slump. Emerging markets are still way too heavy in debt, but they do represent the last area of real growth in the world today (unlike most developed markets). Small caps have pulled back to a compelling buy spot, we bought some last week. Commodities have recovered from their fall wipe out and appear to be establishing a new uptrend, but here again, they are highly dependent on a non-recessionary outcome (TBD). Finally, we like bonds of all sorts outside of corporate credit mentioned above. The odds of a rate cut in 2019 are now accelerating as evidence of a pending recession continues to unfold. A dovish Fed and a weak economy are the perfect tailwinds for bond investors. Our income strategies are now annualizing over 8{1de7caaf0b891e8de3ff5bef940389bb3ad66cfa642e6e11bdb96925e6e15654} net of fees since becoming fully invested back in late November (white vertical line on the chart). All time new highs are happening in these strategies every week and each month. Pictured below is our Freeway High Income strategy over the last three years net of all fees. This is an illustration alone based on our internal tracking accounts. Please see our composite performance disclosure document.
Investors should be engaged with this market but selectively.Thankfully, there are a lot of options to choose from. Starting next week, the “Show Me” market will begin. Wise investors will watch market action closely as new information is revealed.Next week, we plan to roll out a strategy by strategy quarterly update provided by Sean Powers and myself for those looking for a little insight. In May, we’ll follow up with our next Solution Series workshop diving deeper into TWO BRAND NEW INVESTMENT STRATEGIES and how others are evolving to adapt to structural changes in the financial markets. You won’t want to miss these so please tune in.
That’s it for now.
Cheers,
Sam Jones
President – All Season Financial Advisors
