It has been an interesting two months on financial markets. After the worst month of December for U.S. equites since the 1930s, we got the best January since 1987. Wild market swings on very little change in macro fundamentals. Obviously speculation over the popping of the equity bubble and forced unwinding of leveraged long positions drove panic selling in December. The panic was capped off after the December FOMC meeting at which Fed chair Jerome Powell seemed oblivious to the ongoing correction in equities. The relief rally off the December lows attained a gain +14% by the end of January when Powell & Company decided to do a 180-degree change in their interest rate outlook, adding further fuel to the rally. Rather than two more rate hikes in 2019, somehow between the December FOMC meeting and the January FOMC meeting the Fed Funds rate was deemed to have attained the neutral level (the rate consistent with long-run trend economic growth). Instead of saving the market in December with this revelation of interest rate neutrality, the Fed saved this bailout card for what may be the late stages of the current relief rally.
Macro data this week was actually strong, which makes the Fed’s decision to end the rate hike cycle even more incongruous with their “data driven focus”. Despite much delayed data due to the government shutdown, key manufacturing survey indexes came in strong. The Chicago Fed National Activity Index rose to 0.27 in December from 0.21 the prior month. The ISM PMI picked up to 56.6 in January after slowing to 54.1 the prior month (beating the consensus call for 54.3). In addition, the Non-Farm Payrolls number looked good, with 304k jobs added in January versus 222k the prior month and 170k expected. The only disappointment in the data this week was Consumer Confidence, which slipped to 120.2 in January from 126.6 (124.0 expected), as the stock market rout in December likely added to gloominess.
The Fed Once Again “Has Our Backs”?
The Federal Reserve is back into the game of managing equity markets. For a fleeting minute in 2018, it appeared that the Fed was ready to let markets trade off company fundamentals and economic data. By giving markets the impression in 2018 that “measured rate hikes” were in the cards for the foreseeable future, traders assumed that the Fed would not be supporting equity prices as in the past (non-Friendly Fed). However once traders began playing the short side of the equity market, the Fed quickly realized that the bubble they created cannot be left unattended. So not only has the Fed’s inappropriate monetary policy pushed U.S. equity index to goofy levels over the past few years, the FOMC (perhaps by ignorance) has again been creating winners and losers in the past months by proffering pro-cyclical commentaries directed to the markets. We are fed-up, again. If the Fed wants to make targeting the S&P 500 a policy objective, lets just come out of the closet and have Congress change the central bank’s mandate. The current “gaming” of Fed policy is creating exaggerated, speculative market swings. While fundamentals dominate in the long-run, many investors and managers hit risk limits – most recently due to Fed speak – that create losses. A discreet, yet transparent Fed (do we really need FOMC members to be financial Rock Stars?) will likely reduce equity market volatility as investors refocus on fundamentals and not gaming way-to-frequent Fed speak.
Where Do We Go From Here?
The old mantra is “Don’t Fight the Fed”. If indeed the Fed is once again signaling its support for equity markets by ending rate hikes, it would not be wise to be short-selling. At the same time, betting on risk assets, which are admittedly pretty close to being priced for perfection (has they have been since Trump’s election) is not likely the winning strategy after the +14% rally in the S&P 500. In effect, the market is saying that everything will play out fine in 2019:
• Central bankers will figure out the appropriate monetary policy
• The U.S. government shutdown will have a limited impact on the economy
• A hard Brexit will be avoided
• The Trade War will end with a lasting accord
• The economic slowdown will remain modest (relative to consensus forecasts)
In other words, they are a lot more variables that need to go right to keep equities afloat than the alternative. Our bet since last year is that 2018 was the beginning of a giant topping process in U.S. equites. A giant top to go along with the giant bubble-bull market since 2009. We demonstrated that the ends of all bull markets have seen major backing-and-filling saw-toothed declines (see Bear Market Tendencies from the week of December 21). The initial up-waves after the kick-off of prior bear markets have averaged about +7%, making the current up-wave of +14% exceptional (like everything else we have experienced over the past few years).
In the near-term the Fed wants people to believe it is “friendly” towards the markets, so we expect the “pain trade” (the direction that hurts the most investors/managers) to be rising equity prices. However, we cannot play defense and offensive at the same time in our strategies (without excessive, speculative market timing). We are continuing to focus on the long-term trade, which gives us a bearish bias (beyond whatever the current rally has left in it). In addition to the five bullet points above, we have a few more ongoing worries.
First, fiscal policy has fired all their bullets at this time. Trump got in his tax cut before the Democrats took over Congress. Getting more fiscal stimulus out of Washington, especially with a mixed White House and Congress, will take a major crisis. Remember in 2008, the TARP spending package was even voted down by Congress after the first vote. Don’t count on Federal spending / tax cuts to save markets until it’s too late. This is not going to matter to day-traders, but if a deep recession hits, this is one safety net that won’t catch us. By the same token, monetary policy is “spent” with less margin for rate cuts than at the end of prior expansions. However central bank monetary chicanery knows no limit, so another QE bail-out (or some new innovation in monetary policy) is always a possibility. It remains to be seen, in crashing markets, if (1) the Fed is willing to demonstrate that financial market management is a policy objective and (2) the Fed’s action will be credible in the eyes of investors to reverse selling.
Second is our on-going concern about equity valuations (or rather valuations of major U.S. equity index). The S&P 500 Price-to-EBITDA ratio remains near Tech Bubble highs, despite the Q4 price correction.
Again, valuations have not mattered for a long time. However over the long-term, a return-to-the-mean phenomenon always plays out. There is no new paradigm in which the S&P 500 will be permanently more expensive than we have known throughout stock market history! Long-term buy/hold investing is fine, as long as you rotate into stock classes that offer the best relative valuations. For us, these stocks classes include Emerging Market and oil stocks, and not the big U.S. index stocks.
Our third reason not to get aggressive today is technical price action. Forgetting about the daily price swings, a long-term weekly chart of the S&P 500 clearly shows the topping pattern that appears to be in place.
To maintain our bearish bias long-term, we’d need the S&P 500 to stay below its 40-week moving average, crossed to the downside last October. The 40-week is at 2742 on the S&P 500 as we write. It will be interesting, after six weeks of gains, what, if anything, will slow the equity gains before the S&P 500 gets to its 40-week moving average.
We have seen optimism return to the equity markets along will forced share re-purchases after many stoplosses were triggered in December. Sentiment reached washout levels, provoking a rally that most could not foresee in the December bloodshed. We have erred on the side of caution, moving into cash in most portfolios. Equities will enjoy the “Fed put” for a while, but the numerous variables listed above will not all play out nicely in 2019, as the market appears to be pricing in. Whether you are a Bull or a Bear, 2019 will offer a better buying opportunity later this year.