As we reach the end of 2018, the outlook for 2019 looks rather bleak. The markets seem to have realized what many of us have been warning of for some time now. That is, a financial system that is highly levered in conjunction with quantitative tightening, rate hikes, and an economy that has run out of room to grow. Working from the top down, and as a starting point for this analysis, I will highlight a few charts that I have come across that give a good picture of where we are in relation to macro-level drivers of US equity returns.
The Buffett Yardstick (as measured by the ratio of US stock market capitalization to GDP), turns out to be a powerful predictor of future returns of the US equity market. This relationship can be explained intuitively and simplistically as follows: the price you pay for an asset determines the rate of return you receive on your investment in that asset. If the entire investor base of the US economy is paying a high price relative to the total production the US economy, they are getting a bad deal. When inverted and compared to forward 10 year total returns of US equities, as illustrated in the figure below (sourced from the Felder Report), the current reading predicts an average total return of about -2% for the next 10 years.
Source: The Felder Report
The recovery/boom stage of the business cycle experienced since 2009 has been one that has lasted longer than most would have expected. But with the cycle long in the tooth, macroeconomic data as strong as those throughout 2018 are destined not to last. The following chart takes a selection of macroeconomic data points and measures their position relative to their historical distributions to give a statistic that approximates the risk of a bear market/recession.
Source: JP Scott, CFA Twitter
With the possibility of a recession coming to the fore, credit markets are beginning to reflect a more worrisome mentality. The leveraged loan market, the riskiest and least liquid of the credit markets, has seen massive outflows in the last month. High yield corporate bonds have also seen their fair share of selling pressure, with high yield spreads breaking out of this years trading range. However, credit spreads are still low relative to historical moments of panic or instability such as 2015/16, 2008, 2001/2 and 2011.
Although the situation for the financial markets looking into 2019 and onward seems gloomy, between now and "the big one" there is bound to be an opportunity to get short at higher levels, or at lower implied volatility if you are able to trade options.
Markets don't go straight up or straight down, there are always counter-trend dips and bounces. From an Elliot Wave perspective, bear markets occur in 3 waves. If we are to see wave A stop out at the around the 2400 level for the S&P 500, which coincides with a 23.6% Fibonacci retracement or any other technically significant level around that mark, a counter-trend rally should ensue. This situation would allow the hawk-eyed hedger to buy short to medium term put options at a relative discount, or the futures trader to go short at a higher level with a more favorable risk reward.
Source: IG Markets
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in SPY over 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.