Q3 2019 Market Update: Cracks in the Foundation

We see cracks developing in the foundation of the bull market in stocks. As we know from the bizarre reality of 2019 life in America, most people believe what they want to believe – and make their own “facts” if necessary. The same is true of markets. Human nature hasn’t changed in centuries, which leads to recurring errors in decision-making. A notable book on investment psychology is “Popular Delusions and the Madness of Crowds.” Delusions and madness of crowds indeed, from political upheaval in the U.K. and U.S., as well as in financial markets! Even though automated computer trading systems now account for an estimated 80% of trading in the stock market, crowd psychology still matters – and that goes for consumer confidence in the economy, too.
As we’ve noted before, going against the popular wisdom usually presents the most profitable investment opportunities. The stock market ultimately is one big confidence game, and investor psychology can change suddenly. Changes in consumer confidence, however, tend to occur more slowly. Consumer confidence is holding up for now, though a recent survey showed that 50% of consumers expect an economic recession by the end of next year.
As a structure’s foundation eventually succumbs to the weight bearing down on it, so too does the foundation of a stock bull market succumb to the unbearable weight of outsized valuations and investor expectations that are no longer supported by corporate earnings growth and the financial resources of investors.
The record-long bull market since 2009 has had three key supports: 1) unprecedented monetary stimulus by the Federal Reserve (interest rate cuts and money printing); 2) corporate share buybacks, largely with borrowed money; and 3) the market leadership of this era’s market “darlings,” which are widely owned stocks, based on the belief in the companies’ lasting dominance of their markets.
Unfortunately, only the first of the three supports for the bull market remains. The Federal Reserve, after a pause from 2015 to 2018, seems almost certain to again make sharp cuts in short-term interest rates and to purchase many billions of dollars’ worth of bonds to pump money into the system.
The other two bull market supports have ended. Corporate share buybacks reached record levels in recent years but peaked almost a year ago.
Every era has an industry or set of stocks that captures investors’ imagination. Whether it was the breakthrough of radio in the 1920s (RCA fell 98% in the 1929 market crash) or dot.com stocks in the 1990s (many of which fell close to 100%), in times of high confidence, investors’ emotional pendulum swings strongly from fear to greed.
In this bull market, the darlings were, as usual, technology related: the FAANGs (Facebook, Amazon, Apple, Netflix, and Google). For years, these were favorites of not only individual investors but hedge funds and other institutions. Yet most of these stocks peaked a year ago or more, with the exception of Google, which peaked this past spring.
There are other cracks in the bull market’s foundation that signal trouble ahead. One is the selling of a company’s stock by company insiders (executives and board members), which is the highest since the 2000 peak in the technology stock bubble. To paraphrase legendary investor Warren Buffett, “Who would you rather invest with, company insiders who intimately know a company, or the general investing public?”
Another is the market for initial public offerings (IPOs). Owners of private companies tend to offer shares of stock to the public for the first time when share prices are generally high to at least partially cash out. It used to be that before going public, a company had to demonstrate past profitability or at least a path that would lead to future profitability. The current IPO market, however, has featured mainly “unicorns,” as they’re known (companies valued at more than $1 billion but which haven’t yet earned a profit).
Newly public unicorns haven’t been doing well lately. Take Uber, the ride-sharing business that went public in May at a value of approximately $70 BILLION. Uber hadn’t earned a profit and said it might never be profitable. The stock has fallen 30% since the IPO. Peloton, the fitness app company, went public on September 23 at a value of $8 billion, even though the company’s operating loss doubled in the latest quarter. Another example is the office-sharing company, WeWork, which had planned to go public over the summer at an estimated value of close to $50 billion. When more-recent estimates of investor demand reflected a value close to “only” $15 billion, the company shelved its plan to go public and began laying off employees.
Once crowd market psychology shifts – regardless of the “tipping point” or catalyst – we expect to see waves of stock-selling by the computerized trading algorithms and by redemptions from stock index mutual funds and exchange-traded funds (ETFs).
What could disrupt this likely path? For one, an increasingly cornered and desperate Donald Trump. Trump is likely to do anything that he can claim to be a “success” before the election, particularly a trade deal with China (even when it likely will be immaterial). Or, under pressure from Trump, the Federal Reserve is even more likely to sharply cut its key interest rate amid economic slowing and to resume money printing. We think both outcomes will be too late to overturn inexorable economic and market cycles. Also, the panacea of additional monetary stimulus should already be expected by investors and discounted in market prices.
In addition, low (or even negative) interest rates haven’t kept Europe out of economic stagnation or a declining stock market. The European Central Bank’s (ECB) overnight interest rate is -0.50% (yes, lenders must pay to have their funds held by the ECB). Furthermore, history shows that desperate interest rate cuts by central banks indicate economic weakness or a financial crisis, and stock prices follow plunging corporate profits in an economic recession.
We think our client portfolios are well positioned for the much more difficult conditions that seem likely based on nearly a century of market history. Shifts out of riskier stock market sectors (particularly technology stocks) and into lower-risk sectors (notably real estate investment trusts (REITs), communications services, and consumer staples) will likely dampen portfolio losses, as will robust levels of cash reserves. Finally, this year’s addition of put options as insurance against a catastrophic market decline adds a third, most solid leg, of our three-pronged strategy to protect client assets. Now, we wait patiently for the better investing opportunities that will inevitably arise.