A trusted friend noted to us the other day the market is acting like the economy ran straight into a brick wall with no skid marks. His point, while funny, is well taken. Something is amiss as the data is in serious conflict. The economic backdrop is still quite strong yet markets have gone haywire. So, what is going on?
Bear markets don’t start by collapsing 9% in one month, followed by another 12% collapse two months later. Bear markets erode value over time usually in response to investors’ loss of faith in the ability of earnings to materialize or some known exogenous event. The last true bear market in 2000-2002 was the result of investor realization then that earnings of much of the tech world were a mirage – a mirage borne out subsequently by a wave of very high-profile bankruptcies and frauds. We are not counting the 2008-2009 global financial crisis (GFC) as a market drop driven by a recession. The GFC was a result of an over-levered financial system that caused credit markets to seize once it broke and that resulted in a very temporary earnings collapse and recession, which was way different from 2000-2002.
We suspect we are seeing the effects today of a toxic mix that hit all at once including: (1) China trade fears raising concerns over supply chain impacts to earnings; (2) an unpredictable White House and the pall that places on markets; and (3) rate fears which started in October and have continued unabated since, magnified by the recent misstep from the Fed. Beyond the three big issues of trade, Trump and the trend of rates, we could also add sub-bullets: 4) beyond Trump political/economic uncertainty is also the instability of Merkel, May, and Macron in a world of consolidation of authority by Putin and Xi, 5) unresolved Italy issues and the direction (or ability) of the ECB to help what may be a terminally-flawed Euro, 6) the direction of the dollar…changing again…but which was pretty high and hurting US competitiveness; and lastly 7) uncertainty about oil prices and who wins and who losses in the short and long term.
Boiling all seven issues down in a cauldron of reduced year-end liquidity and passive investment see-saw flows spells one word: uncertainty. Markets have in the past often suddenly gone “risk-off” as needed to regroup in periods of rampant uncertainty. If so, time will fill in data and we will all research and hopefully conclude ways of continuing to invest in less uncertain…just risky…environments. We have spoken frequently about investing during periods of higher volatility and uncertainty where the rewards ultimately were great (1996-1999). The uncertainty of Q4 2018 could turn into more certainty in Q1/2019. There is no path we are on now that couldn’t turn in a direction quite favorable to markets.
While not directly related, we also think a market too skewed toward passive vehicles is having an impact – as blind, wholesale passive unwinding is occurring in response to massive redemptions. We have discussed the potential negative impacts of passive vehicles before here, here and also here. Between the start of 2015 and December 2017, flows into equity ETF’s almost doubled from approximately $900 million to almost $1.8 billion. Between February and March of 2018, when the market first dipped, outflows from equity ETF’s totaled $134 million. In October 2018 alone, outflows were $124 million. December’s data isn’t in yet. The correlation between flows and market performance is palpable. But, while systematic redemptions are no doubt a contributor to the pressure on stocks, the better question is why are investors running for the hills?
We believe the market drop has gone too far and there is no smoking gun (yet) pointing to recession. The proper measure of the yield curve (3-month T-bills to the 10-year) is not yet inverted. Credit spreads are up sharply, but more in response to equity markets and still more stable than during the 2011 euro-zone shock and the 2014-2016 oil shock. Yet, forward market multiples have been knocked back to more than five-year lows. We would quote Michael Darda, MKM’s excellent macro-economist here: “At 14x, the market is nearly a multiple point below where it was in early 2007 when yield curve and M1 money growth were both negative and the NY Fed’s recession probability model hit 39.5%. Today, the curve is relatively flat but technically upward sloping and the NY Fed’s recession probably model ‘only’ stands at 18.7%.”
Back to the no skid marks reaction from the markets. One of the factors we keep coming back to is the PMI relative to the S&P 500. The spread differential between the two is now wider than it has been in the past 31 years. Before you jump out of your seats, we know the PMI isn’t a great predictor of stock market movements – indeed, the strongest historical rallies have come off a low PMI reading. We also know that PMI’s reverse, and a reversal from historical highs is almost a certainty, but lofty PMI readings also signify a healthy economic backdrop which frequently extends far longer than investors expect. Further, at many points historically, PMI’s have trended down from historic highs without ever tipping the economy into a recession.
We are suggesting that the market is already pricing in a recession even though we might not get one. S&P 500 futures are down nearly 19% from the September peak (the median stock market decline associated with a recession over the last century is just over 25%). We don’t believe the economic cycle is ending and also don’t believe we are headed for significantly lower stock prices from here. We do not (yet) have an inverted yield curve. Too many people refer to the wrong yield curve when speaking of “inversion.” It’s the the 3-month T-bill to the 10-year, and that is still +25 basis points.
Put us in the camp of being surprised by the Fed’s recent move and we understand the logic behind the calls for Powell’s head. The Fed’s first measure is inflation, and it admitted that inflation was not a factor. So, why raise? If the Fed is willing to be flexible and responsive going forward, we may actually not get a recession.