Why The Fed Is Not Likely To Save This Ailing Bull Market

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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: Victor Dergunov
Summary

Stocks are trading near all-time highs again as the Fed put appears to be back on the table.

However, with multi-decade low unemployment, CPI inflation at 2%, and stock prices near all-time highs, is the market too optimistic about future rate cuts?

A lot of bearish elements appear to be taking place beneath the markets surface.

The U.S. consumer may be weaker than anticipated, and a prolonged trade dispute with China could tilt the U.S. into a recession.

If the Fed becomes ultra-accommodative, the stock market bubble could inflate further, but a recession will ultimately kill this ailing bull run.

Stock market Image Source

Don't Bet On The Fed To Bail Out The Stock Market

The S&P 500 and stocks, in general, have made a substantial rebound in recent days. In fact, the SPX had gained approximately 6.5% after bouncing off major support at 2,725 and topping out at 2,900 resistance.

Source: StockCharts.com

Stocks are now at a critical crossroads. Does the SPX breakout above the 2,900 level and go on to make new all-time highs, or is the market getting ready to unravel, and are much lower prices likely going forward?

A lot depends on the Fed and whether a comprehensive trade deal with China can get done.

Additionally, market participants should not ignore the mounting signs of an approaching recession. This is a time to exercise caution, and despite the Fed's ability to expand the current credit and stock market bubbles, a recession will ultimately kill this ailing bull run.

Is The Market Too Optimistic On Rate Cuts?

Most market participants (per CME Group) now expect the Fed funds rate to be 50-100 basis points lower by the end of the year.

Source: CMEGroup.com

Firstly, that seems quite ambitious for a six-month period, especially 75-100 basis points. Secondly, what exactly will lower rates accomplish, and is it ultimately bullish for the economy?

We know that weaker monetary policy will likely influence the dollar, interest rates, credit standards, risk assets, and other elements in the economy.

A weaker dollar should be positive, as it will make U.S. goods more competitive in other countries. Thus, corporations with much of their sales coming from abroad are likely to benefit from a weak dollar.

However, lower rates, easier credit standards, and a push towards risk assets? Is this what the economy needs at a time of record debt levels, and record stock prices?

How Much Debt?

Just to reiterate, every kind of debt in the U.S. is at a record high.

  • Total personal debt in the U.S. is approaching $20 trillion.
  • Mortgage debt is at about $15.6 trillion.
  • Student loan debt is over $1.6 trillion.
  • Credit card debt is nearing $1.1 trillion.

The U.S. is likely in the very late stages of a debt cycle, and consumers should be winding down their debt loads to limit the ultimate impact on the economy.

Instead, lower rates and a likely easing in credit standards should enable this credit bubble to expand even further. The Fed likely realizes this, so, is "kicking the can down the road" the right policy here?

How Expensive Are Stocks?

Let's face it, stocks are far from cheap right now. The trailing P/E ratio for the S&P 500 is about 21.5 right now, quite high by historical standards. Furthermore, the Shiller P/E ratio, is around 30, about twice as high as its historic median.

Let's be honest, these are bubble like levels by historic standards, and no, I don't think that "it is different this time". The CAPE ratio/Shiller P/E ratio, which many economists consider to be a much better gauge of a company's value than a normal P/E ratio has only been higher in one other bull market cycle, and that was during the dotcom bubble.

Shiller P/E Ratio

Source: Multpl.com

Does It Make Sense To Cut Rates Here?

Bringing interest rates lower will discourage investors from allocating capital to bonds as treasuries like the 10-year yielding around 2% will likely yield even less going forward.

Given that inflation will likely be at 2% or higher, investors will be receiving zero, or possibly negative inflation adjusted returns on many widely-held bonds.

CPI Inflation

Source: TradingEconomics.com

Furthermore, consumers will have no incentive to save money, as their holdings in savings accounts will decay due to a combination of inflation and abnormally low interest rates. So, is it a wise monetary policy to blow the debt and stock market bubbles even bigger from here?

Market participants may be too optimistic on the Fed lowering rates and are likely to be deeply disappointed if the Fed doesn't act as is anticipated. After all, the Fed has only a dual mandate, price stability, and maximum employment.

CPI Inflation is at 2%, which is around the Fed's target rate of inflation, and lowering rates will likely cause inflation to rise above the Fed's target rate. Also, despite the weaker-than-expected non-farm payrolls, the unemployment rate remained at just 3.6%, a multi-decade low. Additionally, stocks are trading around all-time highs.

Judging by these figures, and if the Fed remains true to its dual mandate, there appears to be little to no justification to lower rates from here. Moreover, if the Fed does choose to lower rates under current economic conditions, the Federal Reserve risks losing credibility as it will be actively diverting from its dual mandate policy.

Unemployment Rate Typically Bottoms Right Before Recessions

If we look back through recent history, we can see that every recession/bear market in stocks was preceded by a "low unemployment rate". We can see what appears to be a bottoming in unemployment right before the early 1990s recession, in 2000, right before the financial crisis of 2008, and right now.

Unemployment Rate Historic

The Fed is in a tough position right now, because if it does not act as the market expects, it will "disappoint" market participants, the economic slowdown will likely intensify, and a bear market in stocks could ensue.

On the other hand, if the Fed cuts rates and brings the funds rate back down to or close to zero, it will be actively pushing inflation above 2%, while the economy appears to be at or near full employment.

Furthermore, it will be at risk of blowing out the credit and stock market bubbles even bigger than they are already. Is this really the legacy this Fed wants to leave behind?

Small Cap Underperformance Continues

We can see that while the Nasdaq 100, and the S&P 500 are up by roughly 5% and 4% over the past year, respectively, the small cap index has underperformed notably and is down by nearly 9% over the last 12 months.

Chart Data by YCharts

Typically, in a healthy bull market, you want to see somewhat of the opposite occur. Small caps should be leading, as it would signal faith in a robust domestic economy, due to the high percentage of revenues most small-cap companies generate from the U.S. market.

Instead, we are seeing the large multinational S&P 500 "leading" the market, suggesting more reliance on international revenue growth and profits. However, with Chinese/U.S. trade tensions likely to disrupt global growth, we will probably see a greater-than-anticipated slowdown in revenues and profit-wise from most companies, not just the small caps tied mostly to the U.S. market.

Don't Underestimate The Bearish Market Rotation

Despite the market trading around all-time highs once again, I must point out the evidently bearish sector rotation. Also, this is not something that started happening last week or last month. This is something that has been with this market for a while now, about a year or so.

Over the past year:

  • Utilities sector is up by 23.5%
  • Real estate is up by 18.3%
  • Consumer staples sector is up by 15%
  • Healthcare is up by 7.5%
  • Energy is down by 21%
  • Materials sector is down by 6%
  • Industrials sector is down by 1%
  • Financial sector is down by 3%
  • Technology is up by 6%
  • Communication services sector is up by 5%
  • Consumer discretionary sector is up by 5%

Clearly, we can see defensive sectors outperforming, with the most defensive, utilities, real estate, and consumer staples trading at or near all-time highs. Healthcare is lagging but is also doing quite well relative to other sectors in the economy.

On the other hand, we can see the more cyclical sectors like energy, materials, industrials, and financials underperform. Technology, communication, and consumer discretionary are a bit more universal and are still trading relatively well due to the perception of a "strong consumer" in the U.S, but this could prove to be temporary, as consumer confidence appears to have peaked and is in a downward trend now.

U.S. Consumer Likely Weaker Than Appears

We can also see that consumer confidence typically peaks around market tops, right before a recession/bear market occurs. We've seen this occur right before the bear market in the late 1980s, right before the meltdowns in 2000, and 2007/08, and we appear to be witnessing a similar phenomenon now.

Consumer Confidence Historic

Image Source

So, why are investors piling into sectors like Utilities? Did you know that the trailing P/E ratio on the Dow Utility index is roughly 30? This is quite remarkable considering that the Nasdaq 100 is trading at around 23 times trailing earnings.

This is very atypical and suggests that investors are willing to pay unusually high prices to own stocks that will likely have stable earnings throughout a recession. I'm not saying to go out and buy utilities at 30 times earnings, but something is happening here, it has been occurring for some time now, and market participants should be increasingly cautious going forward.

Bearish Rate Inversion Continues

We've seen the bearish rate inversion dance for some time now. The 1-year is yielding more than the 5-year, and remarkably, the 3-month is yielding more than the 10-year now. This is signaling that market participants are buying into longer-term bonds at current rates as bond investors believe the Fed will cause rates to go even lower, soon.

Chart Data by YCharts

Yes, an argument could be made that the Fed is being proactive, and the bond market realizes this and is acting accordingly. However, one should not ignore the high level of correlation between inverting rates, and upcoming recessions.

In recent history, we saw prominent rate inversions before the early 1990s recession, around 2000, leading up to the financial crisis of 2007/08, and now.

Chart Data by YCharts

Why Trump Is Not Likely To Cave On Trade

The U.S. China trade war is intensifying, and President Trump is not likely to back down. The reason I don't think the president will back down is because the trade imbalance with China is enormous and is disproportionately skewed in China's favor.

In fact, it has been this way for years, and it has been one of the main reasons why China's economy has become such a global powerhouse in recent decades. China said its overall trade surplus with the U.S. was roughly $350 billion last year. However, due to the way this data is compiled, the actual number is probably significantly higher.

China's exports to the U.S. rose by roughly 11.3%, while U.S. imports to china increased by just 0.7% according to the data. So, China essentially continues to swamp the U.S. with cheap goods it produces, while importing very few goods (relatively speaking) from the U.S. Other data implies the U.S. trade imbalance with China was about $420 billion in 2018.

Image Source

In other words, the U.S. is getting ripped off. China's economy gets to continuously grow its manufacturing capacity while it supplies the U.S., its domestic economy, and many other parts of the world with goods and services, while importing very few goods and services from the U.S. China also has a tendency to "borrow" U.S. intellectual property, use unfair trade tariff tactics, and apply other strategies that favor its economy over the U.S.'s.

China trade is nothing like Mexico trade, in case anyone believes President Trump will simply announce all's good with China someday soon. The President ran on building a wall between the U.S. and Mexico to curb illegal immigration, and that campaign promise is being fulfilled. The President also ran on establishing a much fairer trade relationship with China. This campaign promise will be more difficult to fulfill, but President Trump is not likely to back down otherwise.

The China Advantage

Unfortunately, time is not on President Trump's side, as his reelection campaign is next year, and China essentially has a dictator for life. Also, the structure of the government and the economies are not on President Trump's side. Whereas China has a one-party system that can essentially centrally manage the entire economy, including the central bank, President Trump has the Democratic party, and an independent Fed to deal with.

Therefore, this trade war is likely to drag on, should intensify, and is likely to decrease global growth. In the end, the U.S. consumer will be forced to pay higher prices for goods made in China, and given that about 70% of the U.S.'s GDP is consumer oriented, higher prices, coupled with enormous debt loads, could push the U.S. into a recession.

Political Instability Likely To Weigh On Markets

By the way, 2020 is election year, and nothing would be more detrimental to the President's chances for reelection than a weakening U.S. economy. Therefore, 2020 should be a tough and volatile year for markets regardless if there is a recession or not.

Image Source

Some market participants may perceive a Democratic President as more bearish for markets, as a Democratic President may repeal some of President Trump tax cuts in an attempt to fund other projects that may not necessarily be bullish for stocks.

What The VIX Is Telling Us

The VIX is telling us that not all is well with the market. Despite approaching all-time highs once again, the VIX is nowhere near its normally relaxed level of 10-12. In fact, the VIX is around the 16 level, indicating an increased amount of anxiety, and nervousness surrounding stocks.

Bull Markets Don't Die Of Old Age, They Get Killed By Recessions

This is now by far the longest bull market we have had in the history of the U.S. Yes, it's true that bull markets don't die of old age, but recessions do kill them. And, it is only a matter of time until the next recession strikes and kills this ailing bull.

The Fed holds the key to prolonging the current economic expansion, and with enough easing stocks could go higher from here. However, this will not be an organic, healthy expansion, but will be more of a bubble like inflationary one, that will likely make the situation substantially worse when the credit, and stock market bubbles finally pop.

  • Don't ignore all the warnings signs; the Fed is not about to ease rates because the economy is strong and doing well.
  • If the Fed does ease, it is because the economy is weakening and cannot sustain organic growth without monetary stimulus.
  • With two out of three much worse than expected non-farm payroll reports, we are starting to see more of a negative trend in employment numbers.
  • Also, we typically see rock bottom unemployment right before a recession strikes.
  • Rates are clearly inverting, another pre-recessionary signal.
  • Stock market rotation has been quite bearish for a while now and suggests investors are getting out of cyclical sectors and building increasing positions in defensive names.
  • Small caps are underperforming dramatically, a very unhealthy signal.
  • Trump is not likely to back down on China trade, but unfortunately, neither the time nor America's political or economic structures are on his side.
  • In other words, China will likely "win" the trade war, even if it causes substantial slowdowns in both countries and in the global economy, in general.
  • Don't underestimate the impact of higher prices on the consumer and its impact on U.S. GDP.
  • Also, China could essentially stage a boycott of U.S. goods, impacting technology firms, in particular.
  • Don't forget about election year in 2020; with a weakening economy, President Trump's chances of winning the election are also weakening.
  • Regardless, expect increased volatility from now on and in 2020.
  • The VIX is showing signs of increased anxiety and nervousness in markets, and for good reason.

The bottom line is that while stocks could go marginally higher over the next 6 months or so, there is more downside risk than upside reward going forward. This is especially true if the trade war intensifies and/or the Fed's policy does not live up to the market's expectations.

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: This article expresses solely my opinions, is produced for informational purposes only and is not a recommendation to buy or sell any securities. Investing comes with risk to loss of principal. Please consider consulting a professional before putting any capital at risk.