Market View: The August-to-November window of Year Seven has shown a strong downward bias, even when the extreme case of 1987 is omitted. The S&P 500 might correct 6-8%, with the Russell 2000 down 13-14%. We are already halfway there. With the completion of this sell-off, there is a good chance of another up leg, which could be the bull market's last. A standard balanced portfolio with 60% in the S&P 500 and 40% in 10-year Treasuries has generated 8% in annualized return since 1880. The same 60/40 mix over the past 138 years provided a median portfolio yield of 4.1%, with more than half generated by income. Today, the yield is 2.1%. Stocks were more overvalued in early 2000 with bonds in 2016. Today, both are overvalued, and returns could be stuck between 3% and 4% over 10 years.
Investors should be on the lookout for technical indicators for some red flags. A breakdown in markets before the final culmination is a process, not a quick reaction. The bull market peaked in 1998, yet the Nasdaq and the blue-chip indexes went up for another 2 years. The very disjointed price action of the past couple of weeks could be the beginning of a topping process. A short-term correction can be followed by a new rebound before the bull market comes to an end sometime in 2018.
There is already a slowdown in the auto market, with single-family housing close to peaking out. Also, the banking sector, a barometer for the health of the overall economy, is acting as one would expect toward the end of an expansion phase. FDIC, in its quarterly, said that that total loans and leases by banks and other insured institutions rose by just 3.7% from a year earlier, a third consecutive quarterly deceleration, and is down from a 6.7% pace of growth a year ago. Credit card charge-offs soared by 24.5% in 2Q17, marking the seventh straight increase. Charge-offs on loans to commercial and industrial borrowers, however, declined by 9.7%, possibly due to a recovering energy sector. Add to that the Federal Reserve unwind of its balance sheet and higher interest rates.
With low interest rates far too long, the level at which the rates begin to bite can be lower than commonly believed. For example, a 10-year bond yield of 3% or 3.5% might be enough for investors to dump stocks, as opposed to a 5.5% to 6% in earlier days. Adding to all this is an assumption that nothing will be done to lower individual tax rates or corporate tax rates until much later in 2018, while companies are expected to face rising wage pressures. Moreover, annual nonfarm payroll employment growth has slowed to 1.5%. In the past, when you've approached that level, a recession has usually been on the 12-month horizon.
DowDuPont (NYSE:DWDP): This story might not be completely over, even though the merger is complete. There are multiple ways to win as DWDP separates into at least three companies, each with a number of incremental independent paths to further increase shareholder value. At the merger level, the story is still unfolding. Execution on $3 billion of cost synergies and $1 billion of growth synergies as the merged entity then breaks up into at least three companies remains to be seen. There is also an under-levered balance sheet to take advantage of, as net debt/EBITDA stands at 1.5x. Materials Co. - one of the expected spin-off companies - is likely receiving a lower implied multiple due to markets being overly bearish on the ethylene cycle. This value will be unlocked as the cycle evolves and if DWDP separates and monetizes the commodity assets. Then comes the Ag Company, as it shows earnings growth in the near future, with stability in seed pricing and some improvement in crop chemistry inventory levels. With Syngenta delisted and Monsanto acquired by Bayer (OTCPK:BAYZF), Ag Company remains the only global publicly traded pure play on seeds, biotech, and crop chemistry. On the Specialty Company, the CEO Ed Breen's history, this company can see strategic activity and can be potentially sold. Given the cost synergies, the combined company trades at 9x EBITDA, which might be a bit low if an analysis is done based on sum-of-the-parts.