Yesterday was an ugly reminder of the fourth quarter. The Nasdaq fell 3.4%, its worst decline since December 4th. The S&P 500 wasn’t much better. The big falls came on the announcement that Trump was considering raising tariffs on a further $300 bn of Chinese imports following the failure of negotiations last week. Investors are anxious that the trade war may continue to escalate and impact the global economy. One economist summarized the situation this way, saying “The confrontation has now escalated to a battle of testosterone between two leaders who believe they have much to prove to their constituents. But the longer this exhibition of chest-beating lasts, the greater the odds of a US, if not global, recession”.
FINSUM: Though recently we have been more placid, a couple of months ago we were worried that a deal might be hard to complete because of how much China has on the line politically. The country’s unelected leaders need to keep their people happy, which means the stakes are incredibly high for them.
What is the biggest threat to the bull market? Is it a recession, high valuations, interest rate volatility? In reality, the biggest threat to the bull market might be rearing its ugly head now—a trade war. Trade tensions between the US and China have skyrocketed again this week and it has investors worried that there could be a global slowdown in trading which would sink the economy. In fact, that is the point that some don’t understand—it is not just about whether the US and China close a deal in the near term, it is about how the trade tensions the US and China create percolate through the global economy. Astute market watchers will have noticed new data out of China shows that exports have dropped, a sign of potential weakening.
FINSUM: We think cooler heads will prevail and the US and China will get a deal done. Our expectation is that it will not be ground-breaking in scope, but that it will be enough so that both countries can claim victory and investors can happily put these tensions in the rear view mirror.
One of the behaviors that we like to follow to see the underlying health of markets is whether investors are “buying the dip”. Such behavior tends to indicate a fundamental belief in the direction of the market. Therefore, the recent drop off in investors doing so is worrying, but not for the reason that seems obvious. The lack of buy the dip is because until this week, the market had rarely fallen this year. That has meant buying behavior has been concentrated in the hands of bulls not afraid the buy into a rich market, which left many discount-seekers looking from the outside in. Now, many top analysts, and likely investors alongside them, have turned bearish.
FINSUM: The velocity of the market’s gains this year has been very impressive, but it naturally makes a lot of people worry it could come down just as fast.
Stocks are once again nearing all-time highs, which is understandably making investors nervous about a repeat of the fourth quarter occurring. While that fear is healthy, the reality is that the underlying conditions of the market are a world different now. Not only are valuations lower, but the economy is looking robust, and perhaps most importantly of all, the Fed has let off the gas pedal with hikes, which puts recession risk much lower. All of these factors seem to conspire to make a perfect environment for stock price appreciation.
FINSUM: Anyone who reads FINSUM knows we lean towards bearish news, but the truth is that our better judgment is telling us that now is probably a time to be optimistic, as the trifecta of reasonable valuations, a solid/strong economy, and a dovish Fed, are in place.
There have been a lot of bullish indicators lately, and not just in share prices rising. However, there is a big warning sign that investors need to be paying attention to. One of the challenges of assessing corporate earnings is to get a feel for where things are really headed when the whole Wall Street reporting mechanism is stacked to make you think companies are always outperforming. One way to do so is to look at spreads between GAAP earnings and so-called “adjusted earnings”, or the doctored earnings companies love to show to make themselves appear more attractive. The wider the spread, the more companies are reaching to appear as though things look good. This, therefore, makes it a bellwether for how earnings and the economy are really trending. The spread between the two types of earnings stood at $200 bn for year-end 2018, the highest level since 2010.
FINSUM: This is not a perfect proxy, but it is certainly indicative, and the indication right now is not positive.