2019 Bull or Bear?

I've been wrestling with my thoughts about where this market is headed for some time. Coming into 2018 I was medium term bearish because there was too much complacency and the market got very overbought having gone straight up for all of 2017. I was also wrestling with the notion that the January top could have been the bull market top. I mentioned the possibility of a 20% drop to wring out the complacency that had built up to that peak. Here's some things  I also said earlier in the year:


" If we are to assume that the bull market is still in tact, before it's ready to resume its upward march on a sustainable basis I expect to see the opposite of what we saw at the peak. I expect to see bears outnumber bulls 2:1, major outflows and the permabears coming out of the woodwork claiming that the bull market is dead. It will take some time but I believe that the lemming stampede into to ETF index funds will get undone and we will see a lemming stampede out of them at some point this year which could crater the market. "


We have seen the above play out. The SPX declined 20% off its high, AAII bears outnumbered bulls more or less about 2:1 for 3 weeks now, there have been heavy fund outflows and the the market hit extremely oversold level and you have seen people calling this a bear market. The market has unwound that ridiculous move from September 2017 to early January 2018 and I believe that if the bull market is still alive, is now in a position to resume its advance in a sustainable way given the severity of the oversold condition and clearing of excesses. But, what if this is more than just a severe bull market correction?  Could this be the start of a big bear market like 2000 or 2008?  I see conflicting signs. What I'm going to do now is act as an attorney for and against a bear market presenting arguments of either case. 


Here is a checklist of many things that have preceded a big bear market:

The economy is widely considered as being strong from the public's point of view (check), unemployment rate is historically low (check), consumer confidence is historically high (check). There was a bubble of some sort that burst (check - cryto). The Fed is raising rates for at least a year (check) and is unfazed by signs of slowing growth (check). Just prior to the market peak, the rise in the stock market became increasingly narrow with only a  handful of stocks driving it  (check - FAANGS).  Traditional market valuation metrics near historical highs (check). Housing is rolling over (check). Heavy inflows to equity funds (check).

Here are arguments that the bull market is not over yet: 

In 1987 and 1998 the markets experienced a sharp 20-25% decline but it did not end those bull markets. In 1987 and 1998, the economy did fine but the market got ahead of itself and complacency became acute just like the market did coming into 2018. A major decline was needed to clear out the excesses and to rebuild the wall of worry that bull markets must climb.

Bull markets are born on pessimism, rise on skepticism, mature on optimism and die of euphoria. The bull market was hated pretty much every step of the way until 2017 when we finally did see optimism/complacency but it could hardly be characterized as euphoria. Sure, there was euphoria in bitcoin but it wasn't tied to the stock market/economy  (except for some parts of the the semi-conductor space)  to nearly the same degree as the internet and housing bubbles were and so its fallout should not lead to a recession like those other 2 bubbles did.

Although rates have risen, real interest rates are barely positive and therefore not restrictive for borrowing/growth. At prior bull market peaks real interest rates where at 3%+. The yield curve as measured by the spread between the 2 and 10 years never inverted and therefore not signalling recession and its recessions that have led to the 40%+ bear markets. . Only the 3 and 5 years got  inverted which is not a recession signal. There has never been so much attention being paid to the yield curve like this which makes it less likely to be something to worry about. 

We never saw a large flood of low quality IPOs in 2018 which is something you typically see near a major peak signalling greed/euphoria. 

Given how long pessimism prevailed it wouldn't be unreasonable to expect that optimism can prevail for a few years before the end of the bull run and we only did see optimism for about a year or so. The same goes with consumer sentiment. Yes, it recently hit levels which are closer to the top end of the historical range but before you sound the contrarian alarm bells you need to realize that consumer sentiment was abnormally low from 2009-2014 and so so it would not be unreasonable to see sentiment stay "sticky" on optimistic side for a few years. That is what happened in the mid-late 80's and 90s. 

The fiscal deficit was never this high at the start of a major bear market, whereas typically at the start of a bear it is low and declining or in a surplus which is a drag on economic growth (deficit spending adds to GDP, a surplus takes away from GDP). 

This waterfall type decline we're experiencing is what you typically see in a severe market correction or the final phase of a bear market, not the beginning of one. The only time this was not the case was the crash of 1929. When prior big bear markets began, the initial decline from the peak was a lot less severe and the economy had been showing clear signs of contracting.  That's not what happened this time. This decline appears largely self inflicted due to a botched Fed policy stance  and political fumbling which can be undone in 2019. There are some leading indications  of decelerating growth but nothing to suggest the economy has hit a major turning point. 

Just prior to major bull market peaks credit stress was clearly rising. Just prior to this decline credit stress was low and has recently been rising modestly, likely tied to the collapse of the oil price.  We could (and likely) will get a downward blip in economic activity in the coming months, but to see the market drop 20%  like this without any visible material weakness in earnings or the economy smacks of panic/forced selling.
 
Alright, so now that I've laid out the bear and bull case I want to discuss some X factors that are unique to this market cycle:

We have a Fed head in Powell who is too hawkish and painted himself into a corner. After those big declines in 1987 and 1998 we had a market friendly Fed one way or another come out say "we got your back". In 1998 the Fed actually slashed rates by 75 bps. We don't have market friendly Fed right now which is not a good combination especially in the face of slowing growth. I believe at some point Powell will have to significantly backtrack his 2019 outlook and may have to actually cut rates. The flatness of the yield curve is saying right now that monetary policy may be tight, not excessively tight, but tight. One way or another, the markets will force the Fed to act. The question is at what point? Are they going to act only after the market drops another 15% and it's painfully clear the economy is tanking or will they admit they made a mistake and act sooner? Or does it ever matter if the Fed acts? 

We have been in an ultra low interest rate environment for so long that even though interest rates have only risen modestly by historical standards the negative impact of rising rates on borrowers could be larger than what would normally be expected because  people/corporations may have been addicted to these low rates for so long.

We have a US president that bashes people on twitter daily showing signs of metal illness in my opinion.  His administration seems to be unraveling which is causing him to lash out even more. According to an article I read 62% of top-level White House positions have seen turnover under Trump as of December 2018. I kind of get this sense that the wheels are falling off here. 


We also have markets dominated by algos which exacerbate movements to the upside and downside which makes comparing the stages of a bear market to other ones in the past less reliable. Maybe won't just see just a moderate decline in the first leg like in the past.  It's important to not get head faked and to focus on the fundamentals and expectations/sentiment. 

On the positive side of X factors we have China pledging stimulus for 2019 and seems bending to make a trade deal. A recession does not seemed to be baked in the cake at this point. The Fed created a self inflicted wound which is not too late to undue. If they can just find it in themselves to admit their mistake and back off it would do the market a lot of good. 

So in conclusion, I remain agnostic about the market for 2019 as I can see the possibility of both  very positive and very negative outcomes. Things were much clearer to me last year at this time. In the short/medium term, the decline has caused sentiment to tun quite negative and the market got sufficiently oversold to at least warrant a multi-week rebound regardless if this is the beginning of a big bear market or not. But I still think we haven't seen full capitulation yet. Even if you think there will be a bullish resolution to this decline, history has shown that the market doesn't simply do a V rally from the bottom and never look back. There would likely be some base building with retesting or break of the initial low.  I also get the sense that despite the negativity that's out there, there may still be too much bottom fishing and a fear of missing the rally from trader types. Even some noted permabears like Hussman have made mention of the oversold condition of the market. That to me says any bounce will likely not last. We haven't seen the VIX break 40 which to me suggests that a full capitulation is lacking. I also noticed that Wall Street strategists are too bullish for 2019 although targets are being slashed daily.  So, it wouldn't surprise me to see the market do well into early-mid January but stay on guard. 

I welcome any comments to discuss what could be in store for 2019.

Powell still didn't listen....Mr. Market obliges with a left hook to his jaw.

In my last post I said that the Fed wasn't listening to the market and if they continued not to do so, things could get really bad. Well, despite collapsing oil prices, weakening US housing, emerging signs of stress in the credit markets and ongoing weakness in the global economy, the Fed still hiked rates in December and softened its stance only marginally implying 2 hikes next year rather than 3 and no change in its autopilot plan to unwind QE. The market is rightfully now worried that the Fed is in on track to make the classic mistake of tightening policy in the face of weakening growth prospects which in the past has led to  recessions. I know Trump didn't do Powell any favors by continuing to criticize him on Twitter and urging him not to raise rates, but Powell could have just hiked in December  and said "since the last time I addressed you, we have seen some signs of decelerating growth and a marked decline in short term inflationary pressures.  As such, we are going to be much more flexible with our original plans to hike rates next year and unwind the balance sheet".  If he said that he would put Trump in his place and give the Market the assurance that it was looking for without boxing himself into a corner. Instead Powell decided to play the tough guy and show Trump and everyone else who's boss. Well, Mr. Market showed Mr. Powell who's boss

The good thing about the market declining this hard is that it creates awareness to the authorities that something could be wrong whereas a gradually declining market could give way to complacency - like  the frog in boiling water vs gradual warming water analogy. Powell has come under tremendous fire. Given the market's reaction and heavy criticism of him, he probably realizes that he was wrong and somehow now has to come out and backtrack on his stance without losing too much face....and he needs to capitulate soon.

I will post more soon,