Preparing For The End Of The Cycle: Update December

by: Daniel Schönberger

During December, not only the major indices declined but all eight stocks I covered so far in my series.

Initial weekly claims for unemployment insurance stayed low, but NYSE margin debt is continuing to contract and the yield curve is flattening.

After declining 20%, the S&P 500 might increase over the short term, but over the next few quarters, the outlook remains bleak.

Facebook is inventing its own cryptocurrency, Mastercard increased its dividend and announced a new share buyback program, and Accenture reported quarterly results.

Another month has passed, and I will once again provide an update on my "Preparing for the end of the cycle" series I started in October. Like in my update at the end of November, I will start by looking at the general market and then take a closer look at the individual stocks in the second part of the article.

Macro View

As I already mentioned before, this entire series is built on a very simple premise: I will look at high-quality companies with stocks that probably will outperform the market, but are currently still overvalued. And due to the superiority of these companies, it is unlikely that the stocks will decline in the higher double digits without an overall market decline and general sentiment shift which will also drag the stocks of these high-quality companies under. The individual stocks are not extremely overvalued (most of them are trading with a 20-25% premium), but without a general market decline I am pretty confident that most of these stocks won't reach my preferred entry point (Facebook (FB) is an exception as the company is surrounded by extremely negative news and sentiment).

The stock market itself is a leading indicator for the general economy and to stay ahead of the market (or at least ahead of the general economy), it is important to look at other leading indicators. We will look at the latest margin debt data, the weekly initial claims for unemployment insurance and the yield curve as those three indicators are leading indicators for the general economy.

Margin Debt

The debt cycle is describing the expansion or contraction of credit levels in different stages during the cycle. When analyzing the stock market, it is not only important to look at debt levels of governments, companies or individual debt levels (like student or car loans), but especially at the margin debt levels reported by stock exchanges (the NYSE for example). When investors are euphoric and expect rising stock prices, they will borrow money to buy stocks and the debt margin will expand; if sentiment shifts and the stock market starts to decline investors will sell positions (or be forced to liquidate positions due to margin calls) and debt margin levels will contract very quickly.

At least before the last two recessions, margin debt levels started to contract several months before the stock market reached its peak (on a monthly close basis) and hence margin debt levels can be a leading indicator for the general economy. The indicator is also sending false signals as not every contraction of debt leads to a recession. For example, in 2011 and 2015, debt levels also contracted similar to the current contraction and we didn't see a recession, but only a stock market correction of 10-20%.

(Source: Advisor Perspectives)

In October 2018, debt levels contracted 6.25% month-over-month and in November debt levels contracted additional 2.48% month-over-month (not shown in the chart above). Since its highs in May 2018, margin debt contracted 11.41% overall. Like I said before, margin debt levels also contracted without a recession following and although the current drop is rather steep, we have to pay close attention to the numbers. Although the margin debt levels are a leading indicator, it is a little problematic that the numbers are already several weeks old when reported and right now, the numbers for December would be interesting as I expect a similar steep contraction of debt levels as in October (but we have to wait till the end of January for these numbers).

Initial Claims For Unemployment Insurance

Aside from the margin debt levels, the initial claims for unemployment insurance (seasonally adjusted numbers) can be a leading indicator. When looking at past data, we can see that initial claims for unemployment insurance always started to increase before the US economy entered a recession and usually the number of weekly initial claims hit a top at the end of a recession.

After the number of initial claims increased during November and the first week of December, the number declined once again in the last weeks - in the last two weeks, 216,000 and 217,000 people claimed unemployment insurance for the first time. When solely looking at the number of initial claims for unemployment insurance we can't see any signal for a coming recession, but we will keep a close eye on the weekly published number.

(Source: Federal Reserve Economic Data | FRED | St. Louis Fed)

Yield Curve

Another leading indicator that is already sending clear warning signals is the yield curve. At the beginning of December, the yield curve inverted for the first time since 2007 - at least partially. On December 3rd, 2018, the 3-year treasury yield was 2.84% while the 5-year treasury yield was 2.83%. But the yield curve keeps getting flatter and flatter - the thin red line is showing the yield curve at the end of November and the bold red line is showing the yield curve right now (the blue line is showing the yield curve at the beginning of 2018). Currently, the 1-month yield is higher than the 3-months yield and the 1-year yield is higher than the 2-year and the 3-year yield. At the beginning of November, the spread between the 1-month and the 30-year was 1.17%, at the beginning of December, the spread was 1.07% and right now it is only 0.62%.

(Source: Own work based on data from the U.S. Department of the Treasury)

The following graph is showing the spread between the 10-year treasury and the 2-year treasury. As we can see very clearly, the spread between the 10-year treasury and the 2-year treasury is negative before every single US recession in the past 40 years (meaning the yield curve was inverted). It is also a very good leading indicator and early warning signal as it is producing very few "false signals". The timeframe between the spread being negative for the first time and the following recession fluctuated during the decades, but it didn't occur during the last 40 years that the spread was negative and a recession didn't occur within the next two years. Right now, the spread is 0.21% (and it was already 0.10% a few days ago).

(Source: Federal Reserve Economic Data | FRED | St. Louis Fed)

Technical Analysis

When looking at the current state of the stock market from a technical point of view, we can see that the S&P 500 (SPY), the Dow Jones Industrial Average (DIA), and the Nasdaq-100 (QQQ) might have found a temporary bottom. The S&P 500 declined 20% since the 2018 highs and hit the 200-week simple (black) and exponential (red) moving average. Currently, I would speculate that the S&P 500 will increase to about 2,600-2,630 points and pull back to the former lows from January and March 2018 as well as November and December 2018. This will also reflect a 50% retracement before the next downward wave will begin.

(Source: Own work created with Metatrader 4)

I like to emphasize again that such short-term movements are very speculative, but I think for the next few weeks we might see increasing stock prices and the bearish sentiment might vanish a bit. But for the mid-term view (maybe 12-18 months) I see a bleak future for the US stock market: declining stock prices, as well as bearish sentiment, will return and we will see panic (something we haven't witness so far) until there is blood in the streets and we will finally have reached the end of this cycle.

Individual Stocks

In my series, I covered eight individual companies so far and in the following chart, we look at the development of the stocks during December. Every single stock declined in value - similar to the overall market - with Tencent (OTCPK:TCEHY) only declining 1.65% and Accenture (ACN) declining even 15.0%.

Chart FB data by YCharts

But in the last decade (since March 2009), all seven stocks (Facebook is missing as the IPO was in May 2012) increased more than the S&P 500 (not including dividends). The index increased 238% since March 1st, 2009, with 3M (MMM) increasing only 317% (worst performing of the seven stocks) and Tencent increasing 3160% (best of the seven).

Chart TCEHY data by YCharts

Among the eight stocks I covered so far, four of them are deriving the competitive advantage from network effects, for three companies the competitive advantage stems from intangible assets (mostly the brand name) and one company's wide economic moat is mostly built on switching costs.

(Source: Own work)

Network Effects

Many studies about wide moats imply that network effects are among the strongest competitive advantages a company can have. According to Morningstar, only 13% of wide and narrow moat stocks gain its competitive advantage from network effects while 58% of wide and narrow moat companies gain its competitive advantage from intangible assets like the brand name (the moat of individual companies can stem from multiple sources).

As mentioned above, the network effect is not only the rarest competitive advantage among companies, it is also the strongest. According to a Morningstar study, companies with a wide moat built on network effects performed the best on almost every metric. Network effects generated high returns over the past decade, but companies with network effects also had the highest variability across metrics like RoE, RoIC, and operating margins.

(Source: Not all moats are created equal)

In the last five years (2012 till 2017) and the last ten years (2007 till 2017) - the study is from 2017 - companies based on network effects have outperformed other moat sources on a total return basis. In my opinion, network effects provide a very strong and wide moat and the rise of the internet and the possibility of people to participate and not only receive information made many great and strong business models possible (for example marketplaces or social networks where people can participate). Morningstar also pointed out, that networks weren't always the strongest competitive advantage and it doesn't have to stay that way forever. In a few years or a decade from now, other moat sources might once again generate higher rates of return.


One of those network effect companies that outperformed the market is Facebook. And although Facebook performed great over the last six years, the last few months certainly weren't easy for shareholders. Year-to-date, Facebook declined 24.5% and is trading 39% below its 52-week high. But as we are looking at the first "Sell" recommendations - for example from the German DZ bank - we might be close to the bottom. When investment banks issue "Sell" recommendations, in many cases the worst is over (and after 39% decline Facebook is certainly more a buy than a sell). According to TipRanks, individual investor sentiment is also extremely negative - another indicator we are close to the bottom.

A few days before Christmas, Bloomberg also reported that Facebook is working on its own cryptocurrency called "Stablecoin" that will let users transfer money over WhatsApp. You probably are familiar with my extremely bearish opinion about Bitcoin (as it was one of the great examples of a bubble in the recent past), but as my bearish opinion stemmed mostly from the hype around Bitcoin that pushed the price to astronomical highs, I am not bearish about the underlying technology. And in the end, it is rather Facebook's move towards a financial service company, that doesn't come as a surprise, but is another step into the right direction and a way to monetarize WhatsApp (like Tencent is doing with WeChat). When looking at Tencent, we see how profitable that segment can be and the growth rates Tencent is reporting for its financial services segment right now are quite impressive.


A few days before Christmas, it was also reported that in China the first games have been approved again after the Chinse government refused to approve any new games since the first quarter of 2018. This was obviously great news for Tencent (and the stock responded accordingly), but this doesn't mean Chinese government will ease up on gaming control. Content will probably be further regulated, which will decrease margins and may even have a negative effect on revenue as the time played will be reduced.

Mastercard (MA)

The financial services company Mastercard announced an increase of its quarterly dividend to $0.33 per share - resulting in an annual dividend of $1.32 and a dividend yield of 0.75%. Additionally, the board also approved a $6.5 billion share repurchase program, authorizing the company to repurchase $6.5 billion of its Class A common stock. The new share repurchase program will become effective at the completion of the company's previously announced $4 billion share repurchase program (about $470 million remaining).

Mastercard has constantly decreased the number of outstanding shares during the last years, but it would speak for management and be a great move if the company would now increase the volume of the share repurchase program as the stock is declining and share repurchase programs are a useful and effective way to reward shareholders. Increasing share repurchase programs make even more sense than increasing the dividend, but I don't blame Mastercard for increasing its dividend.

Brands And Switching Costs: Accenture

Aside from the news regarding the "network effect companies" the consulting firm Accenture (which is deriving its competitive advantage from the brand name and switching costs) reported quarterly earnings. Revenue increased 7.4% YoY and earnings per share increased 9% YoY; Accenture could also beat top and bottom line expectations. Operating margin was stable at 15.4% and growth was well distributed across the five operating groups (only financial services was lagging behind and increased only 1%).

(Source: Accenture Investor Presentation)

Compared to networks, brands are easier to attack for competitors and it takes a lot of money to maintain a brand (advertising, public relations). Dense and interconnected networks, as well as brand names, are both assets which are often very expensive to create, but networks require sometimes less capital spending than brand names making network effect companies more profitable. Nevertheless, investing in companies like Accenture and Moody's Corporation (MCO) that derive their competitive advantage and wide moat from the brand name (and switching costs) can be similar profitable.


Among the eight stocks covered so far, four are trading close to its intrinsic value, but haven't reached our preferred entry point yet: Tencent Holding, Visa Inc., Moody's Corporation and Facebook. Only the last one - Facebook - is trading close to our preferred entry point - $115. The other seven stocks are staying on our watchlist as we are expecting cheaper prices during 2019.


I wish you all the best for 2019 and if the stock market should decline as expected and it gets ugly, don't panic, but be prepared. I might be short-term pessimistic and bearish, but I am long-term optimistic and bullish.

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: I own derivatives which are profiting from a declining Nasdaq-100 and Dow Jones Industrial Average.