When markets fall, investors must decide whether the pullback is based on irrational emotion, in which a buying opportunity presents itself, or the pullback is based on an adverse change in fundamental value. This is the dilemma facing investors today.
BloombergBusiness (Bloomberg.com) published an interesting article on January 11, 2016, “Bank of America: Rail Traffic Is Saying Something Worrying about the U.S. Economy.” The article’s subtitle says it aptly enough – “Rail carloads are looking recessionary.” The article goes on to reference a Bank of America research report on a “substantial and sustained” decline in rail volume. Over the last 30 years, in each of the five times this condition materialized, economic recession started or was just around the corner. Can the U.S. economy be headed towards something worse than slow-growth?
In this third edition on the markets, we’ll discuss why the S&P 500 will likely make its way down to the 1,600 level – a 25% retreat from the 2015 highs. I have stated there are a multitude of reasons why the stock market will likely continue its path further down until a level of significant buying support is reached. I believe this level to be when the S&P 500 index reaches the price territory of 1,600. Over the course of this series, a case is being made for why the current market weakness is foretelling of a bear market rather than temporary correction of a bull market. A correction is a pullback of usually less than 10%, and after, the bull market resumes. A bear market is characterized as a sustained downward trend with a greater than 20% loss.
Remember from the previous editions, quantitative easing (QE) was the Fed’s method for pumping more money into the economy. During recession, the money supply contracts of its own accord, adding further to the deflationary pressures already present during an economic slowdown. Through lessons learned in the past, the Fed attempts to combat deflation typically by increasing the money supply – credit expansion – with lower interest rates. However, if credit is already at extreme levels and interest rates are as low as they can go (bound by zero), some other method to inflate the money supply must be found. QE is the process where the Fed creates money (electronically these days, but very similar to the old days of creating money with a printing press) and then uses those funds to buy assets from the economy, thereby hoping to infuse funds that then become available for consumption and investment.
For the half-decade QE was underway, the final tally shows that the Fed accumulated more than $4 trillion of longer-term U.S. government and mortgage-backed bonds. The Fed’s bond holdings were financed with this newly “printed” money which added a corresponding $4 trillion or a 25% increase to the world’s supply of dollars. The value of the dollar had to fall, leading to increases in the prices of other assets like homes, stocks, bonds. The hope was that while QE was in place, the economy would recover, evolve and expand in other ways so that when QE was halted, these “new shoots” of growth would take over the heavy lifting. However, the U.S. economy has been enabled and has not adapted in the way hoped for. Instead it has remained addicted to its dependence on asset price inflation – rather than productivity – to produce growth. This structural dynamic of the global economy has been in place now since the 1990s, long before the recent Great Recession. More discussion of this issue will appear in future editions.
As QE #3 took effect, there was a mass rush by the stock market to catch the Fed’s final give-away of asset price inflation. This time, the Fed would be taking no chances. Even though the economy was rebounding, in a large way from the impact of new U.S. oil production, the Fed’s QE bond buying finale was intended to overshadow all of its previous efforts. The Fed doubled monthly purchases from $40 billion to over $80 billion.
From the Fed’s perspective, the final round of QE had to be stupendous. With each new round of QE, the “effectiveness” on the underlying economy was becoming less and less, while the potential for asset inflation problems were becoming more and more. The banks receiving the funds from QE weren’t lending out the money. Instead they bought Treasury securities for their own accounts. The Fed’s massive buying pressure was bound to drive bond prices higher. With very little risk, the banks could make oversized gains by using the QE proceeds to buy more financial assets, and then riding the upward trend in price on the coattails of the Fed’s buying spree. The banks’ incentives and the extent of their actions were unavoidable and probably not fully appreciated by the Fed.
The banks can’t be faulted. They made prudent economic decisions. Rational self-interest would determine their course. The banks were either going to make risk-bearing loans to their customers at low interest rates (more risk for less profit), or make more profit with less risk by purchasing Treasuries. Further steering the banks towards the second option were the recent bank regulations. Ill-thought-out and hasty reactions to the crisis, many of the newly enacted laws tied the hands of the banks on certain credit activities. The banks had to choose option number two.
QE was a money-making bonanza for the banks. It allowed them to recapitalize their crisis-damaged balance sheets without further diluting their shareholders. Over the last half-decade, the QE gains contributed handsomely to their bottom lines. The banks needed this income to offset the credit losses and lower loan fees, typical of a deleveraging economy. And without the QE gains, the U.S. banks would have been at greater risk of failure or be forced to raise more capital. An undeniable by-product of QE was a further “bailing-out” of the American banking system. As a result, American banks are now much better capitalized today than most foreign banks.
QE became a significant and positive influence to the global markets’ valuation process. But with its ending, and in light of an apparent global economic slowdown, a meaningful and opposite effect cannot be avoided. And this is what has been happening in the global markets over the last year – a revaluation of all asset prices, without the benefit of QE.
The chart below depicts the S&P 500 (black) and the Dow Jones Transportation (blue) indices for the last four years. At the start of 2013, the S&P was 1,400 while the Transports were at 5,500. With the Fed’s last bout of quantitative easing (QE #3), the indices began their last legs up of the bull market underway since 2009. The returns of this last phase were phenomenal. From the beginning of 2013 through the first half of 2015, the S&P rose 50%, the Transports 70%.
Notice what happened to the Dow Transports in early 2015. QE had already been halted and the Transports started diverging from the S&P, and then breaking the two-year upward trend. Trucking, shipping, rail, and airlines – all started to expect lower revenues and their shareholders responded by selling. Institutional investors who follow Dow Theory must have suspected that the divergence foretold problems for other markets. These sophisticated investors then reduced their overall portfolio holdings. Their selling effectively took another major buyer out of the market. Meanwhile, smaller, less-sophisticated investors kept on buying, supporting a level of the stock market that could only be maintained for another few months.
(Dow Theory is an investing theory named after its creator Charles H. Dow, also a famous journalist and editor. The theory has found much support in the century of its existence. One of the theory’s basic tenets is that the Dow Jones Transportation Index must confirm the broader stock market. If divergence occurs, beware. This makes sense. If the economy slows, the effect on the transportation of people and goods should be an early precursor to a larger economic decline. Recall the article mentioned at the beginning of this commentary about the currently slowing rail volume.)
Then true to course, the broader stock market fell. Last August, the S&P broke the 2,000 support level and could not regain its previous high of 2,100. Based upon precedent of similar trend breaks, a decline of 10% to 15% became an easy outcome. A fall of this magnitude puts the S&P around the 1,800 level, close to where it is now. Some buying support is expected around this price causing the index to stem its current decline, but only temporarily. A bounce back up into the 1,900 price range, before a further fall below 1,800, would not be a surprise.
But again, 1,600 is the S&P 500 price ultimately expected, at least for now. With the headwinds facing the market and uncertainty not yet fully priced in, there is a greater probability of a further fall than a rise to previous highs. Uncertainty is likely not fully priced into the market because the fear factor, as measured by option volatility, has increased but has not reached a crescendo. Again based on precedent, significant buying interest will probably stay on the sidelines until fear and volatility peaks. This will require the market to fall some more.
Adding to the case for an overall bear market, a great many global indices, mutual funds, commodities, ETFs and even individual stocks are now in bear markets. Over half of U.S. stocks are in bear market territory. Oil companies, banks, techs, industrial giants – they are rolling over a few at a time. This process is also a familiar sequence at major market tops. And once in a bear market, reversals do not happen overnight. Significant damage has been done and the rebuilding of buying interest around a certain price level takes time.
CNBC states the average bear market:
- Occurs every three and one-half years,
- Lasts for 15 months,
- Results in a decline of 32%.
Simply put, we are overdue, early on, and haven’t fallen enough. Valuation assumptions, particularly those adopted with the implementation of QE #3 are being torn down and the market may decide that the best place to start to rebuild is at the value before QE #3 took hold – at the S&P price level of 1,600.
From a market technical perspective, there is no significant buying support below 1,800 to help break the fall until the S&P reaches 1,600. But once that point is reached, investors can be confident that buying support will be substantial. There is an adage in the investment business that says that a point of resistance, once crossed, now becomes a point of support. Three times over the last 15 years, the S&P’s territory just below 1,600 has been an important battleground between the bulls and the bears. First, at the market top in 2000 with its ending of the tech bubble and the incredible bull market of the 1990s. Next, at another market top in 2007 following the run up in prices caused by the housing credit bubble. And then again, in 2012 before the start of QE #3. Thus, multi-year buying support should form on the way down at the same point where significant barriers once impeded the way up – around 1,600.
The U.S. stock market has a long way to go in order to repair the damage suffered so far. In addition, the market’s valuation assumptions appear to have changed significantly since the ending of QE. A resumption of the bull market in the shorter-term would only be a gift and should not be expected. Based upon both fundamental and technical analysis, investors should keep in mind that the downside risk currently appears to outweigh the potential for upside.
Christopher Petitt is the author of the book, The Crucible of Global War: And the Sequence that is Leading Back to It. It is available for sale at Amazon.com, Barnesandnoble.com and for order at bookstores everywhere.