Next Market Downturn's ETA - Summer 2019

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Includes: ARKG, ARKK, DDM, DIA, DOG, DXD, EEH, EMQQ, EPS, EQL, FBT, FENY, FEX, FWDD, FXN, HUSV, IGV, IVV, IWL, IWM, IYW, JHML, JKD, OTPIX, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWM, RYARX, RYRSX, SCAP, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, UWM, VDE, VFINX, VOO, VTWO, VV, XLK
by: Bryan Bourgeois

Summary

The stock market and economic conditions are extremely strong, better than we have had for over a decade, but this will not last forever.

Rising rates along with the fading positive effects from the budget spending bill and deregulation will cause economic growth to slow.

The potential risk of a change in administration will cause investors to flee the stock market well in advance of the 2020 election, likely starting next summer.

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I believe we are in the final growth stage of our current economic cycle, which has been one of the longest in modern history now in its 9th year (see chart below). Just as in past stock market booms and busts, the yield curve once again seems to have a high likelihood of predicting the next market peak and crash. The trajectory of the yield curve, along with a few other contributing factors discussed below, suggests a market top and subsequent crash will take place exactly 1 year from now.

Source: S&P Global

The U.S. Bureau of Economic Analysis (BEA) reports Gross Domestic Product (GDP) grew at a 4.1% rate in Q2 2018. According to the Atlanta Fed, GDP for Q3 2018 (current quarter) is estimated at 4.4%. Source: GDPNow

Economic conditions are currently extremely strong, better than we have had for over a decade based on unemployment levels at 3.9% and GDP at $19.39 trillion.

Source: U.S. Bureau of Labor Statistics

Source: World Bank

Even so, headwinds are mounting, and the tailwinds are waning. At the moment, we are benefiting from lower taxes, the increased spending bill passed by Congress and deregulation, all of which have fueled immediate economic growth.

While this has been a boon for the economy, monetary policy here in the US has reversed from stimulating the economy with ultra-low interest rates to hiking rates aggressively to currently 1.91%. What’s more, Fed Chairman Powell is adamant to sticking to continued rate hikes, adding another increase to the Fed Funds Rate likely in September with a 99.8% chance, according to the CME Fed Watch Tool, and possibly another increase in December, currently with a 77.6% chance, also based on the CME Fed Watch Tool, taking the rate to 2.25–2.50% within the next three and a half months. And, it doesn’t stop there. Two or more hikes are expected in 2019 suggested by the Fed's dot plot (see “Implied Fed Funds Target Rate” below), which could bring the Fed Funds Rate to 2.50%–3.25% 1 year from now.

In addition to the Fed raising rates, increasing federal deficits are likely to cause bonds and the US Dollar to fall pushing rates higher even faster. Rising rates will cause the capital markets to tighten which will reduce lending and eventually an economic contraction will surface. Corporate cash will also dry up due to corporations depleting their cash reserve by indiscriminately continuing to buy back their own stock and having to pay down upcoming loans renewing at higher rates.

Moreover, the spending bill Congress passed, and the benefits of deregulation will also cap out likely 1 year from now, reducing the “catch-up” acceleration that we are currently experiencing.

To add fuel to the fire, markets are also likely to sell off in advance of the next US election in 2020 due to the fear of a possible change in the administration, which would likely lead to higher taxes, more regulation and slower economic growth.

While these threats loom, there is a reason to hope. However, this greatly depends on the ability to further enact job-creating and growth-generating policies from the administration and Congress, which may or may not come to fruition. I will discuss the favorable possibilities after outlining our current trajectory of a major market drop 1 year from now. But before we dive into what will cause the market to sell-off as well as the possibilities that the market will have a quick rebound and continue higher, let’s get an update on the current state of economic conditions through the Leading Index of Economic Indicators for the United States.

THE GOOD NEWS – THE ECONOMY IS STRONG. THE BAD NEWS – IT WON’T LAST.

Current Indicators

The Leading Index of Economic Indicators for the United States shows a healthy level of economic activity with no signs of a recession currently in sight, averaging a 1.5% average annualized increase (updated monthly). Yes, economic activity is currently strong, but this won’t last forever.

Below, I will discuss the three primary factors that will lead to the market sell-off exactly 1 year from now. Also, keep in mind, markets are very predictive as equities and bonds are priced by future expectations, usually 6 months–1 year or more in advance and not present conditions, meaning that even though the economy is growing, equities and credit could crater as valuations are re-set.

https://static.seekingalpha.com/uploads/2018/8/22/saupload_lei_thumb1.png

Leading Index for the United States

THE UPCOMING MARKET CORRECTION:

CONTRIBUTING FACTOR #1 – RISING INTEREST RATES

2-Year Yield Curve

In the past two downturns, in 2000 and 2007, before the market crashed, the 2-year yield curve (the difference between the 2 and 10-year treasury bond) inverted. Currently, the yield curve is following the same pattern as the previous two cycles, suggesting the peak of the market will occur exactly 1 year from now.

https://static.seekingalpha.com/uploads/2018/8/22/saupload_2-yr-yield-curve_thumb1.png

$YC2YR - Yield Curve - 2-Year Bonds (EOD)

1YR, 3YR, 5YR, 10YR and 30YR Treasury Yields

Below is another illustration of yields for the 1YR, 3YR, 5YR, 10YR and 30YR treasury yields, also showing the yield curve inverting on a trajectory of exactly 1 year from now, signaling a market top and subsequent sell-off.

https://static.seekingalpha.com/uploads/2018/8/22/saupload_yield-compare_thumb1.png

$UST30Y - 30-Year US Treasury Yield (EOD)

Fed Funds Rate Overlaid With The S&P 500

In addition to the yield curve, the current schedule of rate hikes for the Fed Funds Rate also points exactly to a market top occurring exactly 1 year from now. Below, you will see the Fed Funds Rate overlaid with the S&P 500. In 2000 and 2007, the Fed Funds Rate peaked and hit its long-term resistance (blue line) exactly when the stock market peaked. The current schedule published by the Fed indicates the Fed Funds Rate at 2.50%–3.25% exactly 1 year from now. This level will again take the Fed Funds Rate to its long-term resistance, signaling a peak in the market before a major sell-off.

https://static.seekingalpha.com/uploads/2018/8/22/saupload_sc-1_thumb1.png

$$FEDRATE - Effective Federal Funds Rate

Fed Funds Rate Schedule Of Rate Increases

While economic indicators are currently strong, causing risk assets to continue to appreciate, the Federal Reserve remains committed to rising rates, which will likely hamper capital markets and economic growth. Below is the chart of the latest dot plot, or schedule of rate hikes by the Fed. Currently, the bond market futures are predicting a hike in September, taking the rate to 2.00–2.25% and a 50% chance of another hike in December, taking the rate to 2.25–2.50%. The latest forecast can be viewed here on the CME website that produces the CME Fed Watch Tool.

https://static.seekingalpha.com/uploads/2018/8/22/saupload_Capture-dot-plot_thumb1.png

Federal Reserve Dot Plot

CONTRIBUTING FACTOR #2 – DEFICITS ARE PREDICTED TO CONTINUE TO RISE, CAUSING A SELL-OFF IN BONDS

In addition to the Federal Reserve’s plan to hike rates, natural market forces will also contribute to the rate rise as bonds are sold off. This includes an unusual situation of rising deficits and along with rising rates. Historically, government deficits fall as rates rise. Currently, as the chart below shows, we are confronted with rising rates with an increasing deficit. This unique scenario will likely cause rates to rise even faster as deficits continue to soar and bonds fall.

https://static.seekingalpha.com/uploads/2018/8/22/saupload_deficits_thumb1.png

Source: Bloomberg, BofA Merrill Lynch Global Research

Just as deficits and Fed Funds Rate are usually positively correlated, so is unemployment and the federal budget deficit. Below shows an inverted chart of the Federal Deficit, which is expected to increase along with unemployment declining. This is also unique since higher employment means fewer unemployment benefits and higher tax revenues. However, with our current spending bill, deficits continue to rise, interest rates are rising, which will cause overall debt and debt service to also increase, and bonds to fall.

What will happen when unemployment reverses are starts to climb as people lose their jobs and a recession hits, causing lower tax receipts along with unemployment benefits? Deficits will spike, rates will continue to rise, and markets will certainly fall off a cliff.

https://static.seekingalpha.com/uploads/2018/8/22/saupload_deficits-and-unemployment_thumb1.png

Source: Bloomberg, Goldman Sachs Research

Further exacerbating the problem is the failing infrastructure in the US. Below, we notice that federal and state government investment has been declining since 1952 and is at historical lows, meaning increased expenditures will be needed to rebuild roads, bridges, airports, dams and many other critical areas that have been left unattended for decades. The increased government spending needed to upgrade the dated infrastructure will further add to rising deficits. This additional increase in deficit spending will further cause bonds to sell-off and rates to rise, hindering cheap access to capital and stifling economic growth.

https://static.seekingalpha.com/uploads/2018/8/22/saupload_gov-investment_thumb1.png

Source: TopdownCharts

CONTRIBUTING FACTOR #3 – RISING CORPORATE DEBT AND LIKELY DEPLETION OF CORPORATE CASH AS INTEREST RATES RISE

Companies in the US have been piling on an unprecedented amount of debt, now surpassing $5 trillion. While there are exceptions for a lucky few that have substantial stockpiles of cash, such as Apple (NASDAQ:AAPL), Facebook (NASDAQ:FB) and Google (NASDAQ:GOOG) (NASDAQ:GOOGL), most US corporations are on a ticking time bomb of mounting debt that must be repaid or refinanced at higher rates.

https://static.seekingalpha.com/uploads/2018/8/22/saupload_copro-debt_thumb1.png

Source: Board of Governors of the Federal Reserve System

While debt mounts and interest rates rise, corporations are going to be in for a rude awakening when they are confronted with a $4 trillion wall of debt coming due. This refinance escapade coincidentally begins exactly 1 year from now.

CONTRIBUTING FACTOR #4 – PRESIDENTIAL ELECTION

Another coincidence is that the next US election will become front and center in people’s minds in about 1 year from now. Since the stock market is a leading economic indicator and usually prices in the markets well ahead of the present, this would line up perfectly with a market top and sell-off 1 year from now. However, there are reasons that could derail this thesis. These include the following three de-contributing factors for a market sell-off.

SOME REASONS FOR HOPE

Below are some possible political maneuvers that could give the market another boost. Unfortunately, I do not see any occurring within the next 12 months, so the market sell-off is still on track despite these possible scenarios. However, a strong recovery is possible, making the sell-off steep, but short-lived.

DE-CONTRIBUTING FACTOR #1 – TARIFF-FREE TRADE POLICY ENACTED AMONG G-7

Trump has imposed tariffs as a response to an imbalance of trade and certain elements he deems as “unfair” advantages, including monetary policy divergence and currency manipulation. However, Trump’s primary objective is not tariffs, but rather a reciprocal free trade with all tariffs zeroed out on both sides, which we do not have today. Trump clarified that at the recent G-7 meeting in Quebec, saying to Europeans, Japan and Canada, “We should consider no tariffs, no barriers – scraping all of it.”

If Trump and Larry Kudlow, the original promoter of such policy, were able to secure this policy amongst the G-7 members, the stock market would take off. The enormous benefit through the elimination of the taxes imposed on imported and exported goods via tariffs would launch an unparalleled, mutually reinforcing, global boom.

DE-CONTRIBUTING FACTOR #2 – ADDITIONAL ENERGY DEREGULATION

Trump could further boost growth by rescinding the 2009 anti-fossil-fuel Endangerment Finding of the Obama’s EPA. This could lead to immediate economic benefits for the US economy.

DE-CONTRIBUTING FACTOR #3 – ADDITIONAL TAX CUTS FOR THE MIDDLE CLASS

Trump could further re-boost economic growth with additional tax reform, revisiting unfinished business from the first round of tax reform. He said recently that in October, Congress should have to vote again on the middle-class tax cuts, this time to make them permanent. That was missed last time because not one Democrat would vote for the tax reform tax cuts for working people, which was necessary to break the 60-vote barrier in the Senate.

DE-CONTRIBUTING FACTOR #4 – TRUMP RE-ELECTED

A Trump re-election would most certainly be highly beneficial to the US economy and stock market. Trump’s pro-growth agenda, possibly one day including one or more of the three previous factors above, economic expansion is almost guaranteed. If Trump does get re-elected, the market will continue higher for another few years, but then we will have the biggest crash the world has ever seen, likely in 2022–2023 when the US and global government and private debt implodes on itself and Tump (if re-elected) leaves office.

FINAL THOUGHT

Today, many investors are becoming complacent, forgetting about risk right at the very time they should be thinking about risk. Now is the time to start your plan to protect and profit from the current upward trend in the markets and position your portfolio to safeguard and/or profit from the sell-off that will certainly unfold.

While a downturn or valuation re-set driving stocks lower could occur at any time, I would suspect that we continue to reach new highs as we approach the summer of 2019. Historically, the last upward trend in a long-running bull market is usually the strongest.

Therefore, I currently suggest a risk-on trade in US equities. I particularly like the following ETFs at the moment: the First Trust Energy AlphaDex (FXN), the iShares North American Tech-Software (IGV), the iShares U.S. Technology (IYW), the ARK Innovation ETF (ARKK), the ARK Genomic Revolution Multi-Sector (ARKG), the Technology Select Sector SPDR Fund (XLK), the Vanguard Energy ETF (VDE), the Fidelity MSCI Energy Index (FENY), and the First Trust NYSE Arca Biotechnology (FBT). I also believe certain emerging market equities have huge upside from present levels, including the iShares Latin America 40 (NYSEARCA:ILF) and the Emerging Markets Internet and Ecommerce (EMQQ).

As rates and inflation slowly rise, technology and energy-related equities are likely to outperform. Interest-sensitive investments, such as triple-net and long-term leased publicly-traded REITs, fixed mortgage-backed securities and corporate bonds are unlikely to provide meaningful gains and hold elevated risk-adjusted returns.

My recommendation is to focus on US equities, floating-rate and secured credit and move into emerging market (EM) equities cautiously, and adding to the EM equities especially if the US Dollar softens, which I think is likely to occur in the near future.

As we get closer to the summer of 2019, prudent investors should move to cash as the market weakens and falls below critical technical support levels.

Disclosure: I am/we are long FXN, IGV, IYW, ARKK, ARKG, XLK, VDE, FENY, FBT, EMQQ AND ILF.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.