The Elusive Pending Stock Market Crash
The month of August has done some crazy things over the years in the markets (of course, truth be told, that can be said of any calendar month). In 2011 we saw a massive Europe-driven drop in the stock market that waited until October to begin recovering. In 2015 we saw the market drop nearly 1,000 points in one day (before recovering a bit), and giving markets the first “correction” it had experienced in years1. The real actual beginning signs of the credit crisis that became the great financial crisis actually launched in August 2007 (sub prime markets completely freezing), even though the major headline events wouldn’t come until September 2008 (Lehman bankruptcy, etc.)2. We resist efforts to derive significance from any calendar reality because those efforts are juvenile and potentially dangerous. What August has in common with every month of the year is the need for measured and careful analysis, and the primacy of investor behavior in driving long-term results. There is a lot to chew on this week, and we think it is comprehensible and interesting, but nothing in this week’s Dividend Café will trump this lesson: Avoiding the big financial mistakes will make it a great month, regardless of what the market does! Off we go …
The first movie we watch after Groundhog Day
It really does feel like the same routine over and over – markets are doing well, pundits wonder what happens when markets find out how dysfunctional D.C. is, and then markets respond with more upside. We have laid this out over and over as well, risking our own annoying repetition – that right now markets are earnings-driven and politically de-correlated. But at some point this day-after-day theme has to change, right? At some point, a new key market narrative will surely take over. Well, there are any number of new “themes” that may dominate headlines. Such is market life. Fundamentally, markets are actually always and intrinsically discount mechanisms of earnings, but I digress (we are talking “narratives” here). Could the Fed rock our boat with sudden or excessive “tightening”? Could tax reform fail to materialize? Are Europe’s and Japan’s slight improvement going to be short-lived? Will North Korea go to another level of crazy?
These things are all possibilities, and they are possibly not possibilities (I like the way I said that). My advice is to not get your advice from anyone who was denying Groundhog Day these last 6-9 months.
Tax reform primer
Here is what we do know: The Trump administration has committed to comprehensive tax reform, and the House and Senate leadership have stated it will get done. Here is what we do not know: Will there be more political wisdom and thoughtfulness across all GOP leadership (White House, Congress, etc.) than there was with the health care repeal/replace failure? Here is something else we do not know: How will the tax reform they bring forward deal with pass-through entities (S-corps, LLC’s), expensing for corporations, and the ultimate corporate rate? So we know they are primed and ready, we do not know if they will be successful, and we do not know some of the more granular details on the corporate side. The final thing we do know: The huge beneficiary of corporate tax reduction will be wage earners! Their ability to sell this plan will depend on that message getting across. And I will add that all indications are that they are more prepared to do this right than they were on health care (though I wouldn’t believe their timeline goals if you paid me)
The first month of the second half of 2017 saw the stock market rally continue (+1.9% S&P 500), bringing it’s Year-to-Date return to over 10%3. July saw taxable bonds move up .43% and municipals more than that. Emerging markets flew higher in July, as did oil. The dollar dropped throughout the month. To have been down in July, one would pretty much have to have been long volatility, or short risk assets.
Who you calling “bubble”?
The stock market’s per-year return from 1982 until the famous crash of October 1987: +19.7% (annualized)4
The stock market’s per-year return from 1995 until the tech-driven 2000 meltdown: +26.1% (annualized)5
The stock market’s per-year return from 2009 until present day, coming out of a crisis: +12.5% (annualized)6
We have already talked about P/E ratios that were over 50% higher than present levels in the late 1990’s7. The fact of the matter is that every person you know (I can certainly tell you this is true of every person I know) who is presently whispering about fears of lofty stock prices, was doing the same thing 1,000 points ago, 2,000 points ago, 3,000 points ago, 5,000 points ago, etc. Stock prices will come down at some point because that is what stock prices do – they experience shifts in both fundamentals and sentiment. But a “bubble”? History has a different story to tell, for now.
When we zig, you zag
The stock market was not supposed to show this resilience in the face of a Federal Reserve raising interest rates, right? (three rate hikes going back to December so far, with one or two more expected this year)8. And Draghi over in Europe jawboning their need to reverse monetary direction has added to this narrative of central banks around the world “tightening” the belt, though we have been careful to delineate “normalizing” from “tightening.” But let’s make sure we understand the full scope of what central banks around the world are doing: There have, indeed, been 20 rate hikes around the world so far this year. But there have been 43 rate cuts, the vast majority of which have taken place in emerging markets. And as you know, emerging markets have been flying this year (stock and bond markets). So the global reflation thesis is by no means dead, and much of it is being fed by the fact that while Japan, Europe, and the United States flirted with zero or negative interest rates these last few years, many EM central banks left themselves plenty of room to maneuver. And now, maneuver they are.
A new favorite topic of discussion in our world is how low the “VIX” is, the so-called “fear index,” and how these historically low levels of volatility bode poorly for, well, everything. The big trade has been “bet on higher volatility because vol has been so low,” and frankly I do not even want to think how badly people have been wiped out with that trade this year (unlike buying a stock or some perpetual asset, the VIX is made up of option contracts that have an expiration date; you can’t just “wait for volatility to come higher” – it has to do it on your time table, and suffice it to say, that hasn’t been working). So we know that those betting the VIX will go higher have gotten crushed, and we know that betting on such things is outside of our worldview at The Bahnsen Group (lesson #74: only gamble where the beverages are free). But does the low VIX tell us something about the future? Should we worry about what it means for stocks? It tells us exactly one thing: “Volatility has been low.” I would like to think we already knew that. It does not tell us that it will stay low, or that it is about to go high. It tells us what has been. Combined with low spreads in the high yield bond market, does it imply that investor complacency may be too high? I think it can be said that it contributes to that narrative, but it does so with less fundamental force than something like bond spreads. Look, investor respect for risk is too low. And we don’t know when sentiment will shift (heaven forbid someone try to use any of this as a timing vehicle). But the VIX has become a side show, and not understood by those playing around with it. That ends in pain.
Tale of two countries
U.S. households have been de-leveraging since the aftermath of the financial crisis. Our corporations have a lower debt-to-equity ratio, debt-to-earnings, and debt-to-market cap. It is our government that has ratcheted up debt through the stratosphere. Note the chart below from China. Post crisis, their societal debt has also increased, but it is not the household or government sector where that has been manifested, but rather massive leveraging in their corporate sector. Neither category of debt build-up is necessarily better than the other; they are just different – meaning, each represents a different but not unimportant category of risk.
If only we could get the thrifty consumer to start spending again?
Keep this chart on hand for next time you are told that what is holding the economy back is as slow and stubborn consumer
An update on our friends across the pond
We haven’t written much about the state of the UK since the horrific election results a couple months back. The entire Brexit-planning process is very difficult to write about, first, because of all the hysteria that existed after the referendum, and now, because of the vast range of possibilities that exist within the execution of how it all plays out. We have generally bifurcated between where a “soft” Brexit looked likely and a “hard” Brexit, but even within both of those categories, there are wide ranges of possibilities. Within that simplistic paradigm, it is becoming increasingly obvious that a “softer” Brexit is shaping up, meaning, more time to put it all into place, and more pre-arranged trade cooperation before the exit is formalized. This soft approach may not be best – it risks failing to satisfy any of the agendas and stakeholders in the process, but for the time being, the sterling has moved higher and seemingly stabilized.
Get energized about this hedge
A significant factor in driving the current rally in global risk assets is the confidence markets have in a low cost of capital, something that higher inflation would threaten quite quickly, and something that presently low levels of inflation have facilitated for quite some time. Put differently, a big risk to the present rally would be a sizable pickup in inflation, something that has been so very elusive for some time, much the chagrin of the “perma-inflationistas” … But one thing that could change the low inflation dynamic would be a huge move higher in oil, meaning, that the significant threat to the current global rally (higher inflation) may be able to be mitigated to some degree by owning energy stocks that would benefit from higher oil prices. From where we’re sitting, this is cogent thinking.
Would a competent money manager rather outperform the market when the market is way up, or outperform the market when down? There is no controversy here – downside protection, and relative risk management (limiting drawdowns relative to inevitable market drops) far outweighs add-on points when the market is doing well (and this is true economically, mathematically, and emotionally).
Chart of the Week
We write so much about the various risks and warning signals we see, primarily centered around investor complacency, that every now and then it is helpful to show the various indicators that may tell a different story. If one believes there is a global reflation theme at play, and that overall global demand is picking up in this stage of the post-crisis recovery, giving way to another leg of the market rally (and by the way, that hasn’t really been open to “belief” lately – it has just simply “been”), then this chart may help to reinforce that thesis. It is not perfect, and it is not always a “leading” indicator (though it can be), but Copper prices as a bellwether for industrial production and global demand are generally pretty informative, and we see here the very strong backdrop for risk assets.
Quote of the Week
“Stability breeds instability.”
Originally published on Dividend Cafe.
Trending on Affluent Investor
Sorry. No data so far.