Thursday , 23 May 2024

The Trillion-dollar Question Is, “When will this all end?” (+2K Views)

…History tells us [see here for why that is the case] we should expect higher stock prices in the next quarter, mid-year, and by the end of 2018. The trillion-dollar question is, “When will this all end?”

The original article by Chris Puplava has been edited here for length (…) and clarity ([ ]) by to provide a fast & easy read.

To help answer this question, JP Morgan surveyed each of the major market tops and bear markets since the end of the roaring ‘20s and looked at four different variables related to the macro environment at the time:

  1. recession,
  2. a commodity spike,
  3. an aggressive Fed,
  4. and extreme valuations.

Below is a table of their results followed by an investigation of our own data into each of these bear market macro drivers.

market corrections
Source: JP Morgan, Guide to the Markets

Bear Market Macro Driver #1 – The Risk of a Recession

As we often note, the most consistent macro driver of a bear market is a protracted economic slowdown, or recession. A visual inspection of declines in the S&P 500 going back to the Great Depression shows that most bear markets occur just prior to the onset of a recession (noted in red).

bear markets recessions
Source: Bloomberg, Financial Sense® Wealth Management

Our Financial Sense recession model monitors a wide variety of economic data and generally remains below 20 during economic expansions. We have had some close calls during this economic cycle but have not moved significantly above the 20-level threshold since the Great Recession of 2008. Furthermore, given our current reading of 12, it is highly unlikely that the bull market in stocks is in peril due to an imminent recession.

recession model
Source: Bloomberg, Financial Sense® Wealth Management

Bear Market Macro Driver #2 – Commodity Spike

The second macro driver associated with bear markets is a spike in commodity prices, particularly oil. As noted years back, oil’s relationship to the business cycle can’t be overstated...We can easily observe this by looking at the S&P 500 and oil’s year-over-year price movements going back to the early ’70s.

crude oil spx
Source: Bloomberg, Financial Sense® Wealth Management

Barring some outside geopolitical event like an outbreak of war with North Korea or a conflict in the Middle East, I do not believe that oil will pose a significant threat to the present bull market and economic expansion for several reasons…

1. [As shown in the chart below], the U.S. is estimated to produce more oil than Saudi Arabia this year and is thus a greater marginal driver of oil prices. The stable increase in production by the U.S. should help keep global supply and demand dynamics in balance.

us oil output

2. Another factor that is likely to keep a lid on oil prices is the slowdown we see in Chinese growth. Chinese real estate is very sensitive to moves in government interest rates and the rise in rates over the last year suggests that we should see a decline in Chinese real estate and GDP. A slowdown in China would also likely contribute to a cooling in global growth this year and help mute any oil price spikes.

Bear Market Macro Driver #3 – An Aggressive Fed

…There is a close relationship between past financial crises and Fed tightening cycles, something that we are in the beginning stages of currently.

interest rates financial crises
Source: Bloomberg, Financial Sense® Wealth Management

The question is: how do you objectively gauge whether or not the Fed is aggressive? The easiest way to answer that is looking at where the Federal Funds Rate is relative to 10-year US Treasury yields.

  • When the Fed Funds Rate is above long-term yields, we have a negative spread between short and long-term rates, which is atypical and highlights points of financial tightness in the economy.
  • We see negative spreads often just before a recession begins, which is shown below where the Fed Funds rate is subtracted from the 10-year UST yield. Currently, the 10-yr UST yield is more than a full percentage point above the Fed Funds Rate, but that spread will narrow if the Fed raises rates three times this year per the consensus view.
10 year fed funds
Source: Bloomberg, Financial Sense® Wealth Management

For our own portfolio management process, an important metric we follow is the Federal Funds Risk Neutral Index, comparing Fed monetary policy to current market interest rates and real economic data, to help to gauge the relative tightness or looseness of Fed policy and the risk this poses to the market. As you can see below, the current policy stance is still relatively loose and not yet warning of an overly aggressive Fed.

fed funds risk neutral
Source: Bloomberg, Financial Sense® Wealth Management

Bear Market Macro Driver #4 – Extreme Valuations

The fourth macro factor often associated with bear markets is an extreme overvaluation of stock prices…During economic expansions, one asset class tends to outshine the others, whether it is bonds, stocks, real estate, or some other financial asset (think tech stocks in 2000 or housing in 2005) but [in] this cycle, everything seems to be increasing in value…

Looking at current household net worth relative to disposable income and also relative to nominal GDP shows we are at record extremes. As the Federal Reserve Bank of San Francisco points out, these ratios do not remain elevated for long and often come crashing down to their long-term averages. As such, today’s levels do pose a risk to the stock market and other financial assets in the years ahead, but do not serve as a near-term timing tool.

household net worth
Source: Bloomberg, Financial Sense® Wealth Management

Summarizing the analysis above

The present bull market in stocks and economic expansion are likely to continue given we do not see any red flags suggesting its imminent demise…

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