After two decades in the trenches in the fascinating world of finance, I have seen the stock market weak in November and December only twice – in 2000 and 2007. In both cases, such reverse seasonality preceded big bear markets in the following years. Needless to say, I do not like what I see in November as none of the tried and true indicators that tend to foresee a recession indicate a coming recession right now. That makes the present weakness in this seasonally-strongest time of the year rather perplexing.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
The Conference Board’s Leading Economic Index (LEI) has 10 components. They are:
- Average weekly hours, manufacturing
- Average weekly initial claims for unemployment insurance
- Manufacturers’ new orders, consumer goods and materials
- ISM® Index of New Orders
- Manufacturers’ new orders, nondefense capital goods excluding aircraft orders
- Building permits, new private housing units
- Stock prices, 500 common stocks
- Leading Credit Index™
- Interest rate spread, 10-year Treasury bonds less federal funds
- Average consumer expectations for business conditions
Some of these 10 indicators are soft – not the least of which is #6 (housing), due to rising interest rates, as expected, and #7 (the stock market), likely due to trade frictions and the Fed, but as a whole the LEI does not foretell a recession in 2019. Is it conceivable that both November and December will end up being weak if there is no trade deal with China at the G-20 meeting in Argentina this coming weekend? I suppose it is possible, even though the statistical likelihood of this happening seems rather unlikely.
Typically, if the stock market sells off in a good economy it tends to rebound rather swiftly. There have been over half a dozen sell-offs of the present magnitude in the past 10 years and one that went almost 20% down – in the summer of 2011 – and they all ended up being buying opportunities.
Granted, we have two big complicating factors this time – the Federal Reserve and China. When it comes to the Fed, it seems that President Trump shot himself in the foot with his well-intentioned but poorly-timed tax cut. While I have nothing against lower taxes, if they are accompanied with prudent fiscal management, the President and Congress blew up the federal deficit in a booming economy.
It would have been a lot better for the tax cut to be offset with a spending cut, so this unfortunate deficit situation would not have materialized. One has to do a tax cut in a situation when the economy is much weaker so that it helps spur a recovery, rather than pushing the economy into overdrive.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
It is entirely possible that this poorly-timed fiscal stimulus, likely driven by considerations of the midterm elections, caused the Federal Reserve to press harder on the monetary brakes for fear that the economy would overheat in a late-stage economic expansion. It is not inconceivable that faster monetary tightening, which at the present time is executed by hiking the fed funds rate and letting the runoff rate of the Fed’s balance sheet accelerate, is causing the current problems in the stock market.
In other words, too much of a good thing in the form of a poorly-timed tax cut (without spending cuts) may end up boomeranging in a stumbling stock market, courtesy of the Federal Reserve.
Still, if the Fed does not overdo it and there is no recession in 2019, it would be unheard of for the stock market to decline in a situation where EPS growth in the S&P 500 would be up more than 20% in 2018 and 10% or more in 2019, based on present consensus estimates. That means the S&P 500 would not budge in response to better-than-30% EPS growth over two years – which is not likely.
The China Factor
Because of the way the President has timed his agenda, we now have the double whammy of China trade frictions and an overzealous Fed muddying the waters. If one of those factors goes away or shows signs of improvement, the stock market is likely to celebrate in the seasonally strongest time of the year.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
There are some early signs that Trump wants to close a trade deal with China in Argentina this coming Friday and Saturday. Both the Chinese and the U.S. trade teams are going to Buenos Aires, so an agreement on a framework – it is unlikely to be a final deal – would likely be viewed as a positive by the stock markets in the United States and China.
The stock market in China has much more serious problems, exacerbated by trade frictions courtesy of the credit bubble that has been inflated in China over the past 25 years, so any bounce would likely be an opportunity to sell. As to the stock market in the U.S., we are too far away from a recession at the moment to be worrying about a big bear market at this point.
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