As the S&P 500 (NYSEARCA:SPY) attempts to rally after a successful test of its January low, the dilemma facing investors today is whether to invest as though the 13% correction from all-time highs is complete, or to prune portfolios during this counter-trend rally in preparation for another leg down that takes the index to bear-market lows. I have been arguing for the latter, and nothing from a fundamental or technical standpoint has happened to change my position.
While tracking the revisions to overly optimistic market outlooks for 2016, I have noticed that most Wall Street strategists are conditioning their revised forecasts on the basis that a recession does not occur. So long as the US economy averts recession, the consensus believes that we are in the midst of a correction that is nearly complete, but if the economy goes into recession, then a bear-market decline is a more probable outcome. This scenario is consistent with historical precedent, as bear-market declines and recessions have nearly always come in pairs, but I think the current period will be one of the few exceptions.
The last time the S&P 500 suffered a bear-market decline of 20% or more without the economy going into recession was in 1987, when it fell 33.5%. Prior to that we have to go back to 1966, when the S&P 500 declined 22.1%. I think we are in the midst of another one of these rare occurrences. In substantiating this outlook, I must seemingly contradict myself by arguing that the economic expansion is sustainable, while the bull market in stocks is not. This disconnect is the result of monetary policy, which has had a far more profound effect on financial markets than on the real economy during this expansion. A bear-market decline in stocks should resolve this disconnect.
The Economy - No Recession
While the rate of growth in the US economy appears to be slowing, it does not look like there is a recession on the horizon. It is clear that segments of the US economy, like manufacturing, are in recession. Corporate earnings have declined for several quarters in a row, which is now well understood to be a profits recession. Capital spending continues to be a drag on growth, as does our trade deficit. The destocking of business inventories is also a headwind. Yet the most important factor in the US economy is the consumer, and the rate of consumer spending growth, although also slowing, continues to muddle along at a rate of 2-3%.
The two most important variables with respect to consumer spending are energy prices and wages. The plunge in gas prices has clearly benefited the consumer. It has allowed some to boost discretionary spending on other goods and services, while simply providing relief to others. It has also lowered operating costs for many businesses outside of the energy sector. It is the decline in energy prices that has held the rate of inflation, as measured by either the consumer price index or personal consumption expenditures price index, well below 1%. This is what has allowed workers to see a very modest increase in their real wages.
Wages have been rising at an annual rate close to 2% since 2010, as can be seen above. This means that if the Federal Reserve had achieved its inflation mandate of 2%, real wages, which are adjusted for inflation, would not be increasing at all. Fortunately, we have seen an uptick in wages over the past several months to an annual increase of 2.5%. When we account for an inflation rate of .7%, this means real wages are rising at a rate of 1.8%. That equates to the annualized growth rate of the US economy in the quarter that just ended.
It could be that the decline in energy prices, while having devastated the energy sector, has kept the consumer afloat. What concerns me now is what happens when oil prices recover and the rate of inflation begins to rise. If wages do not rise commensurate, real wages will decline, which will be a major impediment to a continuation of the current expansion.
It is important to remember that these conclusions are all based on the data we have available today. The rate of economic growth in the quarter just ended was a paltry .7% on a quarterly basis. That figure will be revised several more times, at which point it may show either that the economy contracted or that it grew 2%. There is a wide margin for error. For this reason, I focus on changes in the rate of growth, either accelerating or decelerating, rather than on the economy contracting or expanding. On this count, I think there is a much smaller margin for error. The wealth of evidence we have now overwhelmingly points to an economy that is decelerating. This was affirmed by the Organization for Economic Cooperation and Development's most recent update to its forecasts for growth in the US and abroad. The theme below is global deceleration.
The Stock Market - Bear Bound
Like two wheels on a bicycle that rotate in unison, the stock market and the economy typically follow a similar path, with the market rotating right in front of the economy. The stock market is considered a leading indicator of economic activity. In its effort to stimulate the economy, the Federal Reserve sped up the rotation of the front wheel (stock market) and left the rear wheel (economy) behind. Now the Fed is gently tapping on the brakes, but it is fearful that these two wheels will collide as they realign.
As is typical during bear-market declines, there are explosive, yet short-lived, rallies. Last week, stock markets in the US and abroad were plunging, led by new lows in the price of oil. As the S&P 500 fell within a point of its January low, a very timely report of possible production cuts from OPEC hit the news wires, reversing the decline in oil and lifting stock prices around the globe. In the four days that followed the S&P 500 rallied nearly 6%.
In hopes of sustaining the rally, there was a very predictable about-face on Tuesday by one of the most hawkish voting members of the Federal Reserve. Despite being one of the strongest advocates for raising interest rates last year, James Bullard now says it would be "unwise" to raise rates further. Bullard is fearful that falling stock prices will undermine the very modest rate of economic growth we are still realizing. It is as simple as that. The Fed will not raise rates again in 2016.
With the Fed's ability to influence stock prices rapidly waning, investors are refocusing their attention on earnings. The most significant headwinds facing stock prices now are declining corporate profits. Earnings are primarily a function of economic growth, while stock prices are a reflection of the value and sustainability of those earnings. This is principally where the two wheels of the bicycle have separated, as stock prices sped well ahead of the earnings derived from much slower rates of economic growth. Now the two must converge.
Earnings for the S&P 500 companies are falling year-over-year for a third quarter in a row for the first time since the period from Q1 through Q3 of 2009. The culprit in not just the energy sector, as six of the ten S&P sectors are realizing year-over-year declines. Revenues have fallen year-over-year for four consecutive quarters. Telecommunications is the only sector showing an accelerating rate of earnings growth. The most recent weekly update shows that the blended rate of decline has improved to 3.7% from what can be seen below as 5.6% two weeks ago.
Still, the consensus of analysts is not expecting earnings and revenue growth to return until the second half of this year. If that does occur, it could be the needed catalyst to stem a decline and lift stock prices during the summer months. Stock prices will discount an improving earnings outlook by rising in advance of the reporting season.
There is a lot of time between now and the summer, during which stock prices will find equilibrium with the earnings outlook. Consensus earnings estimate for the S&P 500 in 2016 at $124.25 remains too high in my view. Estimates have consistently been too high. If we assume earnings of $118 for 2016, which implies no growth over 2015, and apply the five-year average forward price-to-earnings multiple of 14.4 on that figure, we arrive at a value of 1700 for the index. This level falls in line with what would be a bear-market decline of 20% from the all-time highs of 2134 for the S&P 500.
Yet we know that markets always overshoot in both directions from what would otherwise be reasonable valuations. The technical damage done to the S&P 500 as a result of the correction so far suggests we will see much lower levels than 1700. My downside target has been 1575, which was the peak for this index in 2007 prior to the last recession.
I expect the months ahead to be characterized by increased volatility and a series of lower highs, followed by lower lows, until this bear-market decline is completed. Strategies that focus on wealth preservation, hedging and short-term trading are most likely to prevail. We are in the midst of another rebound in the S&P 500, as can be seen below, that I think will challenge levels between the 50-day and 200-day moving averages (currently 1957 - 2031) before reversing course and eventually breaking below the most recent low at 1810.
There is a legitimate argument that a bear-market decline in stocks will reverse the wealth effect that has fueled a significant percentage of consumer-spending growth in recent years. As a result, growth will slow to such a degree that the economy heads into recession. One mitigating factor would be the length of the bear market. Given a market structure that is dominated by algorithmic trading programs and a financial system that is still flooded with significant amounts of liquidity, I do not think that a 20%+ decline will last long enough to be detrimental to consumer spending growth. Regardless, a recession does not change my outlook for the stock market. If one were to occur, it would most likely worsen the decline in the S&P 500 to levels below my downside target of 1575. It also might be healthier for the economy and the market longer term.
The reason that I hold this view is that recessions are an inevitable event in a free market that is at the mercy of the business cycle. It is a healthy process by which excesses are eradicated. As we near the end of the current expansion, the bear market that I believe we are in the midst of may be nothing more than a prelude to a more significant decline that is coupled with a recession in 2017 or thereafter. This is because the excess that built up prior to the last two recessions and bear market declines in 2000 and 2008 were never extinguished. Instead, it was transferred from corporate balance sheets to consumer balance sheets to what are now government balance sheets. This is a trilogy of boom to busts that I intend to write about moving forward.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Lawrence Fuller is the Managing Director of Fuller Asset Management, a Registered Investment Adviser. This post is for informational purposes only. There are risks involved with investing including loss of principal. Clients of Fuller Asset Management may hold positions in the securities mentioned in this article. Lawrence Fuller makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Fuller Asset Management. There is no guarantee that the goals of the strategies discussed by will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any particular security.