All Along The Watchtower

by: Eric Parnell, CFA


Are you the joker or the thief?

Thoughts on the latest U.S. stock market correction.

The key perspectives to keep in mind going forward.

"There must be some way out of here"

Said the joker to the thief

"There's too much confusion

I can't get no relief”

--All Along The Watchtower, Bob Dylan, 1967

When it comes to investing, are you the joker or the thief?

The joker. Stock investors has spent years reaping the gains provided by torrent of liquidity from the mighty Federal Reserve. But now that stocks are finally falling even for a moment in 2018, they find themselves overwhelmed, confused, and searching for relief. The utterly absurd article fromBloombergis just one of the many examples in the financial media showing how much investors today simply expect that the only thing the Fed should be focused on is saving today’s stock investor from any possible declines in value.

Businessmen, they drink my wine

Plowmen dig my earth

None of them along the line

Know what any of it is worth"

--All Along The Watchtower, Bob Dylan, 1967

Investors today are plagued by this gross sense of entitlement. It was exactly a decade ago in October 2008 that the global financial system was on the brink of evaporating into oblivion. Were it not for the extraordinary monetary policy measures enacted at the time by the Federal Reserve and its major global central bank cohorts, global stock markets may have entered into a terminal downward spiral. And it was in part out of fear that these same monetary policy makers not only maintained but exponentially increased these emergency measures in the years since that catapulted U.S. stock prices from the abyss to well beyond historical peaks.

In the end, today’s stock market highs are nothing more than a byproduct of misguided monetary policies that went way too far for far too long. Yet many stock market jokers believe just as they did nearly two decades ago during the tech bubble that they are entitled to these stock market gains. “The gains in my stock portfolio are mine and mine alone are a result of my hard work and analysis. And anything policies that are being implemented today to take these gains away from me is wrong, regardless of whether these policies make sense for the broader economy and its sustainable health over time”. Except that they are not. And the responsibilities of global policy makers extend well beyond making sure that Joe Blow investor already living large in Toponepercentsville doesn’t suffer a marginal decline in portfolio value over the course of a few weeks time.

"No reason to get excited"

The thief, he kindly spoke

"There are many here among us

Who feel that life is but a joke”

--All Along The Watchtower, Bob Dylan, 1967

The thief. In the decade since the calming of the financial crisis, the thief has invested alongside the joker. They too have reaped the benefits of the policy generosity put forth by global central bank in the form of inflated asset prices including stocks. But these investors have never lost sight of the fact that these gains have been in many respects a joke in that they likely never would have happened if the Fed and other global central banks had either never intervened to save the financial system or had withdrawn their support years ago.

As the U.S. stock market repeatedly overcame seemingly insurmountable obstacles on numerous occasions over the last decade, these investors maintained humility while not losing sight of the underlying risks that were becoming increasingly more pervasive all along the way with each new market high. And they have remained prepared for the various outcomes that might erupt at any given point in time along the way.

So when the stock market suddenly starts falling by -10% in October 2018, the thief is not surprised. Instead, they are prepared. And they are not looking for the policy maker that is already painted into a suffocatingly tight corner to bail them out. Instead, they are considering the potential opportunities that this or any future correction might present, because they recognize that declines in value over any period of time is not a catastrophe but instead a part of a normally functioning market free of government intervention from the mighty monetary policy gods.

“But you and I, we've been through that

And this is not our fate

So let us not talk falsely now

The hour is getting late"

--All Along The Watchtower, Bob Dylan, 1967

Are you the joker or the thief? While the answer to this question has been largely inconsequential when it comes to U.S. stock market investing over the past many years, it is becoming increasingly important today. Why? Because we both have imbibed on the largesse of monetary policy generosity. But the punch bowl is being increasingly drained. And it is being done by a new monetary policy leadership that seems much more keenly aware of the consequences of fostering potential financial instability and how its negative spillover effects can be just as severe if not more so than less than full employment or pricing instability. Put more simply, new Fed Chair Powell and his FOMC team doesn’t really seem to care all that much if the stock market sells off over the course of a few weeks or months, particularly when its still trading at historical high valuations. The famous or infamous depending on your view Greenspan/Bernanke/Yellen put from the past three plus decades may not extend to Powell. Whether the market has woken up to this increasingly reality yet remains to be seen.

Keep it real. With this in mind, it is more important now than ever in the post crisis period for investors to pursue a balanced and well grounded perspective on financial markets. Now is not the time to simply dismiss those with which you may disagree with flippancy and derision. Instead, it is time to stop and to carefully consider what others may be seeing and saying. This is particularly true if you maintain a more bullish view on the U.S. stock market, as the winds that you have enjoyed for so long are no longer at your back. In short, the hour is now getting very late on this historically long bull market.

All along the watchtower

Princes kept the view

While all the women came and went

Barefoot servants too

--All Along The Watchtower, Bob Dylan, 1967

So what exactly is unfolding all along the U.S. stock market watchtower that is threatening to fell this epic bull market?

To begin, perspective. Yes, the U.S. stock market as measured by the S&P 500 Index finally grazed correction territory having fallen by as much as -10% from its highs roughly one month ago. But we must remember a few things.

First, this is still fairly normal. A -10% correction over the course of any amount of time was a regular occurrence in any given trading year for the S&P 500 Index prior to the financial crisis. So the fact that it is taking place today is not unusual or unhealthy. Instead, it is a sign that today’s stock market may actually be returning to some semblance of normal by exhibiting a reflex function. Remember, we are not entitled to a stock market that does nothing other than go up. Putting invested capital at risk of loss it what justifies the higher rate of return that equities are supposed to provide over time, and we must be reminded when owning stocks that risk is something that can cut both ways to the upside and the downside. Why? Because it ensures that we act prudently and efficiently, not recklessly, when allocating our capital.

Second, the decline remains modest to date. although the stock market is indeed close to -10% below its recent highs, the closing value of the S&P 500 on Friday at 2658 would place it in the middle of its trading range for much of the first half of the year. Moreover, it’s closing price of 2658 would have represented a new all-time high on the benchmark index BY A LOT just one year ago at this very same time. Do we need Fed intervention today? Umm, no. Does the Fed need to back off because the market is down a bit over the past few weeks? Once again, no. This is a market behaving normally.

Third, bears are not unleashed all at once. It is important to remember that the U.S. stock market almost never falls in a straight line into the oblivion of a new bear market. This wasn’t true in 2008. It wasn’t true in 1987. It wasn’t true in 1929. And unless we are struck by unprecedented circumstances in 2018, it’s not likely to happen today. The onset of new bear markets are a series of fits and starts, of corrections and countertrend rallies. The hour may be getting late, but it’s not likely that the clock has fully run out just yet. Conditions have been too bullish for too long on so many measures such as historically low volatility and historically tight credit spreads for conditions to suddenly turn so resoundingly and relentlessly bearish for U.S. stocks. A bounce likely lies in our near-term future, and new highs on the S&P 500 Index should not be entirely ruled out before the 2018 calendar year draws to a close.

Lastly, the S&P 500 Index remains orderly despite the recent sharp decline. This was exhibited clearly during Friday’s sell off. The S&P 500 Index opened aggressively to the downside. But no sooner did the market reach 2628 at around 11AM and the decline suddenly stopped, as stocks rallied strongly for the next two hours before thrashing sideways for the remainder of the trading day. What’s so special about 2628? It is almost exactly where the 400-day moving average on the S&P 500 Index currently resides. A key U.S. stock market technical support level was tested for the first time in more than two and a half years on Friday, and stocks responded well to this test, at least for a few hours.

Whether the S&P 500 continue to bounce from this 400-day moving average or ultimately break this level will be worth monitoring in the coming days and weeks, as it will provide information associated with the potentially timing of when this current bull market finally comes to an end.

Next, sobriety. Despite these reassuring perspectives, investors must also keep the following in mind going forward.

First, the Fed no longer has your back. And they may not have your back for another several hundred S&P points at least if not more. They’ve got a job to do in 2018, and it’s not to make sure that the investors that they have coddled for so many years get to keep the riches that they arguably never deserved to generate in the first place and failed to distribute in any meaningful way in support of the economy in recent years anyway. Instead, the Fed seems to believe that investors can take some pain while they snatch every possible rate hike they can in preparing for the next recession that will definitely come at some point in the future. In fact, the Fed under this new leadership may actually think some pain for U.S. stock investors is actually a good thing.

Second, know that "great" corporate earnings were baked in a long time ago. It is true that corporate earnings are still increasing at a double-digit rate on a year over year basis. Investors have been anticipating this fact since the day the tax cuts were signed into law at the end of 2017. What is perhaps more important is the fact that the earnings growth outlook has been decelerating with each passing week for nearly half a year now. And one has to look no further than tech giant Facebook to see how decelerating earnings growth becomes a detriment to a stock price no matter how robust the actual earnings growth may still be.

Third, stock valuations are still historically high even after the recent correction. Put simply, they were expensive at 24 times earnings in May when the S&P 500 Index was trading at 2658, and they are still expensive at 22 times earnings when the S&P 500 Index is trading at 2658 in late October against a historical average around 16 times. Earnings have increased, but they haven’t increased that much in the last five months. And the earnings outlook for many companies are getting slashed this reporting season like a gory Halloween movie. The problem here is that when stocks are priced at a meaningful premium, they will have to fall A LOT more before value buyers even begin to think about stepping in to invest, particularly if the liquidity that had been greasing the markets for so many years is increasingly fading away. In the meantime, investors are relying on the momentum trade to live on for yet another day.

Fourth, the inflation threat is essentially dead. It effectively died on May 17 when the 5-year breakeven inflation rate peaked at a modest 2.16% and has been steadily declining since. Late this week, it dipped to 1.91%, which is lower than where it was at the start of 2017, the entirety of 2013 and much of 2010 and 2011 among other post crisis time periods. The lack of inflation was a “mystery” then, and the “mystery” continues today. This remains bullish for long-term Treasuries (TLT) and bearish for stocks. Why? Because if inflation is fading with the Fed assertively raising interest rates, it implies a potential economic slowdown may be lurking ahead. And arguably the most overhyped indicator of 2018 in the flattening of the Treasury yield curve as measured by the 2/10 spread provides added support to this notion.

Lastly, the S&P 500 Index is alone. It must be noted that every other major equity market index around the world has broken decisively to the downside if not entered full blown bear market territory already. This includes U.S. mid-caps and small caps as well as developed international and emerging market stocks. Heck, nearly half of the companies in the S&P 500 Index itself are in official bear market territory as measured as having fallen by more than -20% from recent highs. And given that I’m not a decoupling guy, either the rest of the world needs to find its giddy up or the S&P 500 is going to join the rest of the world to the downside.

Add in additional elements such as geopolitical uncertainty, mounting financial instability in places like Europe, record levels of growth curbing sovereign and corporate debt relative to underlying GDP in many parts of the world as well as the various potential known and unknown unknowns going forward, and the S&P 500 Index is facing potential downside risk pressures it has not seen in many years now. Whether investors are ready for such a reality today remains to be seen.

Outside, in the distance

A wildcat did growl

Two riders were approaching

The wind began to howl

--All Along The Watchtower, Bob Dylan, 1967

Something wicked this way comes. It has not arrived yet, but it is on its way and it is getting closer. Just as January/February 2018 appears to be to March 2007, it appears that October 2018 may be to August 2007. Stocks had one more major bounce to new all-time highs through October 2007 before the lights went out.

These correlations are not unique to the end of the last bull market. Instead, it is characteristic topping pattern associated of how most every bull market over the last 100+ years. It is a process that plays out over time.

One key to watch in this regard is volatility. If the VIX remains elevated going forward even after today's market stabilizes and finally bounces, it will suggest that the winds are howling and the riders are drawing close.

Tech stocks remain the key to watch. Tech stocks have been driving this rally for the last couple of years now (how very "tech bubblish" of today's market - nothing like following similar footsteps from not that long ago). As long as the uptrend in tech remains intact, the bull market has a more than fighting chance. But once tech starts breaking to the downside, the bull market game is likely over for the current cycle given how weak everything else has already been.

The next bear will not be like 2007-09, 2000-02, 1987 . . . Like all major bear market that have come before as well as those that may come beyond the future, the next bear market will have some similarities but also its own defining characteristics. One thing we do know is the longer that bull markets run, the more dramatic the subsequent bear markets can be once they are finally unleashed. This time around, it will likely be the bursting of the bubble of everything, as this is nothing more than the byproduct of what central banks sought to create for so many years in a misguided attempt to reignite sustainable economic growth in the post crisis period. And given the massive amounts of sovereign and corporate debt that has been accumulated during the post crisis period not to mention the bloated central bank balance sheets, the policy firepower will be scarce to battle the next market downturn and the resulting impact may be muted.

Longer. All of this implies a bear market that may run longer in duration than anything we have experienced in recent decades. Perhaps something as long as several years if not a decade or more. But as countries across the rest of the world including China that have mired in this state for so many years already have repeatedly demonstrated, an economy can perform just fine even if their stock market remains mired in a bear market at levels today are lower than where they were in 2007 or even 2000.

Be the thief, not the joker. Invest in U.S. stocks, participate in any further upside that the broader market or any of its various sub-components may offer going forward, but also stay humble, listen to the various viewpoints of others, recognize the market for what it is including its various risks that are as profound as ever, and be prepared for the greater frequency of downside corrections such as what we are experiencing today.

The hour is getting late. A stock market wildcat is growling in the distance as the winds are beginning to increasingly howl. Be ready and go set a watchlist in preparing to position to protect your portfolio and potentially even capitalize on what lies ahead.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners and Retirement Sentinel makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners and Retirement Sentinel will be met.

Disclosure: I am/we are long TLT.

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: I am long selected individual stocks as part of a broad allocation strategy.