“Three o’clock is always too late or too early for anything you want to do.” Jean-Paul Sartre
“It is easier to find men who will volunteer to die, than to find those who are willing to endure pain with patience.” Julius Caesar
Current market conditions remind me of a scene from the 2000 Ridley Scott movie Gladiator, (https://www.youtube.com/watch?v=FI1ylg4GKv8) in which, the protagonist Maximus (Russel Crowe), a Roman army general turned gladiator, walks out of a wooden cage filled with other fighters, all paying their respects to him, while some so fearful that they can’t control their urine. After killing four opponents in one session, Maximus throws his sword at the spectators, filled with disgust of their enthusiasm towards violence, shouting his famous line “Are you entertained?”.
These days, anyone willing to go out of their wooden cage/comfort zone and invest in stocks, must have the strength and stamina of Maximus, and so I salute them. The same day well respected economists like the Nobel laureate Joseph Stiglitz are warning about a looming recession, stocks keep going up. In my opinion, the line “Are you entertained?” is well deserved due to the limits the US Government is willing to go to keep this sugar high alive. At some point, the proverbial can that has been kicked down the road in the form of government debt and deficit, will have to be addressed. At that time though, likely at a much higher cost.
Those who have been on the sidelines must be scratching their heads and wondering, if it is too late to get in. Will they ever see an opportunity to buy stocks at lower prices?
To add fuel to the fire, FED chairman Jerome Powell comes on the stage, and sings the popular Def Leppard song, crowned as the title of this article. Although, probably a correction is due here. Mr. Powell isn’t adding fuel to the fire, he has started the fire, or maybe is the fire.
FED Driven Rally Still Alive
For those who like to get a quick answer, the reasons why the stock market has been going up lately are: the FED pause on raising rates, and corporate stock buy backs.
Coming into 2019, many have expected to see FED rate increases, and in January when Jerome Powell announced a pause in that action, he had opened the flood gates that probably even Noah himself wasn’t expecting to see happen.
Not only the FED, but also the Bank of Japan and European Central Bank, have stopped their quantitative tightening programs. In fact, don’t be shocked to see if we go back to quantitative easing roll outs by the end of this year. Why? Because the global economy continues to slow down and by then it may need a lift. There is a reason why China has rolled out a 1.5 trillion Yuan stimulus package.
Why did the FED halt? Being data driven, the FED has reached both of its mandates: low inflation and full employment. The US economy is in much better shape than its global partners, but still, at least as far as the FED is concerned, the economy rate isn’t strong enough to justify further rate increases. The signs of this can be seen in low inflation rate and bond yields. In fact, the market is probably pricing a rate cut as a result. I, personally doubt a rate cut is in the cards because the FED needs to be able to use that ammunition when fighting a recession. Japan and Europe are much closer to that scenario, and hence the reason why, their central banks are also on a wait and see mode instead of tightening.
The Bureau of Economic Analysis have reported a US GDP first quarter growth rate of 3.2%. If you’re one that judges a book by its cover, this is of course good news, but for those who like to play Sherlock Holmes, it is due to inventory build-up and improving trade, both of which may have hard time contributing to future growth. If you don’t believe me, ask the FED. Their 2019 annual growth estimate is 2.1%. To reach that average, growth in the following quarters have to be much less than 3.2%.
The second reason why the stock prices have been going up, is the record level corporate stock buy backs. The 2017 tax laws allowed US corporations to repatriate close to $700 billion dollars. Yes, you’ve read that right, and no, it is not a typo. Now, you’d think that money would/should go to capital expenditures, research and development, and new hires…but I’m sorry you’d be wrong. Those freshly received funds went into stock buy backs, which not only increases stock prices, but also improves price earnings ratios as there are now less stocks available for purchase. In English, it means publicly traded companies are not investing in their businesses, or paying down their debt, and debt they have, but they’re buying back their stocks and helping their stock prices go up. If part of your compensation is received in your company stock, you might be happy to see this, but as for the sustainability of the rally, it raises some legitimate questions.
Inverted Yield Curve
Back in March of this year, bond yields have displayed an inverted curve. Usually, the longer the maturity date of a bond, the higher its yield. In rare occasions, this relationship may reverse and when that happens, many interpret it as a strong recession warning sign. In the last 50 years, there have been 9 similar cases and in 7 of them, with an average of 12 months lead time, a recession did in fact materialize. Does it mean we shall see a recession in the US in the next 12 months? Highly unlikely. Forward looking indicators are weakening, but they are still pointing to (albeit slow) growth. The inverted yield curve has formed because bond investors expect the US to follow the rest of the world and like Europe and Japan, feel recessionary pressures soon. I, humbly disagree. With FED on pause, and 2107 tax cuts, the possibility of that scenario has been pushed to late 2020 or 2021.
Let’s not forget, we have seen two waterfall declines in stock prices in 2018, and closed the year with an approximate 8% loss in major US stock indices. So, the economic slow-down rhetoric isn’t delusional. It’s just that the policy response to it has been effective. The confusion arises because the US and the global economies are out of sync. While the US is growing, the world has been slowing down. In the next 12 months, we may see this relationship reversed. If this materializes and if the US dollar reverses its long-time uptrend, international investments, both in stocks and bonds, may start to look attractive.
If you’re looking for a counter argument, look at CEO and CFO confidence indexes. They both point to a recession. The top executives have been exceedingly pessimistic about the earnings potential of their companies. But judging by solid consumer confidence, strong financial conditions, improving housing sector, low interest rates and a dovish FED, I would caution for slower days ahead, but not for a recession.
When you look at the “US stock market”, represented by large indices such as the S&P 500 or Dow 30, the picture looks peachy, but that can be misleading. Usually, strong market performance is led by small caps, financials, and emerging market stocks, with globally 80% of markets above their 50-day moving averages while yields rising. This time around, none of the above boxes have been checked. That being said, stocks tend to close the year on a positive note after a strong first quarter. As for the fundamentals, a mediocre earnings season is already priced in.
Given the tune the FED chairman has been playing, certain sectors such as tech and communication, energy, consumer discretionary and dividend paying quality stocks may still have legs for an up-trend. At all-time highs though, I would look for down periods and/or times of pull back to add exposure to these areas. In fact, I would like to leave you with this consideration: Complacency has reached levels usually seen before a correction. So yes, unfortunately it is a mixed bag of data in front of us.
Thank you for reading my newsletter. I hope you’ve found it a fun read and informative. Please feel free to reach me with questions and comments on email@example.com.
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