Markets May Shake Off Bad News for Quite a While… Or Not 

MarketCommentary2016-croppedThings stabilized a bit in the financial markets in January, and both the Dow Jones Industrial Average and S&P 500 enjoyed increases of just over 7% (although all the major indexes are still down from their peak highs).* Overall, the month was certainly a welcome change from all the volatility of 2018, which ended as Wall Street’s worst year since 2008. In January, big investors seemed to make an effort to shift their focus mainly to positive and hopeful financial news. But why, and how long will they be able to keep it up?

Granted, there was some hopeful economic data for investors to focus on in the first month of the New Year, including strong early fourth quarter earnings reports and the more dovish language coming from the Federal Reserve about interest rates. In its January meeting, the Fed said it would be “patient” with further interest rate hikes, and removed language about “further gradual increases” from its policy statement.** In addition, the U.S. added 304,000 jobs in January (more than anticipated) and the Labor Department reported that average hourly earnings over the last 12 months rose 3.2%.***

However, before you jump on the optimism bandwagon, keep two things in mind. Number one, there was also a lot of positive economic news throughout 2018, yet despite that, the year saw extreme volatility and some of the largest single-day point declines in market history; and number two, in order to focus on the positive headlines in January, investors had to also ignore a lot of negative news, including concerns about the economic impact of the longest government shutdown in US history.

Typical Trend

In truth, what we’re seeing with the markets now is not uncommon from a historical perspective. Investors typically fall into a trend of shaking off bad news toward the end of a cyclical bull market period, and—as we explained in our 2019 market forecast last month— we believe we’re at such a period. We are forecasting a second straight year of losses for the stock market, and an economic slowdown that could lead to a new recession by 2020. Whether we’re in the early stages of the third major sustained market correction of this secular bear market remains to be seen, but it’s certainly possible.

We have also forecast that the Fed is not going to be able to achieve its original goal of approving three additional short-term interest rate hikes this year and may not even end up approving one. The Fed amending its statement in January to remove the “further gradual increases” language suggests to us our forecast is accurate. We believe our forecast is also supported by the fact that long-term interest rates continued to exhibit a strong resistance level throughout January, with the yield on the 10-Year Treasury rate ending the month almost exactly where it started it, at around 2.7%.

As we have explained before, the bond market is often said to be “smarter” than the stock market when it comes to forecasting economic growth, and this resistance level is an example of that. When the Fed instituted its last rate hike in December, that’s when the bond market said, “enough is enough,” and this time bond yields didn’t rise to make room for the Fed’s increase.

As a result, the yield curve remains perilously close to being flat, with the Fed funds rate now at 2.5% and the 10-Year holding fast at around 2.7%. In fact, the yield curve almost did completely flatten on January 3rd when the 10-Year sunk to 2.56%—which could easily happen again. Remember, too, that the yield curve is already partially flat and has been since December 3rd when yields on the 2-Year Treasury rate rose higher than yields on 5-Year Treasuries. As we’ve also mentioned recently, a flat yield curve preceded both of the last two market crashes and is widely regarded as a huge red flag of a coming recession.

Emotional Attachment 

So, with at least as much bad or potentially bad news underlying the good, how and why is it that big investors typically shrug off all the bad news near the end of a bull rally? Psychology is one answer. As we’ve mentioned before, many investors remain “mentally stuck in the 90s” because they first started investing in the 80s and 90s, during the best long-term bull market in US history, and enjoyed great success. Nearly 30 years and two major market crashes later, it’s still the paradigm they’re still used to. They remain committed to it either because it seems logical (even in the face of mounting evidence to the contrary) or because they have an emotional attachment; it’s simply what they’re comfortable with.

Keep in mind, too, that many big investors tend to be competitive by nature. They have an athlete’s perspective and treat investing as a competitive sport. The trouble is, many get so focused on offense and trying to ring every last dime out of a bull market that they ignore or forget the importance of financial defense…until it’s too late.

But how long can these investors continue shaking off bad news and ignoring warning signs near the end of a cyclical bull rally? The answer is: sometimes for quite a while. Remember in 2007, it was widely known in February and March that the subprime mortgage crisis was coming, but it wasn’t until November that the markets started to drop.

The good news about this lag time is that it allows informed investors to make changes and decrease their risk in time to avoid getting caught in the next downdraft. Keep in mind that even after last year’s turmoil and losses, the market overall is still only down about 10% from its peak highs since the Financial Crisis. So, ask yourself: if you were going to make a change, doesn’t it make sense to do it at 10% rather than risk getting caught in a drop that history says could range between 40 and 70%? That, of course, is a rhetorical question.

*“Stocks Wrap Up Best January in 30 Years,” CNN Business, Jan. 31, 2019

**“Treasury Yields Fall Further After Fed Vows Patience,” CNBC, Jan. 31, 2019

***“Why the Fed’s Shift into ‘Superdoveland’ Looks Shaky After the Jobs Report,” MarketWatch, Feb. 1, 2019

Wall Street opens flat ahead of Alphabet results (Reuters)

Screen Shot 2019-02-04 at 9.10.42 AM.png(Reuters) – U.S. stocks opened little changed on Monday as investors took a wait-and-see stance after an earnings-heavy week which included strong U.S. jobs growth data, with Alphabet’s results expected after the bell.

The Dow Jones Industrial Average fell 1.77 points, or 0.01 percent, at the open to 25,062.12.

The S&P 500 opened lower by 0.04 points, or largely unchanged, at 2,706.49. The Nasdaq Composite gained 2.41 points, or 0.03 percent, to 7,266.28 at the opening bell.

Click here to read the full article:
https://www.reuters.com/article/us-usa-stocks/wall-street-opens-flat-ahead-of-alphabet-results-idUSKCN1PT175

US economy lost at least $6 billion to government shutdown: S&P (Reuters)

sugarhigh

(Reuters) – The U.S. economy lost at least $6 billion during the partial shutdown of the federal government due to lost productivity from furloughed workers and economic activity lost to outside business, S&P Global Ratings said on Friday.

President Donald Trump agreed on Friday to end the 35-day partial shutdown, the longest in history, without getting the $5.7 billion he had demanded from Congress for a border wall.

“Although this shutdown has ended, little agreement on Capitol Hill will likely weigh on business confidence and financial market sentiments,” S&P said in a news release.

Click here to read the full article:
https://www.reuters.com/article/us-usa-shutdown-s-p/u-s-economy-lost-at-least-6-billion-to-government-shutdown-sp-idUSKCN1PJ2MU

Fed Says Student Debt Has Hurt the U.S. Housing Market (Yahoo personal finance)

by Josh Mitchell
Wall Street Journal | January 16, 2019

The Federal Reserve has linked rising student debt to a drop in homeownership among young Americans and the flight of college graduates from rural areas, two big shifts that have helped reshape the U.S. economy.

The effect of student debt on the economy has been debated in recent years, as the total has soared to $1.5 trillion, surpassing Americans’ credit-card and car-loan bills. Congress and various White House administrations have pointed to federal student loans as a key way for Americans to pay for college and boost their career earnings. Critics have said the debt is damaging the economic prospects of a generation of Americans.

The Fed research published Wednesday didn’t offer a verdict on those assertions. But it showed that student debt is linked to key life decisions for some—including whether to buy a home and where to live.

Homeownership among people ages 24 to 32 fell 9 percentage points, to 36% from 45%, between 2005 and 2014, the Fed said. While many factors affected the homeowner rate, the Fed said 2 percentage points, or about a fifth, of the decline was tied directly to student debt. That translated into 400,000 borrowers who could have owned a home by 2014 but didn’t because of student loans.

Click here to read the full story:

https://finance.yahoo.com/news/fed-says-student-debt-hurt-225600242.html

China’s exports shrink most in two years, raising risks to global economy (Reuters)

screen shot 2019-01-14 at 8.41.28 amBEIJING (Reuters) – China’s exports unexpectedly fell the most in two years in December, while imports also contracted, pointing to further weakness in the world’s second-largest economy in 2019 and deteriorating global demand.

Click here for the full article:
https://www.reuters.com/article/us-china-economy-trade/chinas-exports-shrink-most-in-two-years-raising-risks-to-global-economy-idUSKCN1P8047

Will Markets Rebound in 2019 or is More Chaos in Store?

MarketCommentary2016-croppedSimply put, the stock market had a terrible 2018—its worst year since the Financial Crisis, by some measures.* So, what does 2019 have in store? No one knows for sure, of course, but by looking at the right details we can get a good idea of where the markets might be headed after a year of historic volatility. With that we’d like to share our 2019 Market Forecast, focusing specifically on three key areas: interest rates, the economy, and the stock market.

Interest Rates

Last month was the stock market’s worst December since the Great Depression. The turmoil was largely due to the Federal Reserve moving forward with another short-term interest rate hike despite the growing threat of a flattened yield curve and more criticism from the Oval Office. The Fed has stated it hopes to approve three additional short-term interest rate increases next year, and while many forecasters are saying that will happen, we say it won’t.

We believe there is an 80% chance the Fed might approve one rate hike in 2019, but only a 10% chance it will approve two, and a 0% chance it will approve three. There are many reasons for this, starting with that ever-increasing threat of a flattened yield curve—a challenge we first predicted three years ago. We knew that there would have to be enough economic growth and inflation for long-term interest rates to rise ahead of short-term rates in order to avoid the risk of a flat yield curve, which can cripple economic progress.

As we predicted, that consistent rise in long-term rates hasn’t happened for several reasons. When the Fed first started raising rates in December 2015 after holding them to near-zero for seven years as part of quantitative easing, the yield on the 10-Year Treasury rate was around 2.20%. Currently it’s at 2.74%, and only briefly topped 3% a few times in 2018.** In other words, the 10-Year is only 0.54% higher, while the Fed funds rate has gone up an entire 2%, leaving the yield curve now perilously close to flat.

This cautious dance between long- and short-term rates is, we believe, a demonstration of how the bond market is “smarter” than the stock market. Each time the Fed announced it was planning to raise short-term rates again, longer-term bonds would sell off, increasing longer term yields and thereby giving the Fed some room to raise rates without flattening the yield curve. However, in December the bond market said: “Enough is enough,” and this time bond yields didn’t rise to make room for the Fed’s next rate hike.

The bond market is basically saying, “We know we’re not going to get the level of economic growth needed to sustain higher interest rates,” and many economic forecasters agree with that analysis.

As you may know, on December 3rd the yield curve already became partially flat when yields on the 2-Year Treasury rate rose higher than yields on 5-Year Treasuries. A flat yield curve preceded both of the last two major market crashes, starting in 2000 and 2007, and is recognized by economists as a huge red flag of a coming recession.

Economy

With that in mind, the second part of our forecast for 2019 is that economic growth will, in fact, slow considerably and possibly even give way to a new recession by the end of the year. The evidence for this is compelling, and many other experts are predicting a new recession is in the works. A recent JP Morgan survey found that 75% of ultra-high net worth investors believe a recession will hit by 2020, with 21% of them predicting it will start in 2019.*** A recent CBS news article also notes that 82% of CFOs for US corporations are projecting a recession by 2020.

Perhaps the main reason is that these investors know that corporations have already ingested all the profits from the Trump Administration’s corporate tax cut. At 15%, that cut was the biggest “boost” provided by the new tax plan, and it helped GDP growth top 4 percent in the second quarter and hit 3.5% in the third quarter last year. But that effect won’t last, which means future growth is more dependent on individual tax cuts, which were only 3% and 4%. Yes, that gives consumers a little extra spending money, but not enough to sustain GDP growth rates of over 3% and 4%. Remember, too, that the biggest consumer demographic—Baby Boomers—are beyond their prime spending years; they’re more focused on paying off debts and saving for retirement, which also makes it harder to achieve the kind of GDP growth we had in the 90s. Even the Fed has forecast GDP growth settling back below 2% by 2020.****

There are many other factors pointing toward stalling growth and a possible recession in the coming year—along with a host of brewing geopolitical factors that could make the economic outlook for 2019 even bleaker. Those include, of course, the ongoing trade war with China, economic instability in Europe and Asia, the mounting federal deficit, and political turmoil in Washington—which is only likely to increase now that Democrats control the House.

Stock Market

Even if none of those situations escalates and leads to a tipping point for the stock market, remember that emotion is the market’s main driver, and that fear alone can have real consequences. Considering just how many “fear factors” are in play right now, the final piece of our forecast for 2019 is, indeed, a stock market drop. It may or may not be the long-overdue third major drop of our current secular bear market cycle, but either way we do believe the stock market will end this year lower than it began once again.

Now, is it possible we’ll see some more spikes and gains over the course of the year? Of course. In fact, it’s a safe bet that there will always be occasional good news throughout the year that gets Wall Street briefly excited. But we believe the spikes will prove to be just more of the extreme volatility we saw in 2018, and that ultimately the stock market will finish 2019 with another loss.

Wagging the Dog

In looking at all the details we’ve discussed, it’s important to remember that recessions and major market corrections have many different causes and symptoms, and that what we’re seeing now are a lot of symptoms with the potential to become causes. That’s how economics and financial markets work: sometimes the tail wags the dog until the dog starts wagging the tail.

For example, sometimes the bond market doesn’t think the economy has enough long-term growth potential so long-term interest rates come down and the yield curve gets flat. That’s a symptom of a possible recession. But sometimes the yield curve becomes flat because other influences don’t allow long-term interest rates to increase, and/or the Fed raises short-term rates too quickly. This is when the symptom can quickly become the cause: banks could stop lending because there’s not enough profit when the yield curve is flat, which would hit businesses and the housing market hard and create a domino effect that leads to an actual recession.

This same idea holds true for the stock market. Sometimes the stock market drops because a recession occurs, and the selloff is a symptom of the recession. But sometimes a volatile or tumbling stock market based on fears of stalling growth and a flattening yield curve (like we’re seeing now) can cause the recession, partly by creating the “reverse wealth effect.” Investors see their 401Ks shrinking and—regardless of whether they have more disposable income thanks to a tax cut or wage increase—they feel less wealthy, so they cut way back on spending and the economy shrinks into recession.

In the end, there are enough symptoms and potential causes of a major market downturn heading into the New Year that it’s really irrelevant whether the dog wags the tail or vice versa. With that in mind, investors who haven’t yet reduced their stock market risk and shifted their focus to income-generating financial strategies might want to consider making that their top New Year’s resolution before the narrowing window of opportunity closes.

*“US Stocks Remain on Track for Their Worst Year Since 2008,” NPR.org, Dec. 25, 2018
**“Yahoo Finance,” Dec. 27, 2018
***“75 Percent of the Ultra Rich Forecast a Recession in the Next Two Years,” MarketWatch.com, Sept. 19, 2018.
****FederalReserve.gov