After calling for a short covering rally in October – the best gains of the year – a few weeks ago we suggested the market rally was fizzling and that it was time to return to being cautious. As of last night that view still remains and we continue to see some significant changes in global financial markets that are worrisome for equity markets. As we noted in that column, equities have cornered themselves to a point where under a normal distribution of outcomes are at a high probability of falling.
We explained that equity markets sold off in August due to the fears of a weak economy, China slowdown and pretty much anything to do with “weakness”. Fears the Fed would not be able to raise rates until late 2016 received a lot of airplay. Fast forward to this month and one strong employment number last month has shifted this market view to a rate rise occurring in December. Fed speakers all week have been telling us a rate hike is coming provided the one more data point, being the US employment figure, doesn’t pose any negative surprise. If we see a strong employment number again the market will begin to question whether the Fed is behind the curve and if a more aggressive rate hike schedule will be needed. So the market is cornered. Weak numbers are bad for growth and corporate profits so equities decline, while strong numbers will add fuel to the rate hike cycle and although good for the economy, will drive equity markets lower as the initial reaction will be to fear there will be more rate hikes than the market has currently priced in.
Previously during the era of “QE” it was the exact opposite. Good economic data meant the US economy was finally recovering, stimulus was working and corporate profits would continue to grow. Poor data would mean the Federal Reserve would be required to maintain or increase the level of its stimulus program. The idea is that eventually further down the road this stimulus will transpire to robust growth.
Well readers that time is now and unfortunately the data is not as robust as anyone would have expected considering all the stimulus provided globally. The Fed is adamant it wants to start raising rates and to me this feels very much like Europe 2011 all over again. Back then the ECB raised rates on April 7th by 25 basis points – far too early for the economy to handle – and four months later it had a huge debt crisis on its hands.
The US economy like Europe at the time, is very patchy (while the ECB raised rates it advised Portugal to formally request a bailout – madness!). Manufacturing is at a 3-year low, the US housing market is beginning to show signs of slowing, retailers are struggling with huge profit warnings, the oil and commodity sectors are crippled.
For equity investors this spells trouble. The Fed seems to be focused on simply employment data for gauging the decision to raise rates, while the underlying sub-sectors of the US equity market have diverged completely. More and more sectors have entered bear markets while only the few market leaders (Amazon, Facebook, Google and Netflix) are making new highs. Late stage bull markets always see a breakdown in the correlation between sectors.
As I constantly remind people, the GFC of 2008 was created by the US housing crisis. US housing stocks had already lost 90% of their value by the end of 2007 – before the GFC even hit. They peaked in late 2004/early 2005. US investment banks peaked in 2006. This time around, oil and commodity producers peaked 18 months ago, retailers peaked a few months ago, housing stocks have struggled for over a year and biotechs are now a political pawn as price gouging is a key issue for next year’s election.
So when we look at equity markets like the S&P 500, the ASX 200 and even Europe – we have to ask what will drive these markets to new highs that we don’t already know? It won’t be QE, it won’t be a recovery in global growth led by emerging markets, it can’t be the US consumer they are already spending at record levels (take the 17 million new cars now sold per year in the US as an example). Housing? It’s already had a huge recovery. Corporate buybacks are already at record levels while executives are net sellers, which doesn’t give any confidence for the ongoing profitability. At this point I just don’t see anything.
In 2013 I wrote a piece called the Bullish Road Map for the next 3 years and it highlighted that the same macro circumstances that led to the 1995-1998 equity bull market were present once again at the beginning of 2013. Reviewing that research, there are no longer any of those factors remaining. And to me that’s scary.
