Looking For Bear Tracks

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Includes: IVV, SPY
by: Chris Wiles

Summary

Recent market fluctuations are not fundamentally based.

Looking for early signs of the next bear market.

U.S. governmental debt, interest rates, and the slowing Chinese economy are prime drivers of the next downturn.

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Source: Hall of Beorn

Note: A version of this piece was first published on Oct. 18, 2018

It is an old, well-known saw: bull markets don't die of old age. And yet, they do all, eventually, die of something. In the midst of the longest market run up in history, it pays to consider the proximate causes that appear poised to potentially fell this particular bull.

Ben Levisohn of Barron's explained the recent precipitous market drop succinctly: everyone is afraid of something. This seems apt for the moment. Fortunately, while these technical traps ("The stock market is doing what markets do best this afternoon: panic selling without a fundamental reason," said Chris Rupkey) can do damage temporarily to the blood pressure, and perhaps longer term to the ego, bulls also do not die from fear alone.

Hindsight is remarkable in its clarity. The sub-prime lending crisis seems like an all-too-obvious pitfall, looking back, and yet so few of the experts in the mammoth U.S. financial industry saw it coming (and even fewer have proven to be successful prognosticators since). This makes sense, of course, as we look backward to attach meaning to the things that we don't fully understand when they occur. In reality, however, we're just as likely to identify symptoms of financial maladies as we are the causes behind them.

Today, the U.S. economy is in strong, though not superlative, health. Macroeconomic data point to a couple of true potential reasons for concern. In the post-crash autopsy, rising rates combined with a trade war are prime candidates to be chosen as obvious culprits. While both may indeed be contributors to the failing health of the economy and markets in the months (maybe) and years (more probably) ahead, both are, again, symptomatic of greater underlying issues. Namely, U.S. governmental debt and the long-coming downturn in the Chinese economy are far more central factors threatening U.S. economic health.

U.S. federal debt may fail to torpedo the market in this particular business cycle, though it has the long-term capacity to do so like no other factor ever has. The trick is finding the tipping point beyond which growing debt becomes unsustainable, with the increasing cost of debt servicing spiraling as debt buyers inevitably, ultimately, stop demonstrating the willingness necessary to cheaply finance that debt.

While there is clearly a paucity of appetite in the national political arena to make any attempt to address this in the near- to medium-term, I happen to believe that this landmine will sit primed for some time yet. Perhaps the predictable wave of stimulus funding in response to the next market crash will, itself, serve as the trigger.

In the near term, then, growing governmental debt is only inducing a headwind to exacerbate other problems. We may be tempted to blame the Federal Reserve for its purported dedication to a rate-raising campaign to neutral and beyond, but, in reality, there is little question that inflation is rising, and that rates must rise as well. Regardless of whether or not blame for rising interest rates is properly assigned, the insidious effects of rising interest rates will slowly begin manifesting, in the housing market, in the cost of servicing already-high levels of corporate debt, and, ultimately, in reduced household spending.

Likewise, the Chinese economy is at least positioned to induce drag upon the U.S. economy. Completely independent of trade policies, the Chinese economy has long been trending toward what is hoped will be a soft landing. Chinese GDP (official or otherwise) is slowly sagging, just as the Chinese government makes attempts to control runaway local governmental and corporate debt. As the economy slows, this will prove harder and harder to do, as the latter is likely to be sacrificed near-term at the altar of the former. China is already freeing up cash within its banking system, which in turn is funneling more credit into Chinese businesses.

That base case is the best-case scenario. In the worst, the U.S. prosecutes a full-blown trade war with China. China's GDP and industrial production will fall, slowly at first, and then accelerate. Unlike the United States', the Chinese economy is not presently in particularly strong health. Market watchers know this, as the Shanghai Index is already about 50% below its 2015 highs. After initial celebration by some U.S. policy makers, the slowdown in Chinese consumption and industrial production will begin to be reflected in U.S. production, and U.S. GDP. In concert with an ongoing U.S. economic slowdown, that may be all it takes to begin the deleveraging process in the U.S. markets. While high valuations don't cause crashes, they will precipitate large, rapid drops when provided a substantive stimulus.

Ultimately, U.S. policy makers can control the extent to which the Chinese economy slows beyond its baseline trend in the near term, and thereby the follow-on effects for the U.S., though even a near-term political solution would not reverse the slowing of the Chinese economic trajectory altogether. Likewise, it is possible that the Federal Reserve will balance rates hikes and effects masterfully. Federal debt accumulation, however, though certainly capable of being mitigated, looks to go unchecked. Even perfectly navigating these challenges, which is less than probable, would not ensure mid-term economic health, and any combination of missteps could perpetuate a decline with relative rapidity.

In the near term, the markets, and volatility, will climb. The financial industry will collectively look for the first signs of trouble on the horizon, while sailing along blissfully oblivious to the real dangers lurking in the waters below. Looking back, they will undoubtedly opine of the dangers of the shore, overlooking the reef that inflicts the damage.

Here's my forecast:

  • The S&P 500 will have a strong finish to Q4.
  • Volatility will increase in Q1 and Q2 of 2019.
  • The likelihood of a crash in the next three quarters is low, though the probability is increasing beginning in Q3 and Q4 of 2019.

Disclaimer: This piece is purely editorial, reflecting only the personal opinion of the author. It is not representative of Deep Data Financial LLC or Meadowlark Financial Technologies LP, which are data-driven and non-discretionary. It does not, and should not be taken to, represent investment advice.

Disclosure: I am/we are long SPXL.

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.