The Stock Markets Have Been in a Proverbial Pot of Hot Water, Does Anyone Care?

Impeachment and recession loom as notorious 4th quarter begins

Author’s note: Investment markets can be confusing. To try to cut through the chatter and investment slang, we present this monthly view to you. We want to give you a 50,000-foot view of market conditions updated as our view evolves. Currently, our Investment Climate Indicator remains at Stormy. Stormy means that bear market rules apply, and we believe we could be a period of wealth destruction. Stop me if you have heard this one before. If a frog is placed into a hot pot of water, it will immediately sense the temperature, and jump right out, avoiding damage. However, if you place it in tepid water and gradually increase the temperature to a boil, it won’t sense the change. I will stop there, as I want to make sure no frogs are harmed in the making of this column, even hypothetical ones. Since early 2018, the global economy and stock markets have been in that proverbial pot of water. It keeps getting more uncomfortable, with data and historical trends piling up. They spell trouble ahead, but few really care enough to pay attention.

Wake me up when September ends…wake up!

As it the band Green Day were a investment timing service, as October began, the financial market heat lifted again. And it appears we are reaching a boiling point. Whether it is geopolitical tensions including Brexit, Iran, Saudi Arabia, Hong Kong, or the U.S./China trade spat, or the new impeachment talk in D.C., there is a lot of hot water bubbling. While some will point to the tariff thing, the trade war thing or some other thing, the facts are clearer than that. The global economy has been stretched for a long time now. That simply means that any little thing makes it more vulnerable to ending up like a stretched rubber band or a bubble gum bubble being blown. Rubber bands break, bubbles pop. And while September was ultimately a strong month on paper for the stock market, it was practically erased in one day to start October. The culprit: the strongest evidence yet that the U.S. economy is past the point where rate cuts or other stimulative measures can save it from what eventually happens in a cyclical world. A recession is on the way. More importantly for investors, the fear of a possible recession is already here. And, that is really all that matters.

It doesn’t take much

You see, at this stage of the investment cycle for stocks and bonds (yeah, especially bonds), it is a confidence game, pure and simple. Valuations are high, interest rates are low, and manufacturing data shows accelerating weakness. Does that mean that returns will be negative from here forward? Not necessarily. But it does mean that the odds are stacking more against the kind of high-risk, high-return speculative behavior that helped get us this far.

The name of the game: aggressive capital preservation

If you are nearing retirement or recently retired, and you like the level of wealth you have accumulated, realize one thing. The past 10 years’ returns are unlikely to be repeated. Know your risk limit. And, be truthful with yourself about how you will react if some combination of events creates renewed turmoil in your portfolio. This is not the kind of thing where it makes sense to skip the dress rehearsal.

U.S. Stock Market

The S&P 500 is now up over 20% for 2019. But if you look at the return since 4 weeks prior to the end of the year, the figure drops to 8.4%. And, if you go back to one year ago, it is just 4.1%. That tells us that 2019 has been, above all, a claw of just a few months of losses late last year. Losses that began around this time of year. History is littered with fourth quarters that erased the rest of the year’s gains. And, while I am not predicting that here, I do believe that when a true emotional tipping point hits again, wealth will be erased much faster than many think.

Bond Market

The bond market continues to be a friend to traders, but a danger to investors. That is, if you thought bond market prices are going to move gradually, without much fanfare, as they have for most of your lifetime, think again. Low rates and Fed policy speculation (thanks, internet and instant global communication) have essentially made bonds a weapon for traders. For savers, they get a little yield and a lot of volatility. That’s the opposite of what they came to expect in the past. This chart shows the now-familiar ride that investors in long-term Treasuries have experienced (price only, not including the income rate) the past 5 years. Yes, I know. Looks like a stock chart. Nope, its a bond chart.

Key Market Stress Points

• Impeachment: if it proceeds and turns out like Clinton, no problem for investors. If it proceeds and turns out like Nixon? Big problem for investors. More on this if it merits attention in future articles.
• Fed rate decisions: I am starting to think this is fading in importance. Barring another major “stimulus” event (QE5?), rates may be cut further, but all it does it take away needed ammunition for Fed policy later. Still a key issue for markets, but the scenarios appear to be well-scouted by investors at this point. That takes away much of the “surprise factor.”
• Geopolitical: it seems the only perking up the stock market gets is on speculation that substantive talks between the U.S. and China will occur. Meanwhile, the damage is literally done, at least in part. Manufacturing is weak, corporations have limited visibility, and earnings are expected to be down on average for the past quarter. Wrong direction. And, as expressed here in past articles, China thinks in decades.
• Valuation: The Shiller CAPE version is finally falling, after being up near its 1929 level. However, that is probably just another indicator that the bear market for stocks is underway.
• Index mania: S&P 500 index funds are very popular. That type of herd mentality will likely contribute to the next bear market panic. This is more evident as we start to see other parts of the stock market (e.g. small caps) falling already.
• Credit: Consumer credit growth is unsustainable, and many corporations are highly indebted. That’s a nagging issue, as it was a decade ago.
• Bond market risks: Approximately 50% of bonds in investment grade bond funds are rated BBB, the lowest of the 4 possible rating categories. Many of those bonds are likely to be downgraded at some point, and there is a nasty potential ripple effect.
• Sentiment: TV coverage of the stock market is dominated by companies that don’t make a profit. Perhaps now that severl high-profile IPOs have been exposed for the speculative situations they are, this will right-size the risk-seeking attitude a bit…but who am I kidding? It will take more than that.

The Plan

Bottom-line: don’t get complacent. Look forward. The investment climate is changing. And perhaps that other side of the storm, beyond the eye of the hurricane I have used as a metaphor for this year, is getting closer. I am neither bull nor a bear. I am a realist and a devout risk-manager. Be careful, understand what you own, and respect the laws of gravity. This is a group of 100 ETFs I track to get a general sense of global market conditions for investors, over the time period shown. It indicates a strong 9 months, but that only allowed the past 12 months to edge out a 2% gain. The best thing you can say about September was that it was a broad-based rally, at least with larger stocks. The average S&P stock (RSP) was up over 3%, comfortably ahead of the same group of stocks weighted by market cap (i.e. SPY, or the standard S&P 500). Utilities, Financials and Energy led in September. But for the year, the firtst 2 have been leaders, the second a laggard. Gold mining stocks, volatile as always, gave back a bunch of their gains from the past 12 months. Meanwhile, home construction stocks have surged, as if lower interest rates will spur more building. Call me skeptical. One thing the U.S. Congress seems to agree on is that some of the tech giants have become very powerful. The threat of being political footballs has kept a specialty ETF that tracks many of those leaders (FDN) in negative territory the past 12 months. It is still the 3-year leader in this group, though. Dividend stocks had a solid September. And, the media seems to be warming up the relative attractiveness of “value stocks” in a low interest rate environment. This could be a relative out-performance area if the broad market turns down. Remember, its been a growth stock-dominated journey for a while now. Pot stocks were (pardon the pun) “smoked” in September, adding to a tough year. This smells like a symptom of a growing “risk-off” attitude by investors. After all, there are not yet any blue chip stocks in this sector. Asia stock markets in U.S. Dollar terms are down over the past 12 months, but bounced in September. But as with the U.S., it has been a lot of shaking around, but no sustained direction for a while. The exception is China’s “A Share” segment, which is focused more on China’s domestic market. This is different from many China stock investments, which are limited to global businesses based in China or nearby. A 25% return for long-term Treasury Bonds (TLT) is something that does not happen very often. For that to repeat itself soon, long-term interest rates would have to go to just about 0%. Tiny cracks are emerging in the lower-quality bond market. But for now, they are just cracks. Just in case you were tempted to think of gold and oil as being correlated, consider that the former has outperformed the latter by a whopping 50% during the past 12 months. And yet, the 3-year difference is modest. Source for all ETF data: Ycharts.com Related: Impeachment? Maybe. Recession? Yes.