Could This Friday Be An Inflection Point?

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Includes: DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, HUSV, IVV, IWL, IWM, JHML, JKD, OTPIX, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWM, RYARX, RYRSX, 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, UDN, UDOW, UDPIX, UPRO, URTY, USDU, UUP, UWM, VFINX, VOO, VTWO, VV
by: Mark Bern, CFA

Summary

We could be heading for further correction in stocks, a recession or another leg up.

A lot may hinge on the upcoming Employment Situation Report.

What are the probabilities of a recession or continued growth?

The fact is that nobody can consistently and accurately predict what will happen in the future because there are just too many variables and too many potential unknowns that could arise out of nowhere. But we all try because that is what drives our investing decisions.

Could stocks fall further? Of course they could. Could the economy fall into a recession? Not as likely, but still possible. Will stocks rally to new highs in the coming months? Also, a possibility. In this article, I will attempt to explain some (not all) factors that should influence the market direction between now and year end.

October Employment Situation Report

Rarely has the monthly Employment Situation Report from the BLS (Bureau of Labor Statistics) been more important to market participants. Next Friday, November 2nd, the BLS is scheduled to release its report for the month of October. All states will not have provided finalized data so this version will be preliminary in nature and contain several estimated values and the really important aspects will be in the details, but the headline number is what the market will be watching.

We Need a Goldilocks Report

If the headline number indicates a slow down in job creation the markets could interpret that to mean that the economy will slow more in coming months. That could solicit a negative response by investors and send stocks lower still as fears of the next recession continue to mount. This would be a knee-jerk reaction that we should not pay attention to as it does not really change the long-term trend. Only if stocks fall below the lows set during the first quarter should we begin to consider this a real threat to the health of the bull market. But, still, it could test our mettle and shake out a lot of the investor with weaker convictions.

If the headline number indicates that job creation remains strong, the markets could assume that the Fed (Federal Reserve Bank of the U.S.) will raise interest rates even faster to head off potential wage inflation before it gets out of hand. Of course, we could use a little wage inflation but the Fed isn’t as concerned about the needs of the economy and its people as it is about inflationary pressures. That could also spook investors and result in further erosion of stock prices in the short term. Again, it would be a knee-jerk reaction to which we should not give much credit since one data point does not a trend make. We would need several months of reports heading in the same direction before we should get too worried. The Fed knows this and will probably not adjust its plans without further supportive data.

But, if the number of jobs created is somewhere in the middle of the range, indicating that the economy is still in growth mode but not overheating, worries may dissipate and investors could begin picking up some bargains creating strong support under the market. If that is the case we could see stocks begin to rally again.

Dollar Strength

Another piece to the puzzle (the economy really is a complicated game with a huge number of interacting variables) in the health of the global economy is the strength of the USD (U.S. dollar) relative to other major currencies. As the USD moves higher several things happen (I won‘t try to list everything but just some of the more important relationships that we need to be aware of at this juncture).

First, there is a direct impact on profits of U.S. multinational corporations. When the USD rises against other currencies the sales of U.S. companies in other countries are worth less in USD terms so profits are discounted by change in relative currency values.

Second, U.S. exports become more expensive for consumers in other countries leading to less demand for U.S. made products by overseas customers. This, of course, can increase the U.S. trade deficit with many of its trading partners and slow sales (and profits) of U.S. exporting companies. But, since we import far more than we export, the impact is not as significant as one might expect (unless, of course, you happen to be one of the major U.S. exporters) to the overall economy.

Third, U.S. imports will cost less in USD terms helping to reduce inflationary pressures in the U.S. economy but potentially causing the U.S. trade deficit to widen as consumer demand rises. But because of the tariffs, recently implemented prices are not likely to fall enough to stimulate higher demand so this should not be as material as it would be otherwise. That is not to say that the trade deficit will not grow (as it already has) but that it should grow less aggressively because some of the higher cost inflicted on companies by the tariffs will be passed onto consumers in higher prices thereby deflating demand somewhat. It is also important to note here that the Chinese Yuan has decreased in value relative to the USD by about 10% this year (roughly equal to the current tariffs on most imports from that country) so there should be little or no increase in cost to be passed on…yet. That could change on January 1 st as the Administration has announced its intention to raise tariffs on China to 25% across the board at that time if negotiations have not resumed.

Fourth, several emerging market (EM) countries have significantly increased debt denominated in USD. This causes the cost of interest payments (more USD for every unit of local currency) to rise while revenues are still generated primarily in local currencies. Some EM countries have reduced USD denominated debt and overall it is less a problem that in the past but others continued down the riskier path and increased USD debt, both public (government) and private (corporate) causing a lot of pain and leading to recessions. The EM countries with the most USD denominated debt are (in no particular order): Turkey, South Africa, China, Turkey, Iran, Argentina, Russia, India, and Chile. Another currency that has been roiled by the markets this year is the Brazilian real.

Why the USD is Strengthening

When U.S. interest rates rise while rates in other countries remain low, the USD strengthens because money that would have been invested elsewhere gets invested in U.S. Treasuries. That reduces capital investment in EM countries more than in developed countries. Also, as the U.S. economy grows at a faster pace, due to its sheer size and importance in the global economy, its relative strength buoys investment interest in the U.S. causing further strength in the USD. Finally, as inflation in the U.S. remains lower than in EM countries, when combined with the first two factors (and other less significant factors) the USD strengthens because it is less likely to be as negatively impacted by the decaying influence of inflation.

Mid-term Elections

Historically, the year following a mid-term election results in strong gains in stocks.

“ In midterms going back to 1946, the S&P 500 index had an average price return of 16.7 percent in the 12 months after the elections, according to CFRA.” Quote is from this Washington Post article.

The S&P 500 (SPY) has risen in every 12-month period following each mid-term election since 1946. That constitutes 18 straight elections and 18 straight rising markets. It does not seem to matter what the makeup of Congress is as it has varied significantly over that period. Of course, that does not mean that we should automatically expect that the market head higher for a 19th straight time.

There always seems to be a lot on the line during an election year, whether it is of the presidential or mid-term variety. Usually the outcome has very little influence on the economy primarily because our federal politicians tend to be more reactionary than proactive on the issues that matter. Our current President does not seem to care if he is rocking the boat meaning that all conventional wisdom gets thrown out the door for as long as he controls the White House and his party (Republicans) control Congress.

This is not to say that I favor one party over another. I actually despise politics for a number of reasons, the least of which is not the amount of uncertainty and division that campaigns infuse into our economy and the markets. Investors do not like uncertainty as we have painfully witnessed over the course of this past month.

But this time, because of the unconventional approach to governing by the current administration, things could be different. The outcome of this election may create deadlock, which in most circumstances would be a good thing, but in the current environment could lower expectations on many fronts that market participants have been counting on. Better border security means investment. Infrastructure spending means more jobs. Immigration reform could mean a better supply of badly needed skilled workers to fuel continued economic growth. None of that is likely to happen with a gridlocked Congress. And that could deflate expectations for future growth.

But if Republicans were to retain control of both chambers of Congress, our economy would either sink or swim depending upon how much legislative progress can be achieved. They will either be the heroes or look more like the Democrats’ mascot. I do not suggest that anyone vote against their conscience. Nor am I trying to suggest that one party will be more successful. This is just an opinion as to what the outcome could trigger in the markets as a result of mid-term election results and why this time may be different.

Trade War

The trade war with China is now moving into a higher gear. But this is more than just a trade war; it is the recognition by the United States that China has not been playing fair in global trade and that it represents a threat to the existing balance of power in global geopolitical influence. It now appears that we are entering another Cold War of sorts that could last for decades. Admittedly, I did not expect this outcome a few months ago.

On the other hand, it may not last that long because while China has become very powerful economically it has also piled up more debt (as a percentage of GDP) than has the U.S. Its government debt is relatively low, as is its residential debt level, as compared to GDP. The problem is in the corporate sector.

China’s Debt Threat – Financial Times

I do not expect the bubble to burst anytime soon, but the situation does restrain the Chinese government’s flexibility in addressing its responses to the trade dispute. Prior to the trade war with the U.S., China was attempting to tighten some forms of debt creation and encourage more bad loan be written off. But because of the trade dispute, it needs to loosen lending restrictions again to maintain growth. That may be fine in the short term but it could prove unhealthy economically if continued indefinitely. And if the trade war escalates further (which appears to be likely come January 2019) China may be forced to continue a policy it knows could be its own undoing.

While the U.S. may be in a better position to win a trade war neither side would benefit more by continuing an open-ended dispute. At some point my hope is that China will come back to the negotiation tables and that both parties will negotiate in good faith. Otherwise, we could see a stalemate that grows in intensity on multiple fronts and that could wreak havoc on global economic growth due, to a great extent, to the increased uncertainty that would entail.

Consider the Probabilities

There is no way to accurately portray the potential outcomes by percentages other than finding a consensus or accepting assumptions that, by their very nature, would likely contain personal biases. So I want readers to consider watching this following video link created by Chris Ciovacco (Seeking Alpha contributor) that should put our current situation into perspective. I think this may be his best explanation and technical of the market environment from a long-term perspective ever. His next (latest) video is also worth a look.

The perspective that I come away with after watching those videos (from a technical aspect) is that the sky is probably not falling yet. We are closer to a 50/50 probability that the market could go either way. But that is still based more upon the short term. If one were to take the longer view of the trend the bull is still intact but we should be more cautious. Some more downside is possible but it is my opinion that, for the long term investor, it is still too soon to sell shares in quality companies.

Conclusion

Suffice it to say that the coming employment situation report and the market reactions it could cause may influence the outcome of the mid-term elections less than two weeks away. That alone could create further uncertainty in the markets and we should all know how the markets dislike uncertainty.

I’d like to leave readers with one thought: keep things in perspective. So far, the current downdraft in stocks has been less than 10% from recent highs in major indices with the exception of the NASDAQ Composite Index (QQQ). It is merely a correction that leaves the long-term bullish trend intact, so until the trend changes we need to remain long to ensure we do not miss the rebound that is still very possible from both a technical and fundamental analysis of the overall situation.

This recent market gyrations should be considered a speed bump before another leg higher until there is either strong evidence to the contrary or a significant catalyst to derail economic expansion. I continue to believe that the U.S. economy is stronger than many realize.

As always I encourage readers to leave comments as I believe we can all learn from each other. We are all entitled to our opinions and should respect those of others.

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.

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: Mark Bern, CFA, and Mycroft Friedrich collaborate on the Friedrich Global Research marketplace offering.