Weekly Update Special: How can you be complacent and cautious at the same time?
(Editor’s note: I’m spending the next three weeks in Alaska, knocking off the last state I’ve yet to visit. So starting today and over the next two weeks, I’ll be sharing insights I’ve gathered from my sources.)
I was at my dentist’s office a few weeks ago, and a week before that, I went to a new doctor to have a mole removed. Both doctors, obviously, are quite successful. And both asked me, “What do you think about the market?” The first doc told me he sold out of the stock market two years ago—“I’m in cash and Krugerrands.” And the dentist said, “Do you believe this overpriced market! … I’m extremely cautious.” I wasn’t one to argue as I was about to go under the drill. These are the haves, mind you, and everywhere I go, they are worried. Everywhere they are sure we are going to get a 10% correction. If everybody knows it, what’s going to happen? It’s going to be a slow grind higher.
Then, just as everyone starts to give in, we’ll probably get a quick, nastier hit than anyone is expecting, suggested Ned Davis Research’s Tim Hayes at a recent meeting with Federated strategists. And why is it going to be so fast and hard? It’s the proliferation of ETFs and high-frequency trading, which by some estimates now account for as much as half of market volume. That is something I hadn’t considered, and that is something that could happen if these traders shift direction en masse.
This may sound bad, but it’s not. It’s been 25 months since the last 10% correction, and the average for such a correction over the last 83 years is 15 months (though Cornerstone Macro does remind us that the 1990s saw the S&P 500 go eight years without a 10% correction). And until jitters over the crash of a Malaysian passenger jet over the Ukraine a few weeks back, it had been more than 60 trading days since the S&P gained or lost more than 1%. We’re due for a pullback, and that would be great. Quick—so we shouldn’t try to time it. Just like I couldn’t tell when my dentist was finished with his drilling. But in the end, my smile looks great. And as for the market, we’ve got: attractive valuations relative to bonds, expanding earnings, rising multiples and an economy possibly in the early throes of shifting from a very subpar to something more like a normal recovery.
The Zarnowitz Rule, named for the leading business cycle scholar Victor Zarnowitz, says the more rapid the downturn in the economy, the faster the recovery. Looking at the first nine previous recoveries from the 10 postwar recessions—we’re in the 10th now—real annualized GDP averaged 4.1% through the first 19 quarters. This time, it’s running at 2.1%—a full 2 percentage points below average. Why? If the Obama administration inherited the worst recession of the past 10, it should have enjoyed the biggest recovery. But the 2007-09 recession troughed at -8.9%, yet its recovery is currently running nearly 3 points below Reagan’s, which saw GDP expanding at a 4.9% annualized pace 19 quarters after bottoming at a second-worst -7.9% in November 1982.
Academics have suggested Reagan’s recession was cyclical in nature, and cyclical recoveries tend to be steeper and faster; Obama’s was financial in nature, and financial recoveries tend to be slower for longer. But New York Fed President Bill Dudley, a former Goldman Sachs chief economist, says three key fiscal missteps may explain why this recovery continues to be anemic: enactment of the Affordable Care Act, the 2013 tax hike as part of the fiscal-cliff compromise and adoption of the sequester, also part of that compromise. Fed models show the three policies cost the economy 1.75 percentage points of GDP growth annually, enough to lift the U.S. economy to a near-normal recovery had the policies not been adopted.
Everybody knows taxes coming out of individuals’ pockets don’t help the economy grow in the short term. Neither does a sequester that eliminates spending. Nor a law such as the ACA that keeps CEOs and companies large and small from hiring because they don’t know the true costs, or hiring only temps to push them into the exchanges (in June, for example, full-time jobs plunged 523K while part-time jobs soared by about 800K). So I’m wondering if these policies are set in stone; perhaps they’ll be revisited depending on the outcome of the midterm and 2016 elections. I’m also wondering that if the worst recessions tend to bring the strongest recoveries, and if we’ve had the weakest postwar recovery on record yet interest rates are still very low, earnings are good, balance sheets are strong and the Fed is very accommodative, could we get our strong recovery over the next several years to match our secular bull call?
Going back to 1944, year 2 of the presidential cycle is historically the weakest year, with the deepest pullbacks coming in the second and third quarters. We’re in year two now, just exiting Q2 and heading into Q3. Probably 90% of the people in the market know this, so maybe it doesn’t happen now. Certainly the VIX, which continues to trade near a 7-year low, doesn’t belie any major fears. But this seems out of whack with what fund flows are telling us; inflows into bond funds are up dramatically the past two months, while domestic equity funds have experienced substantial outflows, casting doubt on the anticipated great rotation from bonds to stocks. How can you be complacent and cautious at the same time?!!
Perhaps we just keep grinding higher. In fact, the OECD leading economic indicator is showing an unprecedented pattern of slowly trending higher—a slow synchronous global expansion. Meanwhile, the European Central Bank and the Bank of Japan are in the early stages of extraordinary accommodation. And then you have the U.S. midterm elections. Studies show control of Congress is more important than the party in the White House, with the best returns coming when Congress is led by Republicans, which at this stage appears very possible with the Senate up for grabs and key races trending the GOP’s way.
We hold to our expectations of 2,100 on the S&P this year; at which time, we will regroup. Honestly, no one knows when the correction will occur in what is normally a sloppy year within the presidential cycle. Here’s what we do know—after the year 2 presidential-cycle pullback, the S&P on average has experienced a 40% return over the subsequent 10 quarters. We are quite bullish.