Did I just yawn? It felt like I did. It could be that a new set of physical challenges has come with my 50th birthday this year. A mere hour and a half of tennis now demands at least a full day of recovery time. Just one beer leaves me feeling rusty the next morning. So, I guess it’s not out of the ordinary for some form of fatigue to show. But it’s really not fatigue. Deep down I know what the yawn is about—just a feeling. A physical reaction to my state of mind about our current situation in financial markets.
Maybe this shouldn’t be the case. Have I not been paying attention to the recent bout of market volatility? Over the past 22 months alone we’ve experienced five downturns of 6%+. What’s more, two of these were technical corrections—one of 11% and one of 19.7%. The -19.7% drubbing left us dangerously close—3/10ths of 1% close—to a bear market. You can get a sense of the volatility in the chart below that shows the S&P 500’s daily movement over the past last 22 months. Lots of squiggly lines do indicate a sign of instability.
But even given the volatility, the S&P is amazingly flat—literally up only 0.5%—over the past 22 months (international stocks, btw, have fared much worse as they’re down 12-20% over the same time frame). The fact that we’re basically back where we started explains at least part of my complacency.
At the same time, the risks to market have never been so apparent. Ironically, these risks are creating an unprecedented amount of uncertainty about the stock markets next move—either higher or lower. Think about it. During the late 1990’s there was only certainty. Investors were confident that pets.com would reach a market capitalization level higher than that of Disney’s. 2006 housing prices were supposed to reach the moon. We know now that investor certainty during these periods acted only to inflate huge asset bubbles that would eventually burst in dramatic fashion.
This is not the case today. Investors are suspicious as they should be. It’s been 10 years since our last recession. This is not normal as recessions typically come in half that time. But they’re also emotional. Reacting to every risk—perceived and real—in dramatic fashion. Sure, impeachment is a risk. Trade tariffs are real. Recessions do occur and will happen again. Earnings are at stake. Risks have always been a big part of our economy and are now amplified given the length of the economic cycle as well as the global tumult.
The intent of this update, then, is twofold: first, to focus your attention on the risks that matter. Second, to make you, too, ‘yawn’ not out of boredom, but as a way to maintain an emotionless perspective in the face of increased market uncertainty.
Impeachment Risk (this section adapted from an Eddy Elfenbein article on 9/27/19)
There are only a couple of market data points when we talk impeachment. President Clinton was impeached by the House in December 1998. The trial began in January, and Clinton was acquitted on all counts on February 1999.
It’s a slightly complicated story because Russia defaulted in August 1998, and that led to the collapse of the hedge fund Long Term Capital Management in September. A spooked stock market collapsed to a low on October 9, 1998.
After that, the stock market rallied (with tech stocks rallying especially hard) right through the impeachment proceedings. Through it all, impeachment had little impact on stocks. If investors were worried, you wouldn’t know it by looking at a price chart.
Richard Nixon’s impeachment process began in October 1973. This case was more serious, but the facts are muddied by a world that was an absolute mess at the time. Impactful events like the 1973-74 OPEC oil embargo, the 1973 Yom Kippur War, a potential nuclear war with the Soviet Union and the resurgence of inflation were all happening simultaneously. On top of that, the U.S. officially entered a recession in December 1973.
Runaway inflation coupled with a recession were more than enough reasons for markets to crater, but there may also have been a concern that Nixon couldn’t respond to any crisis given his predicament. That can’t be determined. But we do know that the bear market of 1973-74 was one of the worst on record. Investors hadn’t experienced anything like it since the Depression.
Nixon’s resignation in August 1974 was probably a buy signal, even though the Dow didn’t bottom until a few months later. The trough of the market had the Dow closing at 577 which was its lowest point in the last 55 years (1964 to present). However, Watergate’s impact on the stocks market must be seen in the light of the many events that were occurring—all at the same time.
In comparison, although it might be difficult to believe, today’s world affairs are much calmer relative to the Nixon era. Historical precedent should mean that impeachment noise from Washington won’t directly impact markets to any lasting degree. The sole exception, in my mind, would be that these proceedings will provide China with additional motivation to prolong the trade war.
I wrote this in 2018: “I find it almost impossible to game the outcome of the trade war. What I do think is that the market is negatively correlated to successful U.S. negotiations. This, in my view, is true because it’s well documented that the administration looks upon the Dow Jones as a metric of approval. With each tick lower in the Dow I feel that it places the U.S. more squarely over the barrel. We have presidential elections, the Chinese don’t. Therefore, the Chinese might have greater incentive to wait it out, which would act as a continued cloud over the market.”
Most of this holds true today. I would add that impeachment—or even its proceedings—provides an increased incentive for the Chinese to hold out on trade deal negotiations. Further, I am now convinced that the goals of the trade war make it impossible to win; the cost of which have not been felt now, but will be a burden at some point.
Trade War Goals
It is easy to forget that the trade war was initially about making China’s markets fairer for US businesses — ending favoritism for domestic companies, forced technology transfers, and intellectual-property theft. So, basically, a successful trade negotiation based on these goals would allow U.S. companies to more easily set up production within China.
But it seems as if those goals have morphed into Trump’s obsession with trade deficits —with forcing China to buy more US stuff. These are conflicting goals. One is based on capitalism—free your market up so that our companies can compete in your market, a message that is clear and achievable with even the slightest of accommodation by the Chinese. The other is based on populist nationalism—distort the Chinese economy by explicitly forcing it to buy goods from one place rather than another.
Getting a deal done will be difficult enough given that the Chinese have time on their side and impeachment rumblings are only increasing their leverage. A deal is further jeopardized by the U.S. administration’s competing goals. Thus, it’s my bet that the trade deal continues to hang over the market, ultimately limiting upside regardless of whether the costs are real or just perceived.
Trade War Costs
Tariffs act as a tax. The immediate impact of a tax is higher prices (inflationary), which will ultimately reduce production & consumption (deflationary). It’d be difficult to find an economist to support the notion that this type of tax is beneficial for domestic and global growth. This makes it understandable as to why daily trade war headlines continue to toss markets around. But, other than the headline risk, where are we actually feeling trade war costs? It would make sense to me to examine the current state of two important areas of our economy: manufacturers and consumers.
U.S. manufacturers are undoubtedly feeling the pressure. The ISM Manufacturing Index has been deteriorating over the past 12 months and the reading recently broke below 50. At this level it is a sign of contraction in manufacturing.
The consumer, however is still as strong as ever. During the 2nd quarter of 2019 the consumer literally carried the U.S. economy. While business and residential investment, net exports and inventories all declined, real personal consumption expenditures rose at a 4.7% annual rate, the largest increase in 4 1/2 years.
It’s of the utmost importance to put these facts into perspective. The U.S. economy was much more manufacturing based decades ago. Today, however, 70% of the economy is consumer-based. Manufacturing fits within the 18% of ‘Business Investment’ seen in the chart below. It approximates 2/3rd or 12% of overall GDP. Thus, manufacturing has much less importance to the U.S. economy than the consumer.
The trade war is costing the consumer, there’s no doubt about it. Neil Irwin of the NY Times recently estimated that trade tariffs will cost each American family at least $60 per year. That cost, according to Irwin, can reach up to $270 per year in the worst case depending on the amount of tariffs levied on Chinese imports.
But what is clear is that the consumer isn’t slowing down. The reasons can be several–low unemployment, higher wages, increased consumer debt, a wealth effect caused by rising stock markets and real estate assets, overall confidence, etc. But what is indisputable, even as trade war cost projections and daily headlines paint a grim picture, is that hard data shows that the consumer is sustaining GDP growth and adding to company earnings (a topic that we’ll visit later).
Why the wild gyrations in the stock market at even the whiff of trade deal news, then? In part this is an overreaction based on some trained emotional response to this topic. Yes, it’s true that debt is a large component that has propelled the consumer. This won’t go on forever. Additionally, consumer sentiment can act to change consumer spending behavior. But when? Dire predictions had the consumer as dead many, many months ago. So, rather than emotional reactions to the trade war news du jour, I favor a pragmatic approach that fixates on consumer behavior (hard spending data) and consumer sentiment. The ‘bond king’ can provide us with a playbook on how investors should treat consumer sentiment.
Jeffrey Gundlach—the ‘bond king’—in a recent interview on what to watch
“What happens before recession every time in a very convincing pattern is that first consumers start to feel bad about the future. They say ‘the future looks worse than how I feel about the present.’ And that started a while ago now, where the view of the future was much grimmer than the view of today.”
“That puts you on kind of a notice, just like the yield curve inverting, that maybe you’re supposed to be on recession watch. But then what happens is that the consumer continues to be pessimistic about the future, but then their attitudes about the present start to deteriorate,” said Gundlach.
Right now, confidence–about the present–remains solid, which has supported actual consumer spending growth and the economy as a whole. This is what we should be watching. Is the manufacturing index deterioration important? Of course. But it’s real significance will be realized when it both creates pessimism in consumer sentiment readings about the present and shows up in hard data consumer expenditure numbers. Gundlach has put us on notice that this is forthcoming, now it’s our duty to watch the data and react accordingly.
Inverted Yield Curve
The media is throwing people into a frenzy with talk of inversions. Not necessarily ‘fake news’, but just ‘misinterpreted news’ (a phrase that doesn’t quite have the same ring to it). So, let’s define some of these terms. What is the yield curve? It’s the difference between the yields on longer-term and shorter-term Treasuries. A yield curve inversion happens when long-term yields fall below short-term yields. It has historically been viewed as a reliable indicator of upcoming recessions.
Why? The short-term side of the yield curve is an artificial rate, driven mainly by the Federal Reserve. The long-term end of the yield curve—10-year Treasuries and further out—is thought of much more as a market rate indicating bond investors’ long-term views of growth.
Recessions occur when future growth slows. The chart below shows the 10-year minus 2-year Treasury yield. As you can see, it went negative a couple of weeks ago—albeit only for an instant. In essence, investors heralded a recession warning by stating that their disbelief that current interest rates would increase the years to come. Scary stuff, for sure. But while a yield curve inversion has preceded recessions, it doesn’t happen immediately, and the lead time has been very inconsistent. Historically, a recession can come anywhere from one to two years after the curve flips upside-down, and the stock market usually continues to gain—at times it has tallied runaway gains— from the day of the inversion until its cycle peak.
So, once again, investors need to take a deep breath. Yes, inversions are definitely not a good sign, but they remain just that—a sign.
This idea of an “earnings recession” is a false narrative that’s been perpetuated for at least the last year. I must admit, I’m not even really sure what it means as market pundits tend to use the term interchangeably. Some define it as two consecutive quarters of earnings decline while others interpret it as a general dearth in earnings. In either case, the headlines for earnings are markedly worse than the actual data suggests. In fact, the data says that these pronouncements are flat out wrong.
I created the above chart using S&P earnings data and you can see by the upward sloping red line that earnings have increased each quarter from December 2017 to the present. Forecasted earnings are following this same upward growth trend, making this something of a ‘beautiful chart’.
Undoubtedly, there is weakening and risks certainly are rising, but conditions remain basically positive at this point. When you factor in that actual earnings growth usually comes in above expectations, the picture looks even less worrisome. We will see an economic recession as well as some sort of ‘earnings recession’ in the future as growth could fall out of bed at any point—but it’s not apparent in the numbers just yet.
I would be remiss if I didn’t mention another relevant data point that we can glean from the above chart in regards to the markets valuation. You’ll notice that the P/E ratio (blue bars that correspond to the level on the left vertical axis) have been slightly decreasing since December 2017. This is due to steadily rising earnings in face of a stock market that, as we have already established, has achieved zero growth over the past two years. So, the stock market has actually become cheaper—a state that we will always welcome.
Putting a bow on all of this
We’re late in this economic cycle. From an investment perspective this means that there’s no reason to add to stock exposure even after wild drops in stock prices. At the same time, investors should discount some of the chatter on impeachment, the trade war and other false narratives. Overreaction to each headline will cause trigger happy investors to be whipsawed.
A little bit more defensive positioning is in order given the length of this cycle plus the added uncertainty. At the same time, we should closely watch those indicators that matter the most—consumer sentiment about present conditions, consumer spend, & earnings. We’ve been put on notice that a recession is around the corner and these indicators will help warn of its arrival. Having said this, a recession won’t be the end of the world. Just a natural recurring experience that will re-set the level of stocks in time for the beginning of the next cycle.
In the next update I’ll review some other causes that may lead to recession. In the meantime, feel free to write, e-mail or call me with any questions, comments or concerns.