Apocalypse Not Yet

by: Alhambra Investment Partners

By Joseph Y. Calhoun

Kurtz: I watched a snail crawl along the edge of a straight razor. That's my dream; that's my nightmare. Crawling, slithering, along the edge of a straight razor… and surviving. - From Apocalypse Now

It doesn't take much to awaken the bears on Wall Street. A couple of weeks of fairly routine stock market activity to the downside and every website and magazine is sporting a bear. That's right, routine. The stock market - if the S&P 500 is considered "the market" - is down now almost 12% (as of late Friday) from its intra-day high set last May. Predictably, we've been treated to a parade of bearish articles telling us how to invest in a bear market, how to avoid a bear market, why the bear market has a long way to go, why the bear market is almost over already, how to skin a bear like David Bowie and most important, how to steal pic-a-nic baskets like Yogi. It's an ursine takeover.

We've also been treated to a litany of reasons for the global stock selloff. Emerging markets are a favorite bogey man with the Chinese playing a starring role. The narrative goes something like this:

  • Chinese economy slows down
  • Capital flows out of China
  • Capital flows out of other emerging markets
  • The Yuan and other EM currencies fall
  • EM stocks go down, China's stock market crashes
  • Some magic stuff happens at hedge funds
  • US stocks fall

I don't mean to be flip about the stock market correction - and that's all it is right now - but some of the explanations offered are, at best, incomplete. In that narrative above, which is remarkably accurate despite having my tongue planted firmly in my cheek when I wrote it, no where do you see mention of where that capital fleeing China and the other emerging markets might be landing. It is as if it just disappears once it crosses the Chinese border, making me wonder if there might be some bank in Hong Kong with a booming safety deposit box business.

There is no doubt capital is coming out of emerging market economies. That can be readily seen by their devaluing currencies and shrinking dollar reserves. China has "spent" roughly $1 trillion of its reserves trying to make sure the Yuan has a soft landing even if their economy doesn't. But the capital coming out of China and the other emerging markets has to go somewhere. And since it is primarily denominated in dollars, the most likely destination is the US. The capital fleeing the chaos of Shanghai has to be invested somewhere and wherever that is - in this case probably the US - will be better off and the place it is fleeing will be worse off than would have been the case if it had stayed put. I have a hard time connecting those dots in a straight line to a declining US stock market.

There is a connection between the EM economies like China and the US economy but the causation likely runs in the opposite direction. One might ask the obvious question: why is capital fleeing the emerging markets that just a few years ago were reckoned to have much better growth prospects than the stagnant US? The popular narrative is that it is a result of a slowing Chinese economy, a result of the end of their domestic-oriented stimulus. But that explanation seems wanting when one realizes that the Chinese have announced stimulus after stimulus over the last year to little avail. If the Chinese economy is slowing the more likely explanation is that the export markets on which they so depend are having problems.

And of course, the most prominent of those export markets is none other than the US and it is certainly slowing. Our industrial/manufacturing sector is in recession right now and with inventory elevated relative to sales at all levels seems likely to get worse before it gets better. The service sector is still growing and reckoned by most to be sufficient to keep the US out of recession. I have my doubts about that as services are inevitably linked to the goods side of the economy. Truck drivers who are no longer making six figures, as they were at the height of the shale boom, will not buy as many services now that shale has gone bust.

What's really interesting is that the Treasury market indicates a big fall in inflation expectations since the beginning of 2015 while at the same time TIPs yields have risen. That means that even as inflation expectations are falling, real growth expectations are rising. The market appears to be pricing in deflation, a deflation that doesn't hurt real growth and in fact may be positive. Frankly, I'm having a problem figuring out how lower inflation and better real growth are bad for the US stock market.

What then is causing the US market to sell off? The more likely explanation is reduced liquidity, a market event rather than an economic one at least unless it infects some critical piece of the global financial plumbing. There is definitely a shortage of dollars in the world as our Jeff Snider has written about repeatedly. You don't need to take my word or Jeffrey's word though, just ask yourself why China used up a quarter of their reserves over the last year. If the Fed isn't supplying dollars to a Chinese market starved of them, the PBOC seems obliged to step in.

It seems then that the conditions that created a US stock market correction are not about economic growth, at least not about US growth and not yet. And so, maybe this is just a well-deserved US stock market correction, not the big one, the next financial crisis everyone seems to expect and fear. I've said repeatedly that I don't know whether the shale bust will be enough to cause a US recession and frankly I still don't. What seems to be developing so far is an inventory led slowdown that may - but hasn't yet - turn into an inventory-led recession. The bond market so far seems to be saying that's all it is and it won't last. The fear that is driving US stocks lower right now is about the Chinese financial system, about the potential for a Chinese financial sector crisis.

That is a legitimate and scary prospect so fear is a natural response. The Chinese economy has a lot of debt and more specifically a lot of US dollar debt. The Chinese are caught in a trap between their dollar debtors who don't want the Yuan to fall and their exporters who do and a market that is forcing the issue. Which is deemed more important or - more likely -which has greater political influence will decide the issue. Right now, the uncertainty is what is killing them. Those with the ability to get capital out of the Yuan before a devaluation are doing so and creating more pressure on the currency. Until the Chinese do something to allay the fears of further Yuan devaluation or the Fed does something that weakens the dollar, this pressure on the Yuan and the Chinese financial system will continue.

But the US stock market correction may be about done. Sentiment is getting rather extreme. The American Association of Individual Investor's poll has bulls down to just 17.9% a paucity rarely seen and one that contrarians should find appetizing. Other absolute measures of sentiment are not at quite such similar extremes but it does seem that everyone who writes a financial blog or a financial column or gets some face time on CNBC has suddenly discovered their inner bear.

I still think the overall trend for the US stock market has turned lower and that the top is in for this cyclical bull market. But markets rarely move in a straight line and I suspect we are nearing a short term bottom. I would urge investors to review their feelings, their emotions during this correction. If you were tempted to sell or felt uncomfortable with the losses in your account since the beginning of the year, you should probably be looking to sell into any rallies that come along. Reduce your stock allocation to one that is more comfortable because if the current inventory led slowdown turns into an inventory-led recession or if liquidity becomes really scarce, the stock market will do a lot worse than the last two weeks. A routine return to median valuations means a 40% or so drop from here. A trip to typical bear market low valuations would take the market down 70% or so.

Global markets are crawling along the straight razor right now, delicately balanced between normalcy and outright panic. Sentiment though is so negative that the bears should be careful. It may smell like victory, but this is probably just a battle, not the war, Apocalypse Not Yet rather than Apocalypse Now.