2019: Another Bad Year For Stocks, Despite Trade Deal Optimism

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Includes: DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, HUSV, IVV, IWL, IWM, JHML, JKD, OTPIX, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWM, RYARX, RYRSX, SCAP, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, UWM, VFINX, VOO, VTWO, VV
by: Global Opportunities Analyst
Summary

Stocks have rallied sharply on the legitimate hopes of a US-China trade deal.

World economies are showing more signs of slowing and it is not, mostly, because of the US-China trade war.

Economic slowdown is likely to trump trade deal optimism and could deliver another nasty surprise for investors after a disappointing 2018.

The recent market rally has been impressive, and it has mostly relied on two points of optimism: Fed dovishness and the expected US-China trade deal. 2018 turned out, as I had also expected in early February, to be a pretty bad year for stocks. My pessimism was based on my belief that the economy would weaken but the Fed would not stop its hiking until the market would scare them, which also happened when the S&P 500 hit 2,400. At that point I wrote that it would be an opportunistic, though a relatively short-lived, buying opportunity. I have to acknowledge that I did not expect the S&P to go above 2,800, but I did believe a couple of months of optimism would follow the Fed's new stance on interest rates. And I also wrote that I expect 2019 to "be a bad year for risk assets". There are no signs yet that 2019 will be a bad year for stocks, but it has so far been a bad year for real estate. The Internet is full of news and articles about a weakening housing market (one example), all around the world, with falling transactions, and also prices. Prime properties have been hit hardest so far, but the pain is spreading to all kinds of real estate.

There are real signs of economic weakness that are gathering pace, and it's not just housing any more, as it seemed to be for most of last year. The European Central Bank (ECB), fearing recession, just announced more monetary stimulus. China's economy is also slowing further, which may not come as a surprise, as we have been reading about a Chinese slowdown for years and there hasn't been anything even resembling a recession, let alone a crash. The Chinese are also doing more stimulating, as they have done so repeatedly since the financial crisis of 2008.

So, the Europeans and the Chinese, the two other major economies of the world, beside the US, are applying monetary and other kinds of stimulus programs to help their economies. The US is also doing its part, as the Fed has halted its path of monetary tightening. Everybody is acknowledging that the world economy has weakened. However, stock markets are doing really well for now, with the S&P 500 (arguably the most important stock index) being only about 100 points away from its record highs (chart below from 2009 to 2019).

S&P 500 index With a slowing global economy and a weakening housing market, is it really reasonable for stocks to be doing so well? After all, this isn't a cheap stock market by any historical/traditional standards. Stocks were much more attractive when the S&P was around 2,400 - and I called it a buying opportunity - but they are quite expensive now. And add to this the fact that risks have risen significantly since last year. The Shiller P/E ratio is near record levels (chart below), while the trailing P/E of 21 is not a bargain by any means, and far higher than the median of 14.7.

Shiller P/E ratio Why is the stock market doing so well? The simple answer would be the China trade deal optimism, which, I believe, is not really misplaced. The market, rightly, believes that Mr. Trump hates it when stocks fall so he will do everything he can to sign a deal with the Chinese. Mr. Trump looks at the stock market a lot, and believes that the stock market is some kind of a live appraisal of his presidential performance. He is unlikely to upset the market, and the market gets it. The Chinese are also very eager to do a deal with President Trump in order to avoid the imposition of tariffs. But will a trade deal with China solve all, or at least a big part, of the current economic problems the world is facing? My short answer to this would be no. If two of the world's three major economies impose, and threaten to impose more, tariffs on each other, wouldn't the third (Europe) benefit at least a bit? Shouldn't the trade dispute between US and China divert some trade to other parts of the world, hence benefiting some other economies? This is not an exact science, but it does make sense that if two trading partners engage in a trade dispute, other things being equal, other players ought to benefit, attracting diverted business. However Europe, who is in no trade wars with any of the major players, seems to be doing worse than the other two. Japan, who also isn't in a major trade dispute, isn't doing great either. According to the government, the Japanese economy is suspected to have entered recession.

The fact is that the world economy is slowing and the most important reason behind it is not the US-China trade dispute. The world economy is slowing just like it has always done once in a while. It is natural to expect any economy to go through some weakness after a period of strength. Too many are desperately hoping that a US-China trade deal will deliver a miracle, and this is evident in the euphoric mood of stocks. They may get a massive disappointment.

The economic saturation can be seen in the US Treasury yield curve, which has inverted for some durations though not for the dreaded 10-year and 2-year maturities. However the inversion has occurred for the 1-year and the 5-year, and in between - meaning that longer duration Treasuries have lower yields than shorter duration ones. This shows that the bond market is betting on a recession soon (historically within 2 years of the inversion). The inversion happened back in December, though I had thought that the most followed 10-year and 2-year yield curve would also invert, which hasn't happened. One explanation may be that as policy rates go below inflation (as they have done so in the past for Europe, Japan and so on), the yield curve differentials also get compressed and no longer behave as they would in an environment in which interest rates are much higher than inflation (as used to be the case in the US in previous cycles).

The US-China trade deal, though unlikely, may prove to be the miracle everybody expected, but some kind of a miracle is already priced in. Betting that the market will manage to rise further is in fact betting that the world economy will see some kind of a reversal as it saw back in 2016 when there was no yield curve inversion, interest rates were much lower, and the business cycle was three years younger. 2019 is not 2016. Risk assets - stocks, housing and also corporate bonds - are much more expensive, while there is a lot less (if any) slack left in the economy. Therefore, I still believe that the stock market will do poorly this year. And central bankers do not have the monetary prowess they used to in previous downturns. Policy rates are too low (or already negative) so they cannot be cut by much to stimulate the economy. Central bankers' weakened stimulus measures may very well fail to keep the party going this time.

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.