(Image Source: Popular Science)
We are finally in a market of true ups and downs ladies and gentlemen. The S&P (SPY) lost nearly 7% in October contributing its worth month since September 2011. The Dow Jones (DIA) shed over 5% last month and the Nasdaq (QQQ) (the epitome of the growth story) dropped 9%. This is a market most millennials have never seen and possibly only read about in finance history books. It's a long time coming, and for value investors like myself, we'll finally be able to pick up names we've wanted to purchase or repurchase for years. But are we actually hitting a bear market? Could this just be another small bump in the road like 2015, with another few years of unmatched global growth? Or are we finally seeing fissures in the global growth story, exacerbated by political turmoil, loose lending practices, massive amounts of corporate debt, international trade disputes, and an economy at the brink of overheating?
I'll be looking at some of these possibilities and what it could mean downstream for the health of the market and specific sectors moving forward. As it's a massive undertaking and not something that I could adequately provide all the answers to in a 1200-1500 word piece, I'm going to break down this story into two parts. The first part will be akin to setting the table - providing the global context and how they may all converge to what would become a highly entertaining yet dysfunctional dinner party. The second piece will be focused on sectors and a few names I've been watching and slowly purchasing in preparation for a reversal from growth to value and more realistically, a story from optimism to realism bordering on pessimism.
For those who have read me before or followed me may recall my two-part piece Market Correction Catalyst: The Death Of A Value Salesman and When Growth Stops Growing on the divergence of Growth (IVW) and Value (IVE) and how it relates to the financial markets in general and the possibility to determine how likely a reversal may be. It's been about a year since I wrote that series and especially with all the excitement hitting the market these days, I figured it would be a perfect time to write a new piece on the current market sentiment and where we stand today.
I'm not going to focus on the specific arguments of that series in this, although I may do a follow up and track how that thesis has thus far panned out in the general market wide story.
Unemployment Rate: Too Good To Be True?
(Image Source: sscfdl.com)
I've followed the unemployment rate for quite some time, not just as one of the many indicators for general economic health, and simply factoring in people with jobs typically spend more than people without them; but also possible correlations as a potential economic peak. Now I can't say I came up with this particular correlation and will cite Charles Schwab's (NYSE:SCHW) Jeffrey Kleintop for the analysis, but an important factor to watch:
History shows us that when the unemployment rate and the inflation rate converge to become the same number, a prolonged downturn for the economy and markets often followed."
This correlation is somewhat straightforward - after a recession with unemployment high, prices have to be reduced to cope with the lack of buying power. Hence, as people become employed and incomes rise, companies have the opportunity to raise prices again. Now his analysis indicates that when this number hits zero (delta between inflation and unemployment), it takes about a year after that to kick start a general bear market. This in many forecasters' predictions would coincide with a slowing down in later 2019 early 2020.
(Chart Source: Charles Schwab)
So, while we are not quite there yet, we are on our way. And what is not discussed, which could be a problem lurking under the surface is how underemployment may exacerbate the bear market, as it does not adequately depict the employment landscape as it once did prior to the new "gig-economy". Or that Millennial Men are noticeably not being swept up in the recovery as other demographics.
Mom Don't Worry - He Loans Me A Lot
(Image Source: Loma Linda University)
When things are going well and the economy is running on all cylinders, loaning money to well-established companies just makes sense as a business proposition. If you don't offer competitive rates, someone else will. But at what point will the music stop and we are again short on chairs? Former Federal Reserve chair Janet Yellen had some choice words during her interview with the Financial Times, as the recent numbers coming from the Institute of International Finance cited the debt market has grown to $1.6 trillion (VCLT) (VCSH):
I am worried about the systemic risks associated with these loans[…]There has been a huge deterioration in standards; covenants have been loosened in leveraged lending."
As in most cycles, it's always sunniest at the top. And while it's near impossible to accurately tell when we have hit the pinnacle to be on our way down, it's clear we are getting very close. The Bank of England recently indicated that leveraged loans could be the next 'big short', suggesting that it may be even more dangerous than the subprime mortgages were.
(Image Source: A Writer's Corner)
Now there are many competing theories on the use of tariffs with our trading partners and how more favorable terms may provide higher prices for American goods; which downstream could embolden the US Job market, wage growth, and a resurgence of the American middle class. Now, in theory, it's all possible, but anyone can read the tea leaves and tell you even if this were to happen, there's going to be a lot of pain in the beginning, teetering on private and public austerity.
But it's not all just theoretical. There has been plenty of evidence suggesting a trade war is happening with real consequences, affecting American consumers. The latest evidence to suggest the light at the end of the tunnel is still far from sight, came from the most recent GDP report. While GDP rose at an annualized rate of 3.5%, the net exports of goods and services (which measures the addition or subtraction of trade to overall growth) was negative 1.78%. To put it into context, it was the largest negative GDP trade growth since 1985.
Something even more timely to note was characterized by Michael Feroli, an economist at JPMorgan (JPM). Many businesses opted to import goods and stockpile them, prior to any tariffs being implemented.
This may have reflected front-loading of imports (which increased at a 9.1% rate) ahead of scheduled tariff increases - imports which then end up temporarily in stockpiles."
So, while prices may not be reflected in Q3 or even early Q4, these goods will run out, and when they do, there will undoubtedly be cost impacts downstream.
What Does It All Mean Sensei?
As Sir Isaac Newton said, "what goes up must come down"... at some point. Now some commentators, myself included thought 2018 was going to be more bearish and growth outpacing value would finally swap - but it hasn't exactly gone that way... yet. While the past few months have definitely illustrated the ground may be shakier than in recent memory, there is still plenty of uncertainty if this will become another passing cold or a full-blown sickness. My advice (to myself) and other investing friends and colleagues still is the same. Brace for impact. When growth stops growing, it will cause market wide anxiety that will lead to an initial decline, followed by a general cycling into value over growth - as making modest income with a defensible moat is much better in a tight economy than mountains of debt required for consumer acquisition costs to remain competitive in an ultra-tight technological landscape.
Stay tuned for the part deux of this series, where I'll explore the different sectors and give you an idea of where I'm currently parking my money and plan to into any future turbulence.
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May your falling knives never cut too deep,
Remy Kouffman AKA The Knife Catcher
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.