The running of the bears
With the S&P 500 now in full buying panic mode, up 10% off the dark and scarily unexplainable Christmas Eve low of 2,351, we thought it would be a good time to update our market view, last expressed in mid-December in our memo entitled “Volatile year ahead likely to end well.” Answer: no change. We see a volatile first half, as the markets’ short horizon-oriented investors overreact to signs of the economic soft patch we believe we are in, offset by periods of “sellers’ remorse” as evidence mounts of the very positive 12- to 24-month forward environment that is coming. We are currently in one such moment, and as a secular bull, I must say it is fun to watch the bears in full scramble mode. I am also aware that they will more than likely have their moment in the cave again before this is over. Here’s a brief recap of the key drivers of the market action ahead, and how we think they might play out.
- The Fed The first of the key market drivers continues to be the Federal Reserve. As in 1987, the markets currently are grappling with a new Fed chair amid transition points in the global economy and Fed policy. Tough on all sides. Hanging on every word, the bears unfortunately took Chair Powell at his word in early October when he mistakenly said the Fed was nowhere near the neutral point for policy, implying many more interest-rate hikes ahead. Though subsequent leaks by the Fed staff attempted to correct this unforced error, the bears would hear none of it. Believing the Fed was somehow determined to drive the U.S. economy into a recession and would hike until it succeeded in doing so, the bears took Powell’s words and ran head first into a large claw trap.
- For one, the Fed does not have a recession mandate and given its experiences in 2008, when the wheels very nearly came off entirely, it certainly will err—whatever Powell says or missays—on the side of accommodation. This is sometimes a tough argument for a bull to win as the bear has quotes and texts to cite and all we have is common sense and an assertion drawn from it. The debate may not be resolved until the Fed in fact pauses at its next few meetings. We’ll see. But certainly Powell seems to be trying to improve the communication flow, as he did at his remarkable panel meeting last week when he pulled a prepared text out of his briefcase in response to an impromptu, albeit predictable, question about policy. His clear statement then was that the Fed is aware of market developments, as well as developments in China, and their respective feedback loops to the Fed’s own dual mandate (inflation and jobs). Given these inputs, he noted the Fed might not only pause but, if supported by the data, may even reverse course. All of this was not news to us, but it was, clearly, for the bears. From that moment on, they were in full retreat. As if to kick the poor bears in the back on their way out of the cave, at the D.C. Economic Club meeting yesterday, Powell again stressed that the “Fed is watching and waiting with patience” on whether to boost rates again, given the debate between its positive economic models and the stock market’s negative view about the economy’s direction.
- As noted above, we don’t think the Fed debate is fully resolved, with the bears still believing in, or hoping for, a policy error to end the current expansion—one of the few ways this expansion looks likely to end. Perhaps a very strong economic data point, or a bad inflation print, or simply a verbal slipup at a Fed news conference, will lead them back to policy error land. However, on a 6-month view, we fully expect the Fed to be in full-out pause mode and the economy looking forward to another re-acceleration. A hike then could be on order, but the market would take it in the context of a re-acceleration rather than an already apparent deceleration. Market positive.
- China Another key argument for the bears in December, and likely going forward, has been the public negotiations of the U.S.-China trade deal. Again, abandoning all common sense, the bears insist on reacting only to the letter of what each side says as it attempts to negotiate its position in public. So if President Trump says, “That’s it! We’re pulling out of talks!” or if the so-called March 1 deadline is breached (either of which could very well happen over the course of a difficult negotiation), we’d expect the market to have another leg down. However, on a 6-month view, it seems very likely that both sides will come to an agreement because frankly, such an agreement is in their economic and political self-interest. Again, common sense. We’ll see. But assuming we get a constructive resolution on trade, this would be another driver of a second-half economic re-acceleration on both sides of the Pacific. Market positive. (P.S. We don’t buy the narrative that these two complementary economies are somehow locked in a generation-long clash of civilizations that is immutable. In reality, both countries have more in common than not. Perhaps more on this in a separate piece.)
- Earnings A key third driver of market movements is upon us: earnings season. This could bring more volatility for sure. China may become the new “weather excuse;” certainly Apple led the charge on this last week, blaming a China slowdown for its decision to reduce quarterly guidance for the first time under CEO Tim Cook’s leadership. Whether China or the trade war is blamed, we anticipate that many companies across a broad spectrum will take down guidance for 2019, and perhaps even miss their final 2018 numbers. (Our full-year earnings forecasts for 2018 and 2019—$160 and $170, respectively—remain below consensus for Q4 2018 and are now at reduced consensus for full-year 2019.) What we will be watching is how individual stocks react to reduced guidance. Apple was down big the day of its announcement but has since recovered almost fully. Broadly, we think the market already has more than discounted the modest earnings softness we are expecting; if stocks rise or hold through earnings season, this would be market positive, and very bad news for the bears, all of whom are desperately hoping for a retest lower. We’ll see.
For now, we are watching the running of the bears and trying to enjoy it while we can. We expect they may yet have a brief period where they get to gouge those among us who lose their nerve. Our counsel remains the same: confidence at the lows. Specifically, we are holding firm to our advice to maintain a healthy equity overweight in this environment (the PRISM® committee has remained at a recommended equity allocation of 61% for moderate risk portfolios, 700 basis points above the neutral point, throughout the December sell-off and January rally). Likewise, our year-end target of 3,100 on the S&P is unchanged. We acknowledge that a retest of the lows is likely, although everyone is expecting this, so who knows. But if we get one, absent a dramatic change to the fundamental outlook, we are more likely to add further than to cut and run from a bear running backwards.