Market Correction and Posture Leading into 2019
As of Monday, December 17, 2018 the major market indexes, including the S&P 500 index are testing their previous 12-month lows. Fundamentally the economy appears strong enough to engage in correction tests of 10-15% without flashing signs of a recession. However, from a technically standpoint, it’s important that the S&P 500 remains above 2532 and the Dow Jones Industrial Average remains above 23,500. Otherwise, it will confirm a longer-term decline in search of a new bottom. As of this writing the Dow Jones Industrial Average stands at 23,592, while the S&P 500 closed at 2545.
Earnings growth is expected to slow meaningfully in 2019 as tax benefits roll off, the economy decelerates to a more sustainable pace and oil prices remain muted. This has led to fear of an outright earnings-recession, though according to the equity strategy team at Credit Suisse, this bearish prognostication is entirely out of sync with current economic data. We shall see. Nevertheless, one cannot be caught behind the curve if the economy slows too quickly. For this reason, some hedging seems warranted, even if we are overdue a post-correction short-term rally.
To hedge against current risk, I have moved portfolios into an overweighting of gold stocks, cash and emerging market equities. This has worked well. The following trailing three-month chart from yahoo finance shown below illustrates the outperformance of the Brazil (green), and gold miners Index (yellow) compared to the S&P 500 index (blue).
Bottoming Out or Not
According to Market Edge technical analysis, we are approaching a tradeable bottom. However, if we begin to move below technical support levels an increase in additional hedges will occur. If we hold here at key technical support on heavy volume portfolio additions of high quality dividend payers will be added until the market regains greater upside stability.
Politics, the Federal Debt and Growth
The Trump administration is approaching the same federal debt problem President George H.W. Bush battled during his administration. Given the size of the growing federal debt, GDP must grow faster than the federal debt, in order to repress investor fears of slow growth. Otherwise tax increases must be considered. President George H. W. Bush chose to courageously raise taxes. He was a one-term President.
President Trump has chosen to courageously borrow billions more for faster economic growth, a Ronald Reagan tactic-but with a twist. Working with Congress, President Trump has chosen to lower taxes to stimulate the economy for a short time frame. U.S. GDP has risen in response to tax cuts. However, now investors worry of a ballooning federal deficit as tax cuts fade and other economic problems come into view. This perfect storm scenario would help the Democrats and hinder a second Trump term. These compounding problems include an unending trade war with China, slower economic growth in Europe, structural slow growth in the United Kingdom, Italy, China and the U.S. , lower corporate and consumer spending, higher interest rates, higher taxes, wage-rate inflations, weakness in housing, and a flat yield curve which could lead to an inverted yield curve which could lead to a recession. Oh, and a government shutdown which strangely could help the Republicans if it extends economic weakness into 2019 leading a strong economic rebound that phases into half of 2019 and all of 2020 and beyond. FYI; that makes two political parties hoping for a strategic slowdown. Who knew, right?
We are therefore left with two simplistic future-world possibilities
The first is a world of burgeoning federal debt relative to U.S. GDP growth. In such a world the dollar declines, market volatility spikes, and it becomes harder and harder to keep interest rates low, all due to funding the debt. In such a world, gold, international stocks, and emerging market stocks benefit from a weaker dollar. In such a world, emerging-market companies that borrow money in dollars win big because they can pay their dollar denominated debt back in cheaper dollars.
In the second future-world, the U.S. GDP grows faster than the size of the federal debt. Again, this is Ronald Reagan’s world. In such a world the dollar remains relatively strong, U.S. stocks experience greater volatility due to the possibility of a first-world scenario, and investors again favor growth over defensive portfolios. In this second-world scenario an appropriate correction can act to test, reset, and change investor preferences initially from growth to value-based growth and income equities before a final phase of growth takes hold again.
Our current portfolios sport an asset allocation built upon the idea that future-world-two is the most likely outcome. However, with the possibility of a recession now estimated at some 30%, a degree of hedging against future-world-one is necessary. One analyst recently called the tug of war between both future worlds as trench warfare; that is, up and down price action with neither side winning a clear victory.
Your Metric for Who’s Winning the Battle of Future Worlds
As I have stated often, the closer the 10-year treasury comes to yielding 3.5% or more, the more likely one can expect future-world-one to win out. Earlier this year the 10-year treasury peaked at around 3.24%, though it currently sports a yield of closer to 2.9 percent.
As the data below illustrates, each year the stock market moves up to test the high end of its optically fair-value trading range. Thereafter investors worry of over-valuation and test the lows for the year. The SPY, (S&P 500 Index ETF) currently sports a value of approximately 2545 as of this writing. The data show the high and low trading range for each year going back to 2012. Note: This is approximate historic trading range information provided Daily Graphs from 2012 to 2018.
S&P Index ETF High Low
2012 1480 1250
2013 1840 1390
2014 2120 1730
2015 2130 1820
2016 2280 1810
2017 2680 2220
2018 2930 2532 as of this writing
Important note: Past performance is no indicator of future results. Moreover, volatility ranges change significantly every year. It should also be recognized that the tame frame chosen incudes a period under quantities easing (QE) while we are currently entering a period under quantitative tightening (QT). You can find out more about QE or QT by going to Wikiwand.com
Because the current market correction is more technical than fundamental at this point, it may be valuable to know that all corrections are unsettling fast while most all uptrends are lazy-daze slow movements to the upside. So, it’s not important if you hear some prognosticator state that we are in a bear market or structural bull market, which by the way is the stated case by one of Wallstreet’s largest firms. In 2019 U.S. The nation’s GDP is expected to remain in a growth phase this year and next though slowing from an estimated 3.1% growth rate to just 1.5 percent. Such a movement, if it occurs, does not a recession make.
Finally, according to Market Edge Technical Service, the Cyclical Trend Index is flashing bullish signs of a rebound over the next three months. Nevertheless, it is likely that sometime in the first quarter of 2019 the final spike down in this corrective phase may occur. If so a print into the 2300-2400 level may be needed to create such panic that most sellers have been washed out of the market, accommodating a bottoming process that resets a move toward an upside trend.
Thank you for your continued faith and trust.
Investors should be aware that there are risks inherent in all investments such as fluctuations in investment principal. Past performance is not a guarantee of future results. Asset allocation cannot assure a profit nor protect against loss. Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. Views expressed in this newsletter may not reflect the views of Bolton Global Capital or Bolton Global Asset Management. The information provided her is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. VW1/VWA00231.