Looming Stock Market Correction

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by: John M. Mason
Summary

Last week, political uncertainty resulted in a lower stock market and the concern over trade issues grew given President Trump's threat to place tariffs on Mexican goods.

Bond markets appear to be predicting a recession for the near future.

And, Robert Shiller's CAPE measure is indicating that stock prices are overvalued, coming in at values only reached before the 1929 stock market collapse and the 2000 decline.

On Friday, the stock market closed down making May the worst month for stocks this year. The Standard & Poor’s 500 stock index closed at 2,752, down from the historic highs hit toward the end of April.

And, with the growing threat of major tariff changes, the probability that there will be further declines increases.

How the Federal Reserve will respond to this changing environment, to me, is the big question. Investors have raised this issue in the past, but, during the current recovery, the Fed has always responded in a way that convinced market participants of their continued market support.

For example, the latest period of questioning came toward the end of last year when uncertainty arose about whether or not the Fed would continue on supporting higher and higher stock prices. The worry that the Fed might pull back reached a high in December 2018 as the S&P 500, hit a near-term low on December 24 of 2,352.

The Fed, however, convinced investors that it would continue to support the market and the S&P 500 rose again, hitting the new historic high on April 30 of 2,946.

But, now, the environment has changed again and investors are concerned that there could be a market sell-off, one that the Fed may not be able to head off.

The stock market has been pretty robust since the election of Donald Trump, rising steadily from that November month in 2016 from 2,164, to the next high in October 2018 around 2,880.

Since then the stock market has seemed a little less sure of itself. Is this feeling warranted?

Well, in terms of Robert Shiller’s CAPE measure, the stock market is overvalued. For May 2019, the latest month for the CAPE measure, the index comes in at 30.23.

This is below the near-term high reached in September 2018, which was at 32.62.

There are only two other times in Shiller’s recorded history that CAPE has gone above 30.00. These two dates were in June 1997 and August 1929. The timing of each is well known. The first date was in advance of the 2000 stock market correction and the second date was in advance of the stock market crash preceding the Great Depression.

The conclusion one can reach from this is that the current stock market is over-valued and could experience a substantial drop. The stock market always reverts to the mean, and, the argument goes, it will revert to the mean again this time.

The problem is that the CAPE measure cannot tell you when a stock market correction will take place.

So, we can walk away from this measure with the feeling that there could be a stock market correction in the future, but there still will have to be something that triggers the decline and this factor is unknown and will remain unknown until the decline takes place.

But, there is another “signal’ that is flashing a red light: this one coming from the bond market. The US Treasury yield curve is inverted and this condition has almost always anticipated a recession in the near-future. An economic downturn or the anticipation of an economic downturn could be the lightening-rod to set off a market run off.

The question, again, is how long might it be for the economic downturn to occur. And, then we must be concerned about when a stock market correction responding to this situation could take place.

Depending upon how you estimate the inversion, the yield curve has been inverted since early December last year. Thus, the inversion has been in place for six months. So, people have been thinking about this situation for some time.

In addition, the Treasury bond market, itself, is showing expectations of slowing economic growth with only modest inflationary expectations. I have examined this situation more fully elsewhere.

So there are several important market signals pointing to the eventual stock market adjustment.

This brings us back to the position of the Fed. The Fed has basically underwritten the stock market performance of the last ten years as it moved to turn the economy around from the Great Recession and then support the economic recovery through consumer spending generated by the stock market wealth effect.

But the Fed faces an entirely different situation gong forward. Growing political uncertainty is disrupting world financial markets. In March, for example, "risk averse" funds from around the world began to move to "safe haven" markets like ones in the United States, Germany, and Switzerland.

I have recently examined these flows as they helped interest rates in these countries drop substantially. For example, the yield on the 10-year US Treasury Inflation Protected securities (TIPs) have dropped by twenty-five basis points. The yield on the 10-year German bund has dropped to a historic low of a negative 17 basis points. And, the yield on the 10-year government bond of Switzerland has fallen to a negative 47 basis points.

Federal Reserve watchers have wondered how this disrupted situation in world markets would play at the Fed. Might the Fed begin to reduce its policy rate of interest to respond to these international flows of funds.

Then, just last week another disruption hit the financial markets. President Trump announced that he was considering tariffs against goods coming from Mexico starting at the 5 percent level and then increasing by 5 percent for four months after the initials tariffs were introduced.

The stock market immediately reacted to this announcement.

The fact is that the probability of a decline in stock market prices has increased and, in my mind, the increase in this probability is not insignificant.

Bottom line, investors are facing a world of growing uncertainty, with expectations that economic growth might drop back to the lower 2.0’s. The forecast put out by the Federal Reserve picks up on this possibility.

And, there is the real possibility that growing trade wars will cut into the growth rate even further, both in the United States and elsewhere.

Inflationary expectations are low with the inflationary expectations built into the yield of the 5-year US Treasury note falling close to 1.5 percent for the next five years.

So, how will the Federal Reserve function within this world of slower growth, low inflation, and substantial political uncertainty? Almost all economists are saying that Mexico tariffs will be good for nobody. Furthermore, a trade war with China could really damage the Chinese economy, the world economy…and the US economy. What can the Fed do?

The stock market is overvalued; the bond market is predicting a recession; and trade battles can only exacerbate the situation. When might the break in the market happen? What might set off the downward spiral?

And, there is the question about whether or not the Fed has the ammunition to combat a market collapse somewhere, let alone continue to underwrite stock market prices.

Robert Shiller’s CAPE measure has been telling us that a correction is due. Could it be “time” for the correction to take place?

It seems as if the bond markets think such a “time” may be near.

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.