Bear Markets Can Occur Even Without a Recession
"Some say the world will end in fire,
Some say in ice.
From what I've tasted of desire
I hold with those who favor fire.
But if it had to perish twice,
I think I know enough of hate
To say that for destruction ice
Is also great
And would suffice."
-- Robert Frost, Fire and Ice
I was privileged on Saturday night to listen to James Taylor sing at Donald Trump's Mar a Lago home in Palm Beach, Fla. "Sweet Baby James" hasn't lost a step, and sang his classic Fire and Rain:
"Oh, I've seen fire and I've seen rain
I've seen sunny days that I thought would never end
I've seen lonely times when I could not find a friend
But I always thought that I'd see you again."
-- James Taylor, Fire and Rain
In the middle of Fire and Rain, my mind wandered to late investing legend Barton Biggs' profoundly important 1997 essay Fire and Ice, written when he was Morgan Stanley Asset Management's global strategist.
Biggs took the title from the Robert Frost poem above, which deals with a familiar question about the world's fate -- whether it will end in fire or ice. As Biggs wrote:
'While most people believe that fire (inflation) is what destroys markets, ice, as Frost put it, 'is also great and would suffice.'
Ice is loss of pricing power and a world where prices are as likely to go down as up. Ice is an erosion of profits. Ice is excess capacity. Ice is developing countries with low-cost factories and huge (labor) forces."
-- Barton Biggs, A World Lit Only By Fire? (Sept. 22, 1997)
The Three Questions
"Do me wrong, do me right.
Go on and tell me lies but hold me tight.
Save your goodbyes for the morning light,
But don't let me be lonely tonight."
-- James Taylor, Don't Let Me Be Lonely Tonight
My bearish market view for 2016-17 has been framed by the answers to the following questions, which I ask myself every morning:
* In a paperless and cloudy world, are investors and citizens alike as safe as the markets assume we are?
* In a flat, networked and interconnected world, is it even possible for America to be an "oasis of prosperity" and a driver or engine of global economic growth?
* With geopolitical coordination of the G-8 at an all-time low, if the wheels do come off, how slow and inept will the reaction be?
I don't find the answers to any of these questions as reasons to be optimistic right now about the U.S. stock market's outlook.
Numerous Outcomes (Many Adverse) Lie Ahead
"Well, I'm a demolition derby
A hefty hunk of steaming junk."
-- James Taylor, Steamroller
In the four decades I've been investing, I can't recall a time when there were so many possible market and economic outcomes, many of them adverse. Our markets and economies have never been so monetary-policy dependent, as our fiscal authorities have never been so partisan and inert.
Quantitative Easing and the Zero Interest Rate Policy were successful in trickling up to the S&P 500, although that didn't trickle down to the average Joe. Our markets responded exuberantly over the past six years, but I'm fearful that a further drop in U.S. stocks could now run that "movie" in reverse -- triggering a "negative wealth effect" and bringing on a recession.
The risks and unintended consequences of ever-lower interest rates are rising. For example:
* Many companies have abandoned capital spending in favor of financial engineering.
* The risk of "saving ourselves into a recession" (i.e. the "paradox of thrift") is expanding.
* Low interest rates could cause cash hoarding, lowering personal-consumption expenditures.
* The "Ah-Ha Moment," in which investors lose faith in central banks, might be at hand.
* Bank net-interest margins and profitability could become challenged, and lending might be curtailed.
Most importantly, I'm fearful that years of artificially low interest rates have pulled forward economic activity and corporate sales/profits. I continue to see a 35% chance of a "garden-variety" recession and a 15% chance of a deeper recession.
The Technicals
The U.S. stock market's technical condition has been deteriorating over the last 15 months. The market's leadership has faltered, moving averages have been broken and most importantly, stocks hit their final top last spring amid narrowing leadership and eroding breadth.
In the meantime, the quants began to increasingly dominate the trading landscape. Their machines and algos (with leveraged ETFs' cooperation) routinely exaggerated short-term market movements that often got reversed post-haste in the market that's without memory from day to day.
These antics also occasionally disrupted the market by producing major and minor "flash crashes." These were likely a contributing factor to retail investors' reduced confidence, as seen by individual investors' continuous withdrawals out of domestic equity funds.
The Fundamentals
Meanwhile, the fundamentals have deteriorated, but concerns that the fixed-income market is expressing aren't seeping into stocks.
Slowdowns in the once-rapidly growing "BRICs" -- Brazil, Russia, India and China -- have upset commodity prices (especially those of energy-related commodities). This has resulted in an "export" of lower economic activity and reduced profits to the developed world.
As a result of all of the above, "ice" is now appearing everywhere. We're seeing it in the negative real and absolute interest rates around the world and in the widening spreads between investment-grade and high-yield debt. And we're seeing it in the absence of corporate pricing power and the wobbly global economic growth.
As these charts show, consensus S&P 500 profit forecasts have moved steadily lower:
Source: Minack Advisors, IBES/Datastream
Source: Minack Advisors, IBES/Datastream
Trouble Ahead, Trouble Behind
"One man gathers what another man spills."
-- Grateful Dead, St. Stephen
Profit margins look like they're about to decline and "mean-revert." In fact, six to 10 business sectors already experienced year-over-year margin drops during the fourth quarter. The reasons for this include the fact that:
* The U.S. dollar has strengthened over the last year.
* There's no corporate pricing power.
* Sales are stagnating.
* Wages are slowly rising.
* Productivity gains have likely peaked.
* Unit labor costs are going up.
These two charts illustrate the problem:
Source: BEA, Standard & Poor's, Bloomberg, NBER; Minack Advisors
Source: BEA, Standard & Poor's, Bloomberg, NBER; Minack Advisors
Shaky Earnings
The acceleration of downward earnings revisions has outpaced the major market indices' modest 10% decline. So, valuations have grown ever richer and the market's PEG ratio is at an all-time high of 1.7x:
Source: Bloomberg, BEA, NBER, Standard & Poor's
Source: Bloomberg, BEA, NBER, Standard & Poor's
The Bottom Line
"Now the first of December was covered with snow
And so was the turnpike from Stockbridge to Boston.
Though the Berkshires seemed dreamlike on account of that frosting,
With 10 miles behind me and 10,000 more to go."
-- James Taylor, Sweet Baby James
Investors should fear today's "ice," the period of substandard economic activity and tepid profit growth that's likely ahead.
As I've often noted, leveraged ETFs and machines and algos who are agnostic to balance sheets, income statements and private market value now dominate our markets. These "investment strategies of market mass destruction" exaggerate short-term moves, send false messages and blemish the value of stock charts and technical analysis.
I believe that we're currently in a contra-rally that might continue a bit further following the S&P 500's recent, second successful test of its 1,812 low on Jan. 20. However, it remains my contention that the key index began the process of making an important, broad top nine months ago. So, any rallies are to be sold.
I remain modestly bullish for the near term and bearish for the intermediate term. I expect the S&P 500 to decline by a low-double-digit percentage for 2016 as a whole. However, I'm currently positioned only slightly net short -- preferring to see a more rapid buildup in optimistic investor sentiment before expanding my net exposure.
The 2009-2015 bull market reflected a recovery from the 2008 crash, as well as stocks' upward revaluations based on investors' realization that interest rates would probably remain "low for long" by historic standards. But the market's recent "re-rating" of stocks downward seems to reflect a recognition that corporate profits will be "lower for longer," too.
Our recent market weakness might also reflect investors' loss of confidence in central banks, as well as concerns that U.S. monetary policy has lost its effectiveness and/or simply pulled economic activity and corporate sales and profits forward. Again, I call this the "Ah-Ha Moment."
Lastly, while the odds of a recession appear to be mounting, it's important to note that a recession isn't necessarily a precondition for a bear market.
Bear markets can occur even if America fails to fall into a recession, as happened in 1962, 1966, 1987 and 1998. As legendary technical analyst Wally Deemer (a colleague of mine at Putnam in the 1970s) once put it: "You don't buy GDP futures. You buy S&P 500 futures."
