Be Ye a Bear, or Be Ye a Bull?

By Peter H. Lester, Sr.

In recent days, the market is back to setting records beating the all-time highs experienced by the major Indexes.  I thought it might be good to reflect on that, and from an economic standpoint, what policies are in place to sustain or even derail the climb.

 
To many, the financial crisis and corresponding market declines of 2007-2009 (the S&P reached its low point of $756.55 on March 13, 2009) is a distant memory. Whether through mergers, retirements and reorganization, I have been told that over 1/3 of the Fund Managers have turned over since that time – which means, many of them have looked smart for their entire career. And, with a 300% climb, it is easy for all of us to feel pleased with our own investment prowess.

For those of us who are students of economics, vested participants with “skin in the game”, or simply voyeurs who are like the NASCAR fan that only watches the race to witness the crash, there are some interesting developments taking place that we should be watching.

First, the numbers. Several things are different now than they were in the last market downturn. Employment is as close to full employment as we have seen in a long time. The most recent corrected report from February 2018 states that the unemployment rate is at a 17-year low of 3.8%. Since 1974, the unemployment rate has spiked at a rate over 8% three times.

Second, one of the triggers for the “Great Recession” was the amount of consumer debt. Specifically, debt related to home mortgages. The euphoria around buying a home, selling it 2 years later for a handsome profit encouraged many people to purchase homes on a purely speculative basis. Coupled with relatively easy lending practices, and the blur of securitizing these loans in the secondary market, our economy had a toxic mix that created a financial black hole in the marketplace. When the economy slowed, jobs were lost, and mortgage defaults increased. Our economy entered the sphere of that black hole – and its gravitational pull was hard to escape. Additionally, we have seen younger consumers who normally would be moving vertically up the housing spectrum, delay these purchases, making sustained demand for new homes difficult to forecast.

To be clear, for the most part, we are not seeing the same over-building and speculative real estate trends. The troubling sign here is that the Federal Reserve is stating that they expect Consumer Debt to top $4 trillion by the end of 2018. In July, the Federal Reserve reported consumer credit debt increased at an annual rate of 5% (seasonally adjusted) and that non-revolving credit increased at an annual rate of 6.5%. Consumer Credit Debt is debt that is easier to walk from – non-mortgage debt: auto loans, student loans, and credit cards. It is estimated that 10% of income is now going towards servicing this non-mortgage debt – a new high for our consumers.

Thirdly, be ye a Trump supporter or a “Never Trumpster”, there is an amount of uncertainty generated by this administration. Some of it, like the pro-business lifting of regulations, is positive.  Other policies, like the aluminum and steel tariffs, are unsettling. With each tweet, however, the market seems to be getting a little less reactionary.  Since April, the VIX (CBOE Volatility Index) has recently been indicating less nervousness in the market, falling from the low 20’s to 12.29 (as of October 1, 2018).

Forth, I would prefer to focus on economic conditions and policies, and stay away from speculating on future financial market performance. I will simply say that for value investors, when the S&P 500 is trading at a PE of 21.62 (based on trailing earnings as of October 1, 2018), it becomes increasingly difficult to find upside. To put this in perspective, when the S&P peaked in May of 2009, the S&P 500 had a trailing PE of 123.73. From there, it fell to a low of 13.50.

Fifthly, small business sentiment, key to new job growth, is positive. At the same time, the pay and quality of jobs offered is not generating the kind of real wage growth one would anticipate in such a tight labor market.

Sixth, while inflation seems to be in check, there is cause for concern, and the Federal Reserve must be diligent in keeping inflation checked. It is not out of the question that we could have full employment, rising interest rates, improving economy, and declining equity prices simply due to increased inflation and higher interest rates (see the blog Titled – "And Now, It's Time for Something Completely Different: Quantitative Tightening").

Several years ago, I attended a conference and one of the key speakers related that one of the cornerstones of his investment philosophy was: “don’t fight the Fed.” To this end, he related that in the past, the yield curve has been a solid predictor of major financial downturns. The spread between the Fed Funds Rate and the 10-year Treasury is about 100 basis points; and, to take it a step further – the spread between junk bonds and treasuries is relatively low as well. Typically, investors seek quality over return during a recession… they prefer safer investments. For this reason, we see spreads widen considerably as investors reallocate their portfolio to favor lower-risk investment grade assets.

Due to the monetary policy during the Great Recession, it may be the case that the yield curve’s dependability as an indicator will be impacted. This time around, the spreads will be impacted as the Federal Reserve continues to liquidate assets on its balance sheet.  So, as an indicator, the yield curve may not be the best harbinger of things to come. Many believe that the next recession will be the result of a central bank or banks being too aggressive in balance sheet reduction.

Given market conditions, the best indicator may be unemployment and/or a rise in unemployment jobless claims.   A rise in these metrics would indicate that the consumption party is ending, spending will slow, defaults will increase, and a recession is underway.

Moreover, this time, the market decline will be different. With over $2.5 Trillion invested in Exchange Traded Funds (ETFs), if investors decide to move away from equity, the decline will be broad. This time, Investors will not be picking one stock over another, they will be getting out of the market entirely.