Why The Correction Didn't Become A Crash

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Includes: DIA, IVV, SPY
by: James A. Kostohryz

Summary

Many expected the recent pullback to develop into a crash. In this article I explain why a sustained bear market is unlikely for at least 1-2 years.

Excess liquidity plays a major role.

Understanding the cycle of a strengthening economy, increased confidence and the normalization of liquidity preferences is key to understanding the likely course of US stocks in the next 1-2 years.

The decline from the all-time S&P 500 high of 2019 on September 19th to the intra-day low reached on October 15th represented a pullback of 9.8%. Many predicted (and continue to predict) that this decline would turn into a crash. Why didn't a crash or bear market materialize?

In the following essay I will outline four main reasons why this pullback did not become a crash or morph into a bear market. More importantly I will explain why a major bear market is unlikely to develop in the next couple of years until the market makes significant new highs - potentially bubble highs.

Excess Liquidity

As I explained in this article and in this radio interview, US households and businesses are currently holding record amounts of liquidity relative to income. These liquidity levels are far in excess of what households and businesses need under normal conditions. Many businesses and households are increasingly eager to put some of this liquidity - currently earning near 0% - "to work." Therefore any correction in the stock market is likely to be met with significant demand from households and businesses looking to deploy some of their excess liquidity.

This phenomenon explains why every single major pullback and correction in the S&P 500 (NYSEARCA:SPY) since 2009 has failed to produce a typical "re-test" of the recent low. All recoveries have been "v-shaped" recoveries that have taken off from the lows without any "basing." The persistence of this technical behavior over many consecutive corrective cycles is unusual and is symptomatic of the extraordinary levels of demand propitiated by excess liquidity in the economy.

"Buy the dip" is a phenomenon being driven by extraordinary monetary conditions. And as I explained in this article, these highly favorable monetary conditions are going to remain in place long after the Fed stops increasing the size of its balance sheet via quantitative easing (QE).

Normalization Of Liquidity Preference

Confidence in the economy and in financial markets are gradually starting to make a comeback in America, and this process still has a long way to go. Consumer Confidence, as measured by the Conference Board, just reached a seven-year high, driven notably by increased optimism about labor market conditions.

Yet measures such as this of long-term confidence in economic conditions are still decisively below levels that are typical of a late-stage economic recovery or a stock market peak.

As the US economy continues to improve, economic confidence will rise and liquidity preference will tend to normalize. As liquidity preference normalizes, people will begin to spend their liquidity balances more quickly and aggressively. In the context the current record levels of excess liquidity in the US economy, this bodes very well for US economic activity in the next couple of years. It augers even better tidings for the US stock market since many individuals - particularly the wealthiest individuals that disproportionately hold excess liquidity - will prefer to deploy their liquidity toward investment goods than toward consumption.

The US Economy is On The Move

The US economy is currently on track to completely fulfill my bullish projections for US economic growth in the last three quarters of 2014 that I outlined in my 2014 Economic Outlook. It is becoming increasingly clear that the US economy is gathering positive momentum - a process that was only briefly interrupted by extraordinarily bad weather conditions in the first quarter of 2014. Indeed, it is important to note that US economic growth has surpassed 3.0% in four out of the past five quarters.

The gathering momentum in the US economy is important to the US stock market for two reasons. Most obviously, economic strength provides impetus for earnings growth. Second, and even more importantly, gathering economic strength portends well for economic confidence. Economic confidence leads to diminished risk aversion and a normalization of liquidity preferences.

As explained above, in the context of excess liquidity, diminished risk aversion and declining liquidity preferences mean higher rates of expenditure by households and businesses. US equities will be a prime beneficiary of this trend toward more liberal employment of liquidity.

TINA: There is No Alternative

Of course, investors always have alternatives. But with interest rates near 0% and with long-term bond yields near record lows, many investors increasingly feel as if they have no alternative but to jump on the equity bandwagon.

Dividend yields, earnings yields and free cash flow yields on stocks are not high (i.e stocks are not cheap) by historical standards. However, these yields look positively enticing compared to interest rates of near zero for short-term savings vehicles and yields of around 2.3% on 10-year Treasury bonds. They also look enticing compared to investment grade (AAA) corporate bonds of 10-year maturity which are only yielding about 3.1%.

Conclusion

Under present monetary and economic conditions, US stock market pullbacks and/or corrections are unlikely to be sustained for very long. In the current context of excess liquidity and declining liquidity preferences - an environment likely to persist for 1-2 years at least - every dip in the stock market will be seen as an opportunity by businesses and households to deploy their excess liquidity toward assets that yield far more than deposit, savings and money market instruments.

This set of monetary and economic conditions are not auspices for a crash or bear market; they are propitious for the formation of a stock market bubble. In the next few weeks, I will be providing some specific ideas for investments that make sense in this unprecedented environment requiring very difficult choices.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.