The storm has passed. Calmer waters now surround us, a good time for thoughtful contemplation about what lies ahead, at least for the next month and a half. The obsession with predicting the next recession has also passed, another good thing, as well as mid-term elections, another frightful event with unknown ramifications. The S&P 500 index had dropped into negative territory, but a nice November rally soon lifted it back to a 3.2% positive gain for the year. Breathing is a bit easier these days.
Portfolio managers and analysts alike, however, are now planning for the all-important yearend close, hoping to ensure a healthy track record versus the competition. Is all to be well as we head into the Holiday Season? The chart below is but one indication:
Analysts back in the bowels of Bloomberg and Goldman researched the history books and came up with this highly insightful chart, depicting how the next few months have progressed following a mid-term election. Data from 1974 forward suggests that the next eight months, on average, will see a 15% run up in the S&P 500 index. The eleven 4-year episodes preceding 2018 produced the dotted line median, while the Blue line is performance history for the current calendar year. Even at its low point, the forecast would still be positive, roughly a 3% gain, if 2018 does not set a new low-point record.
As with any chart like this, the past is no guarantee of future events, but it is refreshing to see the sun shining brightly through June of 2019. Technical analyses aside, there are fundamental reasons why this pattern of history persists over time. In our case, the Democrats took back the House, which means we will have a split Congress, which means there will be a control over the erratic behavior of the Trump administration, but, at the same time, Democrats will not be able to roll back any of the tax changes or cutbacks in regulations that business executives and the wealthy now enjoy. It will also act as a governor over extreme positions regarding trade policy, another good thing.
With that said, I could stop right here and go back to playing with the grandkids, but wait, there is a little more going on that should not be ignored. The Fed still has another interest rate increase to consider in December, and, given this headline – “The Pros Are Predicting An Imminent Squeeze Higher In Stocks” – what is the thinking behind this type of proposition? As we look about the carnage that has taken place in our global financial markets, the meager gain of 3.5% in the S&P 500 index is stellar by any measure. Global assets are primarily in the red for 2018, about 77% of them, if you assess current valuations. Another analyst pegged the loss rate at 89%. Ouch!
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What is going on with the Fed?
The Fed issued a statement last Thursday, its update on the economy since September. Its opening paragraph said it all: “Information received since the Federal Open Market Committee met in September indicates that the labor market has continued to strengthen and that economic activity has been rising at a strong rate. Job gains have been strong, on average, in recent months, and the unemployment rate has declined. Household spending has continued to grow strongly, while growth of business fixed investment has moderated from its rapid pace earlier in the year. On a 12-month basis, both overall inflation and inflation for items other than food and energy remain near 2 percent. Indicators of longer-term inflation expectations are little changed, on balance.”
Now catch your breadth. That statement was a bit longwinded. It made everything look sunny as could be, or as one Fed watcher put it: “The Fed, or FOMC, is seeing a Goldilocks scenario.” What did the markets do with the news? The S&P 500, as we noted above, was enjoying a nice November rally and had crested at 2800, but the “hawkishness” of the message knocked it down to 2781, not a knockout punch by any means, but a negative reaction, just the same. We suspect that many investors were hoping for a more conciliatory tone after October, perhaps even a waiver of the expected rate hike in December. The absence of accommodative language spooked the Street.
Fed “whisperers” will dissect every nuance of the Fed’s statement this week, but it is not that difficult to determine that all is not well in Denmark, or with the United States economy, for that matter. This time around, Fed policies have contributed to the longest march back to “normal” interest rates in decades. Market forces have been constrained, and easy, cheap credit, like it or not, has created a number of companies that will fail, as soon as interest rates materially climb, so-called “zombie companies”.
For those individuals that witnessed the last two decades of Fed maneuverings, the conditions look eerily the same. The housing industry is and has been suffering, due to rising interest rates and tax changes to valuable home ownership deductions. Home construction and the real estate industry are the backbones of the U.S. economy, closely followed by the automobile industry. Negative impacts have already been showing up in valuations for these two sectors, while the credit granters, i.e., big, small, and large regional banks, have been taking it on the chin.
Here is one illustrative chart for housing – can you say “30% haircut”?
It is no mystery that developed economies are driven by consumer spending. If the outlook is gloomy in that sector, then the road could get bumpy really quickly. To sum it up, one analyst, whose moniker is “DoctorRx”, remarked: “All the above are the “rainy side of the street” that the Fed is either not seeing or, as in 2006-2007, not caring about. In that period, it was “too late”. But in 2000, it was accepted, and the credit-sensitive housing sector became a source of strength during the dot-com recession of 2001. I’m not predicting a recession. What I’m saying is that there are major parts of the economy where the macro data has weakened and may have turned down, and where the judgment of the marketplace says the Fed is making a mistake.” Time will tell.
Is there any momentum left in equities, and what about Emerging Markets?
Above is the diagram that supports the “77% negative” statement a few paragraphs back. The “sunny side of the street” may be in the Fed’s backyard, but it is raining heavily in other locales. Momentum data does not speak to a rosy future either:
The trends, both short and long-term, have been gradual southerly slopes, since the beginning of the year. Many analysts equate these trends with the Fed’s withdrawal of QE stimulus, an “unprecedented” massive reversal that seems to have escaped the mainstream media. In the chart above, do not take solace in the short-term bump up by the Eurostoxx 50. Mario Draghi has yet to announce real tightening on the QE front in Europe, but it, too, will more than likely have the same chilling effect. As the supply of cash shrinks, just as when the tide goes out, several “rocks” will be revealed.
There is a short-term “twist” that should not be overlooked, as well. Many hedge-fund managers overreacted to the October semi-meltdown. As they went out of their way to de-risk and de-leverage their portfolios, the market turned. Black-box algorithms were noting an oversold condition and were feverishly issuing buy signals. The vast majority of asset managers got caught flatfooted. A portion of last week’s rally can be attributed to these folks turning their tankers around and jumping upon the “risk-on” wave. The fear of missing an up tick, especially before yearend, is a powerful motivating factor.
Where will this “risk-on” buying concentrate? Yes, a portion has and will go to U.S. equities, but these securities are extremely expensive at the moment. If you are one that accepts that the USD has finally peaked, then the most attractive positioning may once again be in this year’s “whipping post”, Emerging Market stocks. Kevin Muir at EastWest Investment Management recently wrote: “The spread between P/E ratios of [U.S. stocks and EM equities] has hit a 13-year high”. More simply: The S&P is the most expensive compared to the MSCI Emerging Markets Index since 2005”. The chart below is a compelling argument for carry-trade positioning once again:
What is the Almighty Dollar doing at present, and what could it do?
Of course, the carry-trade does not work as well as it should when the Almighty Dollar is in the ascendant. The USD has been stubborn of late, trading within tight range limits:
It recently broke out above its confining “95” level, which is not according to the prevailing narrative, and it soon established a new resistance level at “97” on the scale. A persistently strong Dollar is not good for exports, EM stocks, precious metals, or commodities. It might help with import prices, but inflation is the downside.
The prevailing narrative, however, asserts that too much capital resides presently in USD denominated assets. Something has to give. According to one analyst: “The results of the midterms are likely to be bearish for the dollar. That’s a consensus view. Less scope for more stimulus and lower long-end yields should both play negative for the greenback, which is already due for a pullback, especially considering how stretched (on the long side) positioning is. America’s fiscal trajectory isn’t going to change materially under a divided Congress, which means the longer-term dollar bearish arguments aren’t going away.” The greenback needs to weaken.
Will the next few months be rosy or repugnant? Will the Fed rain on our parade or paint a sunny picture? Here is one analyst’s take on the days ahead: “The November-January period is the strongest 3-month period of the year, and I saw a stat that midterm periods are typically much stronger than average for that period. So seasonality argues against the bears. The “tape” is, however, at best iffy for the bulls, so the dictum of not fighting either the Fed or the tape does not comport with a bullish posture.”
For those of you that prefer a contrarian view and are reluctant to follow the herd, there are cracks in the infrastructure that can only be exacerbated by rising interest rates and a shrinking money supply. We are in uncharted water, which typically suggests that volatility will increase. What may appear, as calm water, will get choppier down the road.
Prepare accordingly, and remain cautious!