Stock Market Struggles, Recession Threat Minimal

Yesterday the market experienced a follow-through day according to Investor’s Business Daily, only to open sharply lower today and continue lower most of the day.  Overall, the action today increases the odds this correction is going to continue but there is little evidence, if any, we are going into a sustained bear market or recession.

The issue of the day revolves around the yield curve, which is a measure of interest rates at different maturities.  The difference between a 2-year rate and a 10-year rate is essentially zero and is close to inverting (short-term rates higher than long-term rates), which has historically been an early recession indicator.  That may not be the case in the current environment due to the pervasive and continuing low-interest rates here and around the world.  There is even talk of the U.S. eventually moving to a negative-interest rate environment like European and Japanese investors are experiencing.

The Federal Reserve can fix the yield curve inversion by lowering short term rates, which is why the recession warning may be misplaced.  Other parts of the U.S. economy are doing fine.

The more interesting development over the last several weeks is the upward price movement of assets that benefit from inflation.  Gold has move higher and so have some real estate assets.  This may be an indication that if a recession does materialize, investors believe it will be met with a massive round of money creation through both monetary (The Fed) and fiscal (president/congress) policies.

My favorite indicator for the health of the stock market is the behavior of leading stocks.  Below is a chart of 12 top performing stock in 2019, several of them are younger companies or even recent IPOs.  There are many others I could have included.  Generally this type of company is the first to see massive declines when risk leaves the market.  Even after recent selling these stocks are holding up.

Leading Stocks Remain at the top of their trading range.

When the price action for leading stocks I follow start to deteriorate in unexpected ways, I become more concerned about future market action.  That is not how I feel today.

The conversations I have with business leaders and investors suggest there are a lot of opportunities to go after right now and government tax and regulatory policy in the U.S. is favorable.  Overall their outlook is positive.  I think this market will turn positive too, once this correction has run its course.

The Fed Is A Hostage

The Fed is on the verge of a new cycle of cutting interest rates.  This free Macro Watch video, from Richard Duncan Economics, explains what has forced this important shift in Monetary Policy and what lower interest rates could mean for the stock market and the price of gold.

Dightman Capital subscribes to Richard Duncan’s economic service.  We highly recommend his introductory videos and his periodic updates to those individuals that want to develop a better understanding of the current global economic system.  This has provided Dightman Capital with a concrete understanding of money flows via global trade and its impact on trade deficits or surpluses, the relationships and impact on currency demand, and many other important global economic variables.

If you are interested in modern global economics and want to better understand the subject, consider subscribing to his service.  If you read his blog he often provides a discount code.

 

Q2 2019 Market & Economic Review

Volatility returned to the U.S. stock market during the second quarter of 2019.  By the end of May, broad U.S. stock indexes were below levels from the start of April.  The S&P 500 actually traded below its 200 day moving average before a rally kicked off in June which ultimately delivered gains for the quarter.

During the period The Fed moved to a more dovish position, even hinting a rate cut may be needed to keep the economy growing.  Data since The Fed raised rates has shown economic growth moderating and corporate earnings have slowing.  We have not seen data suggesting inflation is on the rise which has helped the The Fed back off the need to raise rates.  On the contrary, policy makers appear concerned about being the cause of an unnecessary slowdown, or even a recession, by raising rates too far too fast.

In terms of fiscal policy, there is little happening in congress regarding an infrastructure bill, or other spending programs, and there is little chance that will change before the 2020 elections.  As long as interest rates remain attractive, lower taxes and regulatory reform seem to be working.  In terms of the impact from tariffs, so far they appear muted but that could change.  Eventually consumers can expect producers and distributors to start passing on the costs they are reportedly absorbing.

As we move into Q3 it appears we have stable and moderate economic growth combined with moderate inflation, an ideal condition for stocks and bonds.  As a result, we have started Q3 strong and look poised to move further into new high territory.

Will A Trade War Take Down The U.S. Stock Market?

What is the biggest risk?

The U.S. stock market is under pressure on concerns over US/China trade talks.  Last week stocks attempted a recovery, but a breakdown in trade talks has increased selling pressure this week.

Given the circumstances, U.S. stocks have held up well.  The topic is not new; the market has had time to consider various scenarios.  Overall, a restriction in trade is bad for the U.S. and China.  Interestingly, so far, the stock market seems to be taking it in stride.  In terms of the major U.S. stock indexes, the selling has been less volatile and on lower volume than we saw last fall when the Q4 correction began.

After a strong rally through April, the stock market is due for a rest.

More importantly, perhaps, is the action of many leading stocks.  They remain in constructive price patterns and are not showing evidence of widespread panic selling.  When leading stocks start to crumble the likelihood of a deeper and prolonged correction increases.

In terms of the stock market performance for the balance of 2019, it may come down to how well U.S. companies have prepared for an extended trade war.  We have already heard from companies like CISCO who has become less reliant on manufacturing in China.  Other manufactures have been reported to be making adjustments to their supply chain out of China as well.

With the push to bring manufacturing back to the U.S. through reduced regulations and tax incentives, U.S. manufacturers in China have more flexibility to deal with the current trade challenges.  For some companies, however, the investment made in China is a long-term commitment.  For those companies and the global economy in general, we can hope for a speedy resolution.

The big worry is whether U.S. companies will suffer an earnings recession due to restricted trade with China.  This is the biggest risk to the U.S. stock market and if one is expected to develop, expect a deeper correction.

China’s move to devalue the Yuan may turn out to be a net positive for the U.S. by reducing import costs, potentially taking some of the sting out higher prices from tariffs.

We should prepare for economic pain.  China is a leading supplier of some rare earth minerals used in high-tech components and materials; expect China to restrict access by U.S.companies in China as well as exports to the U.S.

If there was a time for the U.S. to address our concerns with China trade, it is now.  With tax incentives to onshore corporate money and the healthiest developed economy in the world, the U.S. is in a strong position.  Our economy is on a mild acceleration path whereas China remains on a decelerating path.

The following charts are examples of leading stocks from my Watch List Indicator that are holding up well given current market concerns.  Interested in learning more about my Watch List Indicator? Email me at info@dightmancapital.com.

No specific investment recommendations have been made to any person or entity in this article. Investing involves risk including the loss of capital. Conduct your own research before making any investment decision, or work with an adviser like me.  Call Kelly at 877-874-1133 to schedule a phone call.

Q1 2019 Market & Economic Review

U.S. stocks experienced a strong rally in the first quarter of 2019.  The biggest performance driver came from the Federal Reserve pausing their interest hikes.  Between 2017 and 2018 the Fed raised the Fed Funds rate approximately 8 times and until recently expected to continue raising rates into 2019.  The sell-off in Q4 was largely attributed to the Fed moving too fast with interest rates combined with lofty stock valuations and a mild slowdown in economic activity.  The Fed is also in the process of reducing their balance sheet by selling back the bonds they purchased during their QE program.  They reached a level of $50 billion per month but have since slowed the program dramatically and expect to put it on hold soon.  The Fed actions suggest that while the U.S. economy continues to improve, it remains in a fragile state.

Economically we are experiencing a mild slow-down as reported by Doug Short of Advisor Perspectives in his “The Big Four Economic Indicators”.  For example, January Real Income experienced a sizable decline, but that was after 8 months of growth and followed December’s increase of 1.06%.  Real Sales in February also dipped and 4 out of the last 11 reports have shown declines.  Industrial Production appears to be pausing, with a combination of 2 shallow declines and one small increase during the last three months.  Employment remains the shining star, but February almost reported a decline.  Here’s a look at recent numbers (several reports for March and one for February still need to be updated).

In a report by State Street Global Advisors, they reported confidence of North American investors shows a slight improvement while confidence for European investors declined further.  In the U.S. investors appear skeptical.  In Europe they are faced with BREXIT and a host of other challenges, including violent protest in Paris.

Regarding all the talk about the Yield Curve inversion, we remain in an extremely low interest-rate environment which may reduce the predictability of a future recession a yield curve inversion has had in the past.  The other factor to note is the long lead time between the inversion and the start of a recession (16 months since 1976).

We are at the beginning of Q1 corporate earnings season.  As of last Friday, 25 companies have already reported quarterly earnings.  Overall the market expects a decline in earnings compared to a year ago.  However, as of April 5th industry analysts project a 8% price increase for the S&P 500 over the next 12 months according to FactSet.  During the last 5 years analysts have overestimated their 1-year price target by 1.5%.  The more constructive takeaway here may be the directional move versus the magnitude of the move, especially give the gains produces in Q1.

There are two developments currently working their way through the political process that could have a positive impact on the market.  A favorable resolution to trade negotiations with China and talk of an infrastructure bill, potentially ready for a vote this summer.  Positive developments in these two areas would go a long way toward helping the economy get back onto a stronger growth trajectory.

Overall, I feel pretty good about the economy and markets.

Spare Us the GDP Agony – Brian Wesbury, First Trust

Real GDP grew at a 2.6% annual rate in the fourth quarter, and while some analysts are overly occupied with this “slowdown” from the second and third quarter, we think time will prove it statistical noise.  Even at 2.6%, the pace is a step up from the Plow Horse 2.2% annual rate from mid-2009 (when the recovery started) through early 2017.

Fourth quarter real GDP growth happened in spite of a huge decline in retail sales for December (itself suspicious and likely to be revised higher, as job growth and retailer reports painted a different picture).  Moreover, business investment grew at a 6.2% rate in Q4 and was up 7.2% in 2018, the fastest calendar growth for any year since 2011.

In 2018 as a whole, real GDP grew at the fastest pace for any calendar year since 2005.  And what’s even more impressive is that year-over-year real GDP growth has accelerated in every quarter since the beginning of 2017.  The first quarter of 2017 was up just 1.9% from a year earlier while subsequent quarters showed four-quarter growth of 2.1%, 2.3%, 2.5%, 2.6%, 2.9%, 3.0% and now 3.1%. We expect Q1-2019 GDP to slow like many other Q1s in recent years, meaning this impressive streak may come to an end.  But this too is just statistical noise, and the YOY trend should remain around 3%+ over coming quarters.

“Potential growth,” a measure of how fast the economy can grow when the unemployment rate is stable, has also improved. It’s calculated using “Okun’s Law,” which says that for every 1% per year the economy grows faster than its potential rate, the jobless rate will drop by 0.5 points.

Working backward from the unemployment declines of recent years shows that potential GDP growth has picked up.  From mid-2010 thru mid-2017, potential real GDP grew at just a 0.6% annual rate.  But in 2018, with real GDP growth of 3.1% while the jobless rate dropped only 0.3 points, potential growth was 2.5%.

The worst part of the GDP story is the political gamesmanship of those who say real GDP only grew 2.9% in 2018.  These data distorters are not looking at the size of the economy in the fourth quarter of 2018 compared to the fourth quarter of 2017; instead, they are comparing production through all of 2018 to production in all of 2017.

Here’s why their method is misleading.  Let’s say that in the first quarter of Year 1 a company earns $100 per share then earnings slip to $99 in Q2, $98 in Q3 and $97 in Q4.  Then, in Year 2, earnings start at $97 per share in Q1, go to $98 in Q2, $99 in Q3 and finally back to $100 in Q4.  Overall, for two years earnings per share were flat.  But that’s because earnings growth was bad in Year 1 and good in Year 2.  But the misleading method used by those saying the economy only grew 2.9% in 2018 would compare total earnings in Year 2 ($394) to total earnings in Year 1 ($394) and say the company had zero growth in Year 2!  But that’s nonsense.  What matters in measuring Year 2 is how much earnings grew during the year, and in our example, that was 3.1% in Year 2.

More commentary from Brian Wesbury can be found on his blog.

Inspiring Podcast by Great Investing Minds

Check out this podcast by one of our top investment providers, ARK Investment Management.  In Episode 9 of FYI (For Your Innovation) you are going to hear from three people.  The conversation is led by moderator James Wang (ARK Analyst) as he facilitates a conversation between Catherine Wood (ARK CEO/CIO) and Dr. Art Laffer (Laffer Curve Economist).  During the 33-minute talk they cover innovation cycles, tax policy, global trade, genetics and cancer.  A truly inspiring, power packed podcast, on investing in disruptive innovation.

Now We Need A Follow-Through Day

True, some of the largest single-day stock market gains come during bear markets.  December 26th, 2018 marks the first time the Dow Jones industrial average gain 1,000 point in a single session.  Experienced stock market investors know, one big up day does not mark the end of a downtrend.

Investors should also note, Wednesday’s advance was the first day of a rally attempt.  If stocks can stage another meaningful advance in the next 7 trading days, preferably on day 4 through 7, the worst of the selling may be behind us.  Rally attempts followed by follow-through days are no guarantee, but they often signal the start of a new uptrend.

Source: Investors Business Daily

There were other signs of optimism in Wednesday’s big advance.  Stocks from retails, software, internet and consumer spending led the market’s upside.  Growth stocks are preferred over mature, defensive sectors when leading the market out of its first bear-market correction in seven years.

The ratio of advancing stocks to declining stocks delivered wide breadth, another positive.  Nasdaq winners outpaced losers nearly 4-to-1.  On the NYSE, winners led by 5-to-1.

Also of note, there is a tiny but growing group of quality growth companies forming attractive chart patterns.  These companies feature strong fundamentals, especially in terms of sales and earnings growth.  Often, they are smaller, younger companies introducing new products and services.  It is one of the more encouraging signs given the renaissance of innovation and entrepreneurship underway, something we have not experienced to this degree since the 90’s.

If stocks can hold levels this week and deliver a strong rally on any day next week, that would deliver a perfect follow-though day and improve the odds of a new rally as we enter 2019.

Stocks Turn Bearish

The investment environment continues to deteriorate despite the pickup in economic activity in the U.S. the last couple of years.  As the Big Four Indicators I highlighted recently show, the U.S. economy continues to move in the right direction.

Despite the U.S. economy doing well, international economies are performing poorly with few catalysts outside of fiscal or monetary policy to drive them higher.    Europe is in disarray and in a speech yesterday, China’s Premier Xi, signaled little trade flexibility.

In terms of Monetary Policy (central banks), we are in uncharted territory.  On the one hand, market intervention potentially provides a mechanism to avoid financial contagion.  On the other hand, it has added a lot of debt to the global economy and relies on globalization to keep the party going.  The US and Europe are looking to reduce their exposure to globalization trends.

In terms of Fiscal Policy (government revenue/spending), deficit spending is projected for many years which is a concern after a 9-year economic recovery.

Constant increases in government debt, whether through monetary or fiscal policy, are likely to be a fixture of the 21st century economy.  Investors should expect more market intervention going forward.  My job is to manage the effects it has on investments and purchasing power.  Right now, it is looking like global markets are bracing for another round of asset deflation.

The biggest telltale sign of concern about the potential for further asset deflation is not coming from stocks, it is coming from bonds.  With the Fed now selling $50 billion dollars’ worth of bonds every month through Quantitative Tightening (the opposite of QE), analysts expected yields to go up and bond prices to fall.  That is not happening.  Money is moving to the safety of the 10-year Treasury bond.  Money flows to 10-year Treasuries when it is concerned about asset deflation.  10-year Treasury bonds are again yielding less than 3%!  Yields on the 10-year would be moving higher, and prices lower, if the bond market was expecting economic growth to continue.

Markets are signaling a high likelihood of ongoing asset price weakness. With each passing day more assets are breaking-down through price support levels.   It is entirely possible all of 2017 gains will eventually be erased although stocks still hold on to most of them at this point.

For this reason, I believe it is a good time to be a bit more defensive and raise cash levels.  Once the market settles down, available cash provides the ability to purchase growth investments at potentially lower prices.  Even if you end up reinvesting at higher levels, that is a price worth paying if it provides peace of mind during a turbulent period in the global economy.

The Big Four Indicators (12/7/18)

The Dshort website (part of Advisor Perspectives) hosts an incredible about of economic and market data.  Periodically I feature some of their work, specifically The Big Four Indicators update.  Taken together, these four indicators covering income, employment, retail sales and industrial production are thought to be an excellent monitor of the overall health and direction of the U.S. economy.

Advisor Perspectives, Jill Mislinski, December 7, 2018

The recovery from the Great Recession has been slow but positive.  The most encouraging development recently has been the strength coming from industrial production (purple line).