Q2 2019 Market Update: Beware of the Exhausted Market

It’s unavoidable to discuss world events without mentioning the occupant of the Oval Office, the autocrat wannabe. He reportedly is obsessed with the stock market as a measure of his success as president. As such, his media manipulation extends to investors. With every significant drop in the market, he (or his treasury secretary) hints that a breakthrough in trade negotiations with China is imminent, which has repeatedly caused stock prices to rebound. He also has pressured the (supposedly independent) Federal Reserve to cut its fed funds rate to boost the economy and stock market (and has nominated board candidates who are likely to push for lower interest rates). Yet, he boasts that under his “leadership,” the economy has never been so strong. (Then why does it need monetary stimulus?)
Instead, investors should avoid the shell game and focus on the extreme excesses in the stock market and the rapidly weakening corporate earnings and global economy. Major international stock markets peaked 18 months ago, economies around the world are stagnant or turning down, and conditions in the U.S. are decelerating. After economic growth (in GDP) of 3.1% in the first quarter of 2019, the New York and Atlanta Federal Reserve economic forecasts for the current quarter are for only 1.5% and 1.4% growth, respectively.
Corporate earnings also are deteriorating rapidly. In recent years, companies have pulled various tricks to manipulate reported earnings per share higher (and boost share prices, which benefits company executives). The lack of accounting integrity at major companies has become shameful. Companies exclude large expenses, such as write-downs of overpriced assets from corporate acquisitions, as well as executive compensation that is paid in restricted stock and stock options (now one of the largest expenses for many companies). In addition, borrowing huge amounts of money to repurchase shares on the open market has reduced the number of shares and inflated reported earnings per share at many companies. On a price-to-sales basis (which is almost impossible to manipulate), the stock market is nearly the most expensive in the past century.
Even these dubious reported earnings per share are softening rapidly. One of the many tricks that companies have pulled has been to reduce their “guidance” to stock analysts for the estimated earnings per share (EPS) in the current three-month period. Then, when the quarterly results are announced, the actual EPS “beat” the (low-balled) consensus estimate of the analysts (amazing!), which usually causes the company’s stock to rise. And yet, Bloomberg reported that 82% of companies have reduced their earnings forecast for the quarter just ended (generally to be reported from mid-July to mid-August).
For now, the two major indexes for the U.S. stock market – the S&P 500 and the Dow Jones Industrials – are holding near record highs. Yet, they are up only 2% since last September, and the stock market darlings in recent years – the FAANGs (Facebook, Apple, Amazon, Netflix, and Google) – are all below their record high prices set last summer.
As with the 1960s and 1990s, the current economic expansion and bull stock market have been among the longest on record. Since an estimated 80% of stock market trading activity is now on “autopilot,” with index funds and computer-generated trading based on artificial intelligence, the momentum will continue – until it doesn’t. It’s impossible to predict what the catalyst for an end to the historic bull market will be. But it seems that the economy and the stock market are “exhausted.” History does not bode well for the current period. The market peaks of the bull markets of the 1960s and the 1990s were not topped for nearly fifteen years.
We’ve previously noted the conflicting economic signals from the stock market and the bond market. Stocks have paradoxically rebounded this year despite sliding corporate earnings and growing signs of economic weakness and reduced inflation pressures. It is understandable that the bond market also has been strong, as bonds historically have risen in value while stocks fall in economic recessions. The yield on the U.S. Treasury 2-year note, for example, has fallen from 2.96% last November to 1.83% now. Yet, the Federal Reserve is again a step behind the markets. The Fed announced in December an end to its policy of steady increases in interest rates, but it has not followed market rates lower by cutting the fed funds rate.
Though the Fed is widely expected to start cutting the fed funds rate this month, we expect only a fleeting bounce in stock prices. As noted in last quarter’s commentary, falling interest rates going into recessions have coincided with – and not prevented – sharp declines in stock prices, as plunging corporate profits overwhelm any positive benefits from cutting interest rates.
Furthermore, central banks now have far less ability to cut interest rates in response to economic and market weakness. In response to the financial crisis of 2008, the Fed cut the fed funds rate from 5.25% to a low of 0.25%. Now it’s 2.5%, so there is little room to reduce rates. Even more striking, the overnight rate of the European Central Bank, the ECB, is now minus 0.40%. And the market yield on the 10-year German government note is minus 0.35%. (Banks and investors are charged to hold funds in deposit accounts). What can the ECB do to try to stem the region’s incipient recession? Make the interest rate even more negative? Perhaps. Once again buy massive amounts of bonds in the market to inject cash into markets? Likely. The U.S. Fed will almost surely do that, too, even though since the 2008 financial crisis, the Fed’s holding of bonds purchased on the open market soared from roughly $700 million to $4.25 trillion. At $4 trillion now, how much more can the Fed buy, on top of record corporate, federal government, and consumer debt? Something has to give.
That’s why we continue to rotate stock portfolios out of technology (subject to capital gains tax constraints) and into lower-risk sectors (REITs, consumer staples, telecommunications, and health care). We also have raised cash levels to provide resources for better buying opportunities. Finally, we’ve initiated a strategy of buying put options on the S&P 500 market index to limit portfolio losses from a major bear market (perhaps 45-50%, based on market history).