Is Recent Stock Market Strength a Sign of Safety…or Danger?

Since early October there has been a “bear market” in stocks, both here and abroad. Though some indexes declined approximately 20% from their highest point, most stocks were down much more until just recently. In the past few weeks, stock indexes have rallied about 10% providing some relief for investors, but far from the peak reached in late September. This is a good time to explore if the recent strength in indexes is the beginning of a better stock market or just a short-term advance leading to further trouble ahead. As you know we have kept your portfolio defensive during this period, with less stock exposure and less volatile stocks. Though this is effective during market declines, it can be a bit trying in the face of the recent market strength. How can we determine if there is further downside ahead or if the recent rally is the beginning of a real recovery? Let’s review the data points that were the cause of the tough market. In our view we need these data points to stop trending downward, or to become more clarified, before we take a more “risk on” growth posture.

Economic Data
The economy and stock market are co-dependent. The first sign of economic weakness at the end of the third quarter is what sent stock prices into the downward trajectory. Since that time most leading economic indicators continue to be in a downtrend. Investors need global economic growth to stabilize for stock prices to stage a meaningful long-term recovery. If economic growth can stabilize – albeit at a lower rate – stocks could still do very well and better than most investment alternatives. However, we need to see clearer signs of stability on this front.

Corporate Profit Growth
Economic growth is directly tied to the profitability of companies both here and abroad. We are now at the beginning of earnings season and need to see companies meeting or exceeding the lowered expectations that analysts have adjusted downward since the fourth quarter. Some of the most recent warnings and reports have not been positive, including Apple, JP Morgan, Macy’s and Ford – all of which have been negative. However, the earnings season has just begun and we have some big bellwether companies reporting over the next few weeks including domestic heavyweights Boeing and Caterpillar. These upcoming reports should shed further light on the sustainability of the market’s recent advance. Lastly, when it comes to earnings reports, it is very important that investors realize that these reports are about what happened last quarter and are not a precursor to what may happen going forward. This is why we also want to consider the following three policy challenges. These policy issues need to be better clarified before markets can be on more sound footing.

Federal Reserve (Fed) Policy
The Fed has raised rates nine times over the past two years in an effort to prevent the economy’s growth (inflation) from accelerating too quickly. As we have written before, this effort comes with the risk that the Fed can mistakenly “overshoot” their estimate of interest rate increases versus growth and turn an otherwise sound economy into a recession. This concern is real and is one of the reasons investors have been selling shares. Fortunately, the Fed has recently backed away from being so adamant about further rate hikes. In the short run this has soothed investor’s fears. However, we would like to see further clarity in the Fed’s message and a willingness to reverse course if necessary. The next Fed meeting at the end of this month may provide this.

Global Trade Policy
Tariffs and other impediments to trade with China and other global trading partners are a negative for global and domestic growth. On this front “no news is bad news.” Economic data from China is slowing and they remain an important trading partner for the US and global economy. A trade deal that turns out to be better than earlier perceived would go a long way to alleviate investor fear and support both economic growth and global corporate profitability. We will be watching these negotiations carefully.

Government Shut Down
Though short-term government closures have been stock market nonevents in the past, we are now in uncharted waters. Previous government shut downs have been measured in days while this one is now more than a month old. This has a negative effect on a number of sectors of the US economy and some of our country’s largest corporations. Investors would be wise to consider the shut down as a further risk to stock prices. As with the other policy challenges, any sign of improvement or positive outcome to this standoff would be supportive of a better stock market environment.

Clearly there is no shortage of bad news and challenges on the domestic and global front – for the sake of brevity, we left Brexit and US debt levels out of the discussion. At times the stock market “discounts” all of the bad news by lowering the price of shares. We are not sure that the stock market has fully priced in some of these current risks, particularly given the more recent elevated level of share prices. However, if it turns out that the recent strength is the beginning of the recovery – coupled with some clarity on the issues described above – a re-test or normal correction from these levels would be expected, allowing us an opportunity to invest at more attractive prices in the very near future.

Keep in mind that bear markets often demonstrate periods of short term strength which are followed by declines back to the old lows or even lower. This was the case with the market rally in November that resulted in a further 10% decline in indexes. If this recent strength is just another temporary rally in the bear market – given that all major indexes still remain in long-term downtrends – we want to make sure your assets are safe. In that spirit, we continue with our recent, ongoing mantra of “better to be safe than sorry” when it comes to the bulk of your liquid net worth. Keep in mind that historically bear markets last just 6-8 months and this one is already entering its fourth month. Over the next few weeks and months will be continuing to monitor the data points and view any pull back in stock prices as a possible re-entry point, but one that will need to be validated by better fundamentals.

Our team is excited about the prospect of re-investing in a significant global stock market recovery. While we are wading through this period of data observation, we have been making a great list of stocks that we will be purchasing on your behalf – once the economic environment looks likely to improve. We expect that these companies may lead the recovery and we look forward to getting you more growth oriented.

We hope you find this update helpful. If you have any questions or you have experienced any significant changes in your financial situation please let us know.

All of us appreciate your continued vote of confidence in our work.

Your Team at Main Street Research

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