Game Plan for Next Week – September 2, 2017

The question many of you are asking yourselves these days was nicely captured by The Clash:

“Should I Stay or Should I Go?

If I go, there will be trouble

And if I stay it will be double.

One day it’s fine and next it’s black.

This indecision’s bugging me…”

The Game Plan

This bull market is now the second-longest on record. And with danger seemingly lurking around every corner, the urge to go rather than stay may be particularly strong.

You’ve heard it a hundred times – bull markets don’t die of old age. They don’t die of over-valuation. And they don’t die of geopolitical turmoil. So the question becomes, what does cause the death of a long bull market?

Based on my 30 years of studying market history, the one force that no bull market can survive is the onset of an economic recession. What will bring about the next one? Fortunately, there will be plenty of early warning signs.

Markets stumble all the time, in order to “correct” (punish) irrational exuberance. But in most cases, they only drop 10-15% before coming back. As long as the economy continues to grow that is.

In my view, it doesn’t pay to try to avoid these corrections. By the time your gut tells you that there might be a problem, the market is already down by at least 5%. The typical non-recession market correction is only 9% or so. How in the world are you going to know when it’s safe to get back in? It’s total guesswork.

9 times out of 10 you’re going to wait too long, and end up getting back in at a higher price than you got on the way out. That’s called the “sell low and buy high” strategy. It might make you feel better when you’re out, but it’s an expensive way to calm your nerves.

It makes more sense to ride out these corrections. Take the short-term pain. Build up some scar tissue around your nerve endings. You’ll be better off, financially speaking, if you do.

Recession warning signs

• A year-over-year uptick in the Unemployment rate.
• A year-over-year downtick in Industrial Production.
• An inverted Treasury yield curve.
• A sharp increase in the inflation rate.
• A year-over-year downtick in the Chicago Fed Natl Activity Index
• A year-over-year downtick in the Wilshire 5000 Total Market Index
• A year-over-year downtick in corporate earnings.

Those are the “hard numbers” that I use for recession warnings. They have a very good track record, having correctly forecast 8 of the last 9 recessions. (With no false positives.)

There are also some “soft numbers” and other signs of trouble that are popular among market strategists, although not as accurate as the hard numbers. The table below is from Barron’s, and it summarizes a few of the risks that are weighing on the minds of the editors.

In the past three years, the S&P 500 dropped 7.4% in 2014, 11% in August 2015, and another 11% in 2016. All three of these events turned out to be normal corrections, and therefore, buying opportunities.

But when declines like this are accompanied by a recession, it’s time to play a little defense. It was recessions that made the 2000 and 2008 declines so deep and painful. And it’s safe to assume that when this historic bull market does finally come to an end, it will be a recession that is to blame.

You can't stop what's coming

Some market strategists believe that the next downturn may turn out to be worse than usual. They point out that market works differently today than it did 10 years ago.  For one thing, there has been an explosion in “passive indexing” that uses exchange-traded funds and indexed mutual funds. These funds now account for more than 35% of equity assets under management, according to Morningstar.

When the next bear market hits, investors will do what they always do – liquidate their stock positions. If they have different portfolios of individual stocks, they’ll pick and choose among them, spreading out the selling. But if they all own the same ETFs, everyone selling will be dumping the same stocks at the same time, exerting enormous downward pressure on their prices.

Another problem is that trading is now dominated by machines, as algorithms battle other algorithms for shares of stocks. But machines make mistakes, just as humans do. It was the rise of portfolio insurance, a computer-driven system designed to protect against losses that involved quickly selling into market downdrafts—that turned what could have been a normal selloff on Oct. 19, 1987 into a 25% one-day bloodbath on Black Monday.

This reliance on computer algorithms to make buy and sell decisions is what causes “flash crashes” - violent and sudden price movements as market liquidity disappears, cautions Andrew Lo, a professor of finance at the MIT Sloan School of Management. “That creates vulnerabilities in the financial ecosystem that hadn’t occurred before,” he says. (Barron’s: How This Bull Market Will End”)

That has some investors wondering whether they should stay or they should go.

Recap of the Bull & Bear arguments

The Bullish Case

• The S&P 500 has risen in 9 of the last 10 months.
• Confidence is rising for consumers, investors, and businesses.
• Volatility is at historically low levels.
• Earnings have rebounded, with a 12% increase in the 2^nd quarter.
• Profit margins are fat.
• Unemployment is at a very healthy 4.4%
• Trump is still the President.

The Bearish Case

• The stock market looks tired.
• The pace of gains is slowing.
• Valuations are stretched.
• Market internals are starting to weaken.
• The Fed is preparing to withdraw liquidity.
• They have already started raising rates.
• Wages are not rising fast enough to stimulate spending.
• Geopolitical risks are high.
• Trump is still the President.

Some final thoughts

While valuations are stretched, investors apparently believe that the strong earnings rebound will continue, and thereby cause valuations to become more reasonable. This bull market is likely to continue, until we get tangible signs of a new recession.

When that happens, investors will start to lose confidence in the likelihood of tax reform, infrastructure spending, the return of high-paying factory jobs, etc. When investor confidence begins to fade, the next step is a change in regime, from "buy the dips" to "sell the rallies." 

But we are not at that point yet. The game plan is to stay invested until the hard numbers indicate that the recession threat is real. 

Since March 9, 2009, the bullish case has dominated. My view is that it’s usually a mistake to bet on the reversal of a long-established trend until there are tangible signs that a reversal is likely. I try to let the numbers tell me when to play defense, rather than letting my emotions drive my investment decisions.