Rough Road Ahead For US Stocks

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I’d like to look at two years: 1987 and 1994.

1987 is instructive because the prelude to the market crash of October was a selloff in the bond market that started a few months earlier, combined with the weakening of the dollar. Sound familiar?

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I should point out that bear markets like 1987 or 1998, when not accompanied by a recession, are typically V-shaped and quickly over. It's when you have a bear market, no matter how deep, that is accompanied by a recession that you really have to worry about lengthy recoveries.

1994 is instructive because the Fed commenced a tightening cycle and there was an inflation scare. It didn’t help that there was a great deal of leverage in the bond market, which caused a lot of pain during the selloff.

Historians will note that even though the 10-year yield rose significantly, inflation never really picked up. And the market recovered relatively quickly.

Bulls Everywhere

That being said, it should come as no surprise that correlations among asset classes are up to 90% (source: Deutsche Bank). Everybody seems to be playing the global growth and global reflation trade.

In almost every asset class, all the traders are on the bullish side of the boat—or at least they were until the last few days.

That level of correlation means that pain in one asset class could easily translate to pain in other classes, even as the economic news seemingly gets better and better.

The Fed will have to lean into the market with more than three hikes this year, with more to follow next year. Other major central banks would also have to initiate tightening cycles. We have been addicted to easy money and low interest rates for so long that regime change is scary.

We’re not unlike addicts who finally realize they’re going to have to give up their drug of choice.

In the US equities, mutual fund exposure rose to a six-year high while short interest in stocks and ETFs fell to the lowest level since 2007 in other assets fund exposure to oil is a now about 2.8 standard deviations above the average while long euro shows similar extreme readings. (Source: Bloomberg)

Much of the current good feeling hinges on consumer spending, which is up. This uptick in spending reflects confidence in the future, but its flip side is a lower savings rate.

The Commerce Department reported last week that the savings rate was 2.4% of disposable household income, the lowest since September 2005. That was a housing boom year when people were flipping homes and pulling out equity with wild abandon.

Many would regret it a couple years later.

De-Risk Now

My friend Steve Blumenthal just posted a note in which he talked about his top ten recession indicators. Nine of them were signalling no problem for at least the next nine months. The signals don’t go further than that. GDP growth is not the problem this year.

The problem is overstretched markets and the potential for the Fed to go too far.  We simply don’t know what will happen when the Fed starts removing $150 billion per quarter from its balance sheet by the end of this year.

Maybe they’re right, and it means nothing. Maybe running a $1 trillion yearly deficit doesn’t make a difference. Maybe four interest rate hikes don’t matter.

None of these factors are serious yet, but they will add up over time. Maybe the market will shrug them off, we’ll actually see the 25% earnings growth projected by analysts, and the S&P will end up much higher for the year.

Any number of tail-risk events could change the picture quickly, though: war in Korea or the Middle East, a major terrorist incident or cyberattack, spiraling trade disputes, a bank failure—you know the list. The world can change quickly.

Now is a good time to plan your de-risking strategy. You want to balance it with staying involved in growth assets, if they are part of your plan.

Rather than trying to diversify asset classes, which are marching in lockstep both up and down, I would try to diversify trading strategies. Think about what you’re going to do when the market turns against you.

Hope is not a strategy. You need to have a plan, or you need to find somebody who has a plan that you feel comfortable with.

To sum up, I’m not expecting a major bear market, but a correction is a real possibility. This is going to be a much more volatile year than 2016 or 2017. Overbought and overstretched markets moving in concert with each other are just the right witches’ brew for volatile corrections.

Just saying…

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