I wrote a short article on the S&P 500 (SPY) a couple of months ago. While it seems I was early, we did see the market decline during the month of May before recovering recently.
One could certainly make the argument that the equity market got ahead of itself during the end of last year, at least in comparison to where treasury rates were back then and economic indicators. However, the treasury market is presently painting a bleak picture, while the equity market is a few percentage points from all-time highs.
Figure 1 - Source: YCharts
During the month of May, we saw the equity market decline 6-7%. Oil and other industrial commodities declined even more. While oil, for example, has continued down, the equity market had a nice bounce. I expect that bump to be temporary and there to be more downside for the equity market.
Figure 2 - Source: TradingView
The Q1 2019 GDP growth of 3.1% was significantly stronger than I expected. Inventories inflated the number some, but it was still a good Q1 number. Since then, both the Manufacturing PMI numbers have been edging downwards. While both are still in above 50, they are down significantly from 6 months ago when the equity market was panicking.
Figure 3 - Source: TradingEconomics
We are now looking at an inflation rate close to 2%.
Figure 4 - Source: TradingEconomics
Further tariffs will add some upward pressure on inflation. I think it will be very difficult for the Fed to give the market, the 3 rate cuts in 2019, which it so desperately wants. At least not without some significant turbulence in the market first and consequently lower equity prices.
Figure 5 - Source: Charlie Bilello on Twitter
If there ever is a time when the Fed will have to decide whether to prioritize growth or inflation. I suspect inflation will be thrown under the bus, after being defined as transitory, which might turn out not to be the case. But I don't think the Fed is ready for that just yet.
We have seen a lot of numbers taken to the extreme late this cycle. It doesn't mean they will be a trigger for a crisis, but we do often underestimate the effect of these risks during good times. The below are just some of the many concerns we are seeing in the market today.
- The S&P 500 price to sales ratio is well above the peak during the last cycle. If profit margins contract, there is a lot of downside.
- We are seeing extreme valuations of IPOs which I suspect can only be matched by the peak during the IT Bubble.
- The amount of corporate debt has increased significantly, credit ratings are lower, and the risky debt has higher leverage and weaker covenants.
- We will have a wall of corporate debt maturing over the next few years, with the majority being BBB or lower-rated.
- The government is running a $1T deficit during an economic expansion.
The U.S. Dollar has been trending upwards over the last 6 months, and the DXY moved above the multi-year high of 98 by the end of May. We have recently seen a decline in the DXY as the Fed has made some more dovish comments.
Figure 6 - Source: TradingView
There is often a debate on who suffers the most from a strong dollar, but the reality is that growth both in the U.S. and globally fare less well in a strong dollar environment. A potential change in the dollar strength is what would give me pause, as weakening dollar could provide a lot of stimulus. Having said that, we have so far only seen a minor correction from the high just above 98.
The bond market is calling for several rate cuts this year, the stock market is a few percentage point from all-time high, the dollar is still strong, inflation is not far below target, and the unemployment rate is very low.
I think either the dollar, treasuries, or equities will have re-price at a very different level compared to today. One of them will have to give, and I still think the equity market offers the most attractive risk-reward on the downside. I have increased my short position but will be monitoring the dollar closely.
Disclosure: I am/we are short SPY. 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.