Preparing For The End Of The Cycle: January Update

Summary

• January has been an extremely good month for stocks, but in my opinion we only witnessed a bullish corrective wave within a bearish impulsive wave.
• While weekly initial unemployment claims are down, the yield curve is still pretty flat and margin debt levels continue to contract.
• We should not forget the big picture and the bird‘s eye view: longest bull market in history and extremely high valuation.
• Facebook, MasterCard, Visa and 3M all reported at least decent earnings.

At the end of December, investor sentiment was extremely negative – almost all over the world. The CNN Fear & Greed Index, for example, was signaling extreme fear, but after the bears were in charge for three months and the major US indices (almost) hit the 200-week moving average, a temporary reverse seemed likely and after Christmas the bulls took over again.

Like I mentioned several times, my series “Preparing for the End of the Cycle” is built on the premise that the stock market will decline and we will enter a steep bear market so that even high-quality companies without any fundamental problems will become bargains. Although sentiment shifted and is again rather bullish and signaling maybe even greed, I will keep my series going as I still think we need to prepare for the end of the cycle, which we haven’t seen yet.

Similar to my last monthly updates, I will first look at the macro picture and some macro indicators and then look at the individual stocks covered so far and describe noteworthy developments.

Macro View

For several months, I am now looking at a few indicators that I consider to be leading indicators – for the stock market, but especially for the general economy. On a monthly basis we looked at the NYSE margin debt levels, the initial unemployment claims and the yield curve. And in this article, we will also look at the bigger picture to put these indicators into perspective.

Weekly Initial Unemployment Claims

One of the leading indicators is the number of weekly initial unemployment claims (seasonal adjusted numbers). In contrast to the unemployment rate, the initial unemployment claims are a very good early indicator as the number is published weekly and we can see new developments with almost no time delay. Additionally, it is one of the first numbers to show signs of strength or weakness of the economy. But right now, the number is not really signaling an upcoming recession or a slowdown. During the fourth quarter of 2018, the weekly initial claims increased quite a bit, but last week the number declined to 199,000.

^{(Source: FRED)}

Margin Debt Levels

A second number that can show a stock market decline and an economic slowdown ahead of time are the margin debt levels at the New York Stock Exchange. These numbers can be a leading indicator, but the delayed data is undermining its status as leading indicator a bit.

In December 2018, debt levels declined 6.5% compared to the month before (which is quite steep) and in October 2018 the debt levels already declined 6.3% compared to September 2018. Since its highs in May 2018, margin debt levels constantly declined and are down 17.1% overall. Concluding that a recession has to come would be a bit premature, but it is at least a warning sign. For January I would expect that debt levels increased again as the stock market also started a small rally during that time.

Yield Curve

Similar to the margin debt levels that indicate at least turbulent times, the yield curve is also sending clear warning signals. Compared to one year ago, the yield curve has flattened obviously. While parts of the yield curve are already flat or inversed, the yield curve got a little bit steeper again compared to the end of December. Among many other aspects that influence the current treasury yields, investor expectations have a big influence and hence it is not surprising that the yield curve didn’t flatten further during January.

Instead the spreads between the different yields got a little bit wider once again, but overall the yield curve is rather indicating an upcoming recession than a new long-lasting bull market or continuation of the current bull market for several years.

^{(Source: Own work)}

The big picture

The three indicators above are showing clear warning signs – aside from the weekly initial unemployment claims – but the overall picture can rather be described as mixed and I am not completely surprised about the bullish sentiment of some analysts and investors. Sometimes it makes sense to take a look at the bigger picture and try to put the individual numbers and indicators into perspective.

The bird’s eye view of the stock market is showing us a very mature bull market. In a few weeks, the current bull market maybe lasted for ten years (if the 2018 highs weren’t the top) and this is the longest bull market in history of the US stock market. Without much interpretation, we can state that it gets more and more unrealistic for the bull market to continue, but duration of the bull market alone is no reason for a recession and a stock market crash. Additionally, we should always look at current valuations and raising the question how to value a single stock or the entire stock market accurately. Aside from some other indicators I often look at the CAPE ratio to get a feeling where we might be in the cycle. At the end of December, the CAPE ratio was still 28.3 and therefore one of the most extreme numbers during the last century (and this was after the decline).

It is true that despite the rate hikes by the Fed in the last few years, treasury yields are still rather low (compared to the last decades) and in many European countries interest rates are still zero. The low returns of the bond market are forcing investors to buy other assets (like stocks) and will lead to ongoing buying even at high prices, but this won’t last forever and can’t be used as justification for extreme stock prices forever.

^{(Source: Advisor Perspectives)}

When we are looking at the longest bull market in history, extremely high valuation levels, declining NYSE debt margins and a rather flat yield curve we seriously have to ask ourselves the question if the temporary low point in December was a great buying opportunity for long-term investors. We certainly can buy the dips and I bought Compass Minerals International (NYSE: CMP) shortly after the holidays because the price below $40 was too good to pass up, and so far it turned out great. There always will be some individual companies that are undervalued and can be bought, but I remain sceptic if the Christmas was a great buying opportunity for long-term investors (time will tell). Those who bought in the days after Christmas demonstrated the ability for great timing, but still might regret it in a few months from now.

Even if stocks might climb further – and even if the major US indices would reach its highs again or even climb beyond – the upside potential is very limited in my opinion while the downside risk is rather high and therefore every long-term investor has to ask him- or herself if buying now is the right decision.

Technical View

In my last update at the end of December 2018, I wrote the following – speculative – projection about the US stock market:

When looking at the current state of the stock market from a technical point of view, we can see that the S&P 500 (NYSEARCA: SPY), the Dow Jones Industrial Average (NYSEARCA: DIA) and the Nasdaq-100 (Nasdaq: QQQ) might have found a temporary bottom […] 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.(Update End 2018)

In my opinion we are currently only in a correction of the last downward wave, and this intermediary, corrective wave will be followed by the next bearish wave, which will send the US stock market (as well as the stocks in many other countries) down again. All three major indices are facing massive resistance levels, which probably will limit the upside potential and – in my opinion – will lead to the next downward wave. Currently we are facing declining trendlines connecting the highs of the last four months as well as the 200-day simple moving average.

However, if the major indices should manage to stabilize above the 200-day moving average and break the declining trendline, we might very well see further price increases and maybe even reach the all-time highs again. But even in this scenario, a long-term investor shouldn’t buy at current levels (maybe without a few really undervalued exceptions).

Individual Companies

Similar to the overall market and major indices, many of the companies we covered so far in this series also increased during the last month and almost no stock got any closer to its intrinsic value or our preferred entry point. The only stock trading lower than a month ago is CBOE (CBOE). So far, Facebook (FB) is the big winner as it gained over 20% during the last few weeks (was written after earnings were released, but before market open).

Data by YCharts

For the long-term investor, patience seems to be a very important attribute in order to be successful and often, the decision not to buy and to stay in cash can save a lot of money. After the stock prices rallied for the last few weeks, one might get the feeling of having missed out on a great buying opportunity and must now watch the stock rally from the sidelines. As five out of the eleven stocks covered so far are once again within 10% of the all-time highs, a bear market seems to be far away.

^{(Source: Own work)}

And although one probably doesn’t get the impression right now that the end of the cycle is near and that any of the stocks above will every reach the calculated intrinsic value, we should consider where we are in the cycle, we should consider current valuations and consider how long this bull market has been going on. And considering all these factors I wouldn’t speak of a missed opportunity, but rather see the stock price increase over the past few weeks as a correction that could have been expected after the steep decline in the fourth quarter of 2018 and therefore only as a short delay.

What’s new?

3M (NYSE: MMM)

A few days ago, 3M reported fourth quarter earnings with non-GAAP earnings per share up 10% but revenue declining 0.6% (especially Electronics and Energy declined 4.5%) and guidance for 2019 was trimmed a little. 3M is now expecting organic growth in the range between 1% and 4% - which is solid, but not great. It is also expected, that 3M will announce a dividend increase in the next few days.

Visa (NYSE: V) and MasterCard (NYSE: MA)

Visa could beat top and bottom line expectations and could increase revenue 13% YoY and GAAP EPS even 21% YoY. For 2019, Visa is expecting earnings per share to grow in the high teens on a GAAP nominal dollar basis. For revenue, Visa is expecting revenue growth in the low double digits. The reported numbers show ongoing strength for the wide moat company and in a few hours after this article was finished MasterCard will also report earnings.

Facebook (Nasdaq: FB)

Facebook also reported fourth quarter earnings and could not just only beat revenue expectations, (as revenue increased 30% YoY) but especially EPS expectations. For the full year, revenue increased 38% and diluted earnings per share increased 40%. Facebook jumped more than 10% after earnings and right now it seems like we have missed our chance to buy Facebook when it was undervalued as I have been too greedy and waited for Facebook to hit $115. Of course, we have to pay close attention and see what the next few months will bring, but $123 on Christmas could have been the low for the stock.

Visa, MasterCard and Tencent (OTCPK: OTCPK:TCEHY)

While Tencent’s WeChat is starting to push into Europe, Visa and Mastercard are trying to enter China. However, China’s central bank has refused to acknowledge applications submitted by Visa and Mastercard to process renminbi payments. On the other hand, Tencent announced a collaboration between the company and BHV Marais in France. And granted, it is nothing to get excited about right now, but is showing the way Tencent is headed and that the company has real ambitions to expand outside China.

MasterCard

In January, MasterCard had to accept a fine of €570 million by the European Union. The European Commission fined the credit-card company because MasterCard’s rules prevent retailers from benefiting from lower fees and the company also restricted competition among banks. This is demonstrating two aspects. On the one side, it underlines the extremely wide moat of MasterCard giving the company pricing power as well as the ability to force its customers to accept unfavorable conditions. On the other hand, it is also showing that political institutions are serious about preventing extremely wide moats or trying to limit companies from establishing wider and wider moats.

CBOE

In January it was reported that nine financial firms are planning to start their own low-cost stock exchange. Initial investors will include such large and powerful corporations as Morgan Stanley (NYSE: MS), Bank of America Merrill Lynch (NYSE: BAC), Fidelity Investments or Charles Schwab (NYSE: SCHW). Network effects for stock exchanges are still in play, but this demonstrates once again that stock exchanges are losing the pricing power these companies once had and that the wide moat might erode a bit. Network effects make it still difficult for new competitors to enter the market, but especially big and large corporations have the power to attack companies.

Conclusion

Increasing stock prices and the best January in almost 30 years are nice for investors, but really don’t mean much as it is the big picture that matters. Although most stocks on my watchlist trade higher than a month ago and are further away from its intrinsic value, I don’t think we have missed out on any buying chance yet (maybe for Facebook), but will continue to watch the stocks on our list closely. I know it is annoying and the same I have been telling for months: better buying opportunities will arise in the near-to-mid future and although I buy stocks sporadically, it is still not the right time to invest big.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Analyst’s Disclosure: I am/we are long CMP. 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.

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