Bear Market Or Just A Correction?

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by: Mark Bern, CFA
Summary

Bear Market Case.

Tail winds of economy growth.

The Case for a long overdue Correction within a continuing Bull.

And the verdict is….

Introduction

Obviously nobody knows for sure. That is what makes investing interesting and sometimes downright scary. But we need to parse through the data available and find where our convictions lie. This article is meant to give readers all the ammunition they need to discern a position for themselves but we will also provide our assessment at the end. It is fine to disagree. We need investors on both sides of the argument. That is what makes up a marketplace in the first place.

The Case for a Bear Market Beginning (The Dirty Dozen)

I must start by admitting that I hedged my portfolio from 2014 until recently. So this side of the argument comes second nature for me.

1. The current bull market is one of the longest in history and bull markets cannot go on forever.

2. When bull markets end everything appears to be perfect; low unemployment, strong earnings, high profit margins, high capacity utilization, near record output, stock market indices at record highs, etc.

3. The demographics are turning against the probability of sustaining the bull market rise in consumption. As people age and retire we tend to spend less on consumer products and more on health care and insurance. Average spending per household fall precipitously after age 65 and the baby boomer generation is crossing this milestone in record numbers.

4. The new car sales cycle has probably peaked and will head much lower in coming years. The auto industry accounts for about 2.9% of GDP and directly employs 1.7 million people with many more jobs supported indirectly. A slump in the auto industry will become a drag on overall economic growth in the U.S. The subprime auto loan default rate is rising to near the high levels caused by the financial crisis and will probably go much higher.

5. The millennial generation is getting off to a slow start due to the tremendous burden of $1Trillion+ in student loans. The impact of all this debt is to create an artificial drag on spending for the largest generation in U.S. history right when we need them to pick up the slack from the second largest (and far more wealthy) generation that is retiring in droves.

6. Home prices are getting close to unaffordable levels again and interest rates are rising making buying a first home more difficult for younger adults setting up households. More young adults over the age of 18 are living at home now than ever before. Household formation is much slower than it should be given that wage increases have been limited. Did I mention the added burden of student loans? We may not be facing the same crisis as we did in 2007 but this sector growth machine may not contribute as much as it otherwise could.

7. Federal Reserve policy is complicated. The Fed needs to raise interest rates to give it some flexibility to combat the next recession. It also needs to unwind its mammoth balance sheet to a more reasonable level. Both actions represent tightening in the credit markets which could lead to higher interest rates and more stringent underwriting of loans, both of which normally constrain economic growth. The Fed must balance its efforts to stay ahead of inflation while, at the same time, being flexible and accommodative enough to sustain growth. It could prove a difficult maneuver.

8. Signs of inflation have begun to show up in the economy, still manageable at current levels but much more and the Fed would need to hasten its pace of interest rate hikes or reduce its balance sheet at a faster pace to keep the economy from overheating.

9. The yield curve is the lowest it has been in many years, hovering just above 50 basis points (100 basis point equal 1%, so half of 1%) between the 10 year and 2 year Treasury issues. If the 10 year rate falls below the 2 year rate we will have an inverted yield curve which has always (ALWAYS) been followed by a recession. An inverted yield curve suggests that investors perceive the long-term outlook for the economy is poor and that yield are likely to continue falling. We are not there yet but the yield curve has flattened considerably and at risk of inverting. This is something to watch as the bond market is much larger (about double) the equities market and is more sophisticated in terms of understanding the macro economic environment.

10. There appears to be the potential for a war of some sort, whether on trade or on a military basis than usual. At least that seems to be the perception of many in the media, both here and abroad. The Economist devoted almost an entire issue lately to this topic. Canada recently threatened to pull out of NAFTA negotiations and let the agreement lapse. The U.S. hit imports of solar panels and washing machines from China. China announced tariffs of 57% on solar component imports from the U.S. And, of course, there is the issue of North Korea and its nuclear missile threat (also in The Economist). And let us not forget the Middle East and Iran specifically. It may no longer a front page issue but could return to the headlines at any moment.

11. What happens when the (ECB) European Central Bank starts to tighten monetary policy? Can Japan continue QE forever? These may sound like silly questions but at some point (who knows when) such matters will matter.

12. What will happen this fall if the Democratic Party can take control of either chamber in Congress? We will have deadlock again. That was good when we were otherwise unsure of what new restrictive and costly new regulation was about to become law. Now it could be bad because it would cause progress toward creating a more business-friendly economic environment to a halt: no solution on immigration or border security, no infrastructure bill, and likely no budget which would lead to more federal government shutdowns and potentially put the U.S. debt on credit watch. Artificially higher interest rates overnight anyone?

Tail winds of Economic Growth Ahead (The Sweet Sixteen)

1. Tax reform. Lower corporate tax rates will either lead many corporations to realize an increase of about 21.5% to their bottom lines (35% - 21% = 14%; 14/65 = 21.5%; assuming earnings after taxes is 65%) in coming years or it will allow those U.S. exporters and multinationals to become more price competitive globally leading to rising sales with higher profit margins. Either way it should boost corporate profits considerably making the current stock multiples back down to earth. We realize that the tax rate and the effective tax rate are two things but the law also lowers taxes on foreign profits from 35% to either 15.5% (on cash earnings) or 8.5% on earnings reinvested overseas. This one is huge.

2. Tax reform. Repatriation of overseas cash by U.S. multinationals (I know this is part of the tax reform but it is so important we felt it deserved its own category) could bring up to $2Trillion back to the U.S. A good portion of that cash will be used to buy back company stock, providing additional support for U.S. equities. Some will go into increasing dividends which will also provide support to dividend-paying stocks. Some will go toward acquisitions.

3. Tax reform. Again, the increased profitability repatriated cash hoards will enable companies to increase M&A (merger and acquisition) activity. This provides support for higher equity prices in two ways: first, companies generally offer significant premiums to current prices for the stocks of targeted companies. This provides a direct boost to equity prices here and there; second, when many companies are acquired for cash there will be a lot fewer total shares available to be bought by investors. The investors who received cash from selling their stock to the acquiring companies will now want to reinvest it but there will be fewer shares outstanding of all shares. This is simple supply and demand: the same amount of cash chasing a diminishing number of shares tends to increase the share price of the remaining shares. If will not affect all shares equally, the quality companies will attract more than their fair share of new owners.

4. Tax reform. I know this is getting monotonous. But the additional capital expending that is likely to be generated by the change in the expensing of capital goods and equipment will add more growth (revenue) to the economy and more profits (and tax revenue).

5. Employee bonuses. One of the immediate results of tax reform has been approximately three million working people receiving bonuses from corporate America as a show of support for passage of the bill. The bonuses ranged from $1,000 to $3,000 (most at the lower end). This is money that will be used to either spend or pay down credit card balances making room for more spending in the future. It isn’t a lot but we suspect that wage increases are also coming.

6. The Fed and central banks around the globe continue to keep interest rates low fueling more capital spending and higher asset prices. We believe that unless inflation picks up a lot more than it already has there will be little change in policy as central bankers aspire to avoid rocking the economic boat and promote continued growth.

7. The global economy is growing faster now than a year ago and some laggards of consequence have finally pulled out of recession, namely Brazil and Russia. Even South Africa is beginning to show signs of life as it appears the corrupt President Zuma is nearing departure. Most notable is that Europe seems to be growing better as a whole and even Japan is growing again, albeit slowly. But positive growth always helps the average more than contraction.

8. The USD (U.S. dollar) has been weakening and looks ready to continue to do so for the foreseeable future. This also makes U.S. export more affordable to overseas consumer and industrial buyers. This, along with the lower taxes for U.S. companies, should increase exports of U.S. goods resulting in higher corporate profits and cash flows. This is another boon to equity valuations going forward.

9. We expect the U.S. to experience increased foreign investment both directly through asset purchases and indirectly through equity investments. With the USD much lower foreign currencies that have increased on a relative basis will buy more in the U.S. Foreign investor are very aware of the currency differentials and increased gains available from changes in relative currency values. The U.S. equity market should be looking much more inviting as the impact of tax reform on bottom lines begins to appear later this year.

10. Small business optimism in the U.S. hit an all-time record in 2017. It appears we are at the beginning of a great resurgence in small business growth. This segment of the economy has lagged for nearly a decade under the rising burdens of regulations. That is all changing as businesses below certain size are being exempted from many costly regulations that otherwise made starting or conducting a small business prohibitively expensive. Large corporations can adhere to such regulations because the cost can be spread over a larger base of revenue with administrative cost represent a less significant impact.

11. Earnings estimates are rising for 2018. Wall Street analysts are raising earnings estimates for the coming year to as high as $155. That would mean an increase from the recent 2017 estimate of $124 by 25%. Others are not quite as optimistic but still forecasting a significant increase. Wall Street optimism generally spreads well across the investing spectrum.

12. There is still a lot of money on the sidelines. As we mentioned in an earlier article we believe that FOMO (fear of missing out) will soon hit the markets once earnings improve in quarters one and two for 2018 and the general optimism of Wall Street begins to take root. The small, less experienced investors are always late to the part and, along with the momentum investors, will help carry the bull to new highs because the fear of having missed out on once-in-a-lifetime gains since the last recession will finally entice them into the market that grows ever nearer its top.

13. Forward multiples will begin to appear to be at more normal levels. When forward earnings estimates are accepted broadly and publicized the multiples will no longer look so bad. And when the reality of rising earnings sinks in a lot of stock will start to look cheap (or at least reasonably priced).

14. U.S. GDP growth is poised to grow at perhaps the fastest rate in several years. No more 2% or below for 2018 GDP growth. The consensus is that the economy will grow above 2.5% and potentially hit near 3% this year. It would be hard to make a case for stocks entering a bear market during a year of strong GDP growth.

15. Inflation should remain low for 2018. We know this may seem like a contradiction to one of the dirty dozen above but reality is that with the auto industry sales cycle having peaked and credit tightening (albeit at a very slow pace) inflation should remain tame this year. Imports may cost a little more but most foreign companies will try to keep prices competitive even if they have to reduce profit margins in order to do so. Market share means more to Chinese companies than the bottom line, or so it seems. Above we said interest rates “could” rise faster to combat inflation “if” it comes. But we really do not expect inflationary pressures to mount just yet for many of the reason cited as head winds to growth. Those factors are slowing the economy but may not be strong enough to overcome the mounting strength of the economy. Stock usually do well during periods of low inflation and above average growth.

16. The economy is running on more cylinders than it has in a long time according to recent reports. Here are a few examples:

Construction ended a modest year on a strong note, rising 0.7 percent in December to lift the year-on-year gain by just more than a point to 2.6 percent. The strength has been in housing where residential spending rose 0.5 percent in the month for a yearly and very strong 6.2 percent increase. All components -- single-family, multi-family, home improvements -- have been solid contributors.” Source: econoday.com

Factory orders continue to grow:

The employment cost index is rising but at a manageable rate which should be good for sustained economic growth as wages continue to rise, but not too fast that it causes inflation.

“ Wage costs and benefit costs eased off in the fourth quarter but the trend remains significantly firm. The employment index rose an as-expected 0.6 percent in the fourth quarter which is down 1 tenth from the third quarter -- yet the year-on-year rate continues to move higher, up 1 tenth to 2.6 percent. This rate was last matched in first-quarter 2015 and is otherwise the highest of the post-2008 expansion.” Source: econoday.com

Prices on existing homes continue to rise making homeowners feel a little wealthier which tends to help sustain consumer spending.

Released On 1/30/2018 9:00:00 AM For Nov, 2017

Prior

Prior Revised

Consensus

Consensus Range

Actual

20-city, SA - M/M

0.7 %

0.6 %

0.4 % to 0.7 %

0.7 %

20-city, NSA - M/M

0.2 %

0.2 %

20-city, NSA - Yr/Yr

6.4 %

6.3 %

6.4 %

6.3 % to 6.7 %

6.4 %

Source: econoday.com

The economy created 200,000 more jobs again in January according to the Employment Situation Report from BLS (Bureau of Labor Statistics) exhibiting continued strength. The workforce participation rate has stopped falling and leveled off. This at least points to and end to a negative trend and may signal future improvements ahead.

The heartland of our country appears to be growing steadily as the Chicago PMI (purchasing managers’ index) remains abnormally strong.

The Case for a Correction

The average intra-year stock market decline over the past 37 years is over 14%. In the 2017 the largest decline was less than 3%. Corrections are inevitable and healthy for a bull market to sustain itself. Corrections are generally defined as a stock market drop of more than 10% but less than 20%. When we get to over 20% the conventional view is that we would be in a bear market.

The capacity issue is not that constraining, in our opinion. The labor market is tight but there are a couple of things that we believe will counteract that situation. First, the labor participation rate is still too low. As wages rise more people who had given up looking for a job will re-enter the job market. Second, many boomers are not as ready to retire financially as they may believe. We think that many will either continue to work longer, especially if wages rise, and that more will try retirement but return to work (at least part time) to make ends meet. There is also more slack at lower end of the working age spectrum that includes teens and those in their twenties who have yet to find that first job and because they lack experience are having a hard time finding work. As employers get desperate for workers they will start investing in training the untrained.

In terms of capacity in factories we believe that expansion will ensue to meet rising demand where needed. This is made much more likely by the repatriation of all the cash from overseas. We also believe that many foreign producers will consider setting up shop in the U.S. to produce products to sell here closer to the end market. Robotics will also help make up for labor shortages in many businesses of all sorts, but especially manufacturing.

The auto sales declines will be a drag on the economy but should not be enough to cause a recession. It is nowhere near the size of the real estate industry in terms of employment or its contribution to GDP.

With energy prices at decent levels continued growth in energy production should continue to add jobs. The chemical industry should see further expansion due to the increased availability to relatively cheap feed stocks here in the U.S.

Millennials are getting off to a slow start (on the whole) but enough boomers will likely continue to work longer and keep consuming to narrow the gap. Millennials will not be slowed forever and they will eventually make their contribution felt in the economy. Their consumption will be more muted at this stage that for earlier generations but will continue to grow nonetheless.

Fed and central bank policy is complicated but we think the doves will win the day and keep interest rates from rising too fast to dent the economic growth. Europe and Japan especially do not want to let loose of the reins until those respective economies are on sounder footing.

War is always a threat. Get over it until it actually happens. Sorry to seem cynical but I spent two tours in Vietnam without even knowing for sure why I was there so I think I earned a pass on this one. War can be wrench in the economic machinery but until one happens we think the mere threat will do very little to dampen growth.

The yield curve is likely to widen by later in the year due to the overwhelming abundance of evidence pointing to future growth prospects for U.S. businesses. So, we are not too worried about investors acquiring the perception that the future outlook is worsening before year-end.

The one wild card is the mid-term election in November (War is also a wild card, okay there are two wild cards). If the economy is humming, people are finding jobs, wages are rising faster than inflation, inflation is low, interest rates are not too high, stocks are reaching new heights and we are not in a trade war the probability of the party in power being ousted is pretty low. We think Democrats will need the Republicans to make a big mistake to take control of either chamber of Congress. Of course, there is one other wild card: President Trump. This one could go either way; that is why it is considered a wild card.

The market is due a correction but not necessarily ready to turn bearish.

Conclusion

We believe that the case for continuing this bull market advance is stronger than that for an immediate bear market. We could get a correction of more than 10% but we could also get a pull back of less magnitude. The market needs to take a breath and rest so it can build a foundation from which to launch another leg higher. So, we still believe that the bull market will remain intact but that the current selling could provide some unique opportunities to find a few select, quality companies at reasonable valuations.

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: DISCLAIMER: This analysis is not advice to buy or sell this or any stock; it is just pointing out an objective observation of unique patterns that developed from our research. Factual material is obtained from sources believed to be reliable, but the poster is not responsible for any errors or omissions, or for the results of actions taken based on information contained herein. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice.