What’s Next?
It’s official. We’re now 107 months into this economic expansion without a recession since 2009. It’s the second-longest ever. What next?
The US economy has had seven straight quarters of rising economic growth. As we look forward into the second half of 2018 the growth rate comparisons get more difficult vs. those of 2017. While our models don’t forecast a recession, they do suggest a firmness of inflation and a deceleration of economic growth; not negative economic growth, just a deceleration. This forecast could be why financial markets have been undergoing three months of turbulence. I believe this is the markets way of reassessing the future path of economic growth.
So the critical question is whether the current conditions match up to the repetitive patterns typically found in the months leading to a major market top. The transition from bull market to bear market has followed a very consistent pattern over the last 100 years. As prices rise to unsustainable levels, investors stop buying expensive stocks eventually reaching a point where they begin to sell in order to lock in profits. The metaphor I’ve used in the past to describe this condition is the transition from autumn to winter. During the early days of autumn leaves begin to fall one by one until one day we actually notice the leaves falling. This process warns us of the approaching winter.
The process of individual stocks dropping out of the bull market has historically followed this autumn to winter pattern. It usually occurs over a four to six month period prior to the final peak in the Dow 30 and S&P 500. The process usually begins with Small Cap stocks dropping out first. This selectivity eventually infects the Mid Cap stocks until it finally hits the Large Cap stocks. So once again, we ask ourselves looking through the lens of Supply and Demand, do any of the early warning signs exist that the current bull market is on its last legs?
- Peak prices were achieved simultaneously on January 26th for Small, Mid, and Large cap stocks. This is very unusual because Small Cap stocks would normally peak several months prior to the Large Caps. It’s worth noting that the worst of the actual losses (about 10%) was over about two weeks later on February 9th. This is a fairly common time period for a correction to occur. Ever since then we have been trading sideways.
- The number of stocks hitting new 52 Week lows has been steadily decreasing as the market trades sideways. On February 8th new lows were 9.67%. On March 23rd it dropped to 6.95% and by April 2nd it had dropped further to 4.12%. This trend indicates a market where selling is abating, not intensifying.
- During the transition period from bull to bear market, selling pressure begins to rise as measured by Lowry’s Selling Pressure Index. This Selling Pressure index establishes a rising pattern well before the final peak in prices. Currently, the Selling Pressure index is only two points above its lowest level dating back to March 2009. This suggests a distinct lack of selling and we can only conclude that investors are actually expecting higher prices in the months ahead.
Without belaboring the point further, there is a series of other Supply/Demand and market signals I follow which also suggest a market correction: not the start of something more serious.
However, I do want to point out one aspect of the process where there is a conflict. As mentioned in my opening paragraph, our economic models which measure Economic Growth (GDP), Inflation, Wage Growth, Wage Inflation, Industrial Production, Durable Goods, among other economic data points, are indicating a deceleration (not a recession) in economic growth in the second half of 2018. Regardless of whether it’s a deceleration or recession, logic would suggest some kind of decline in stock prices even if it’s not a crash. Crash or decline, I really wouldn’t want to get caught up in either one.
So this begs the question, which part of the process do I rely on? The Qualitative (Economic Model signals) or the Quantitative (Supply/Demand and market signals) part? Experience has taught me to lend more credence to the Quantitative part until something within it begins to change.
Identifying change or the early warning signs discussed above, requires that we measure and record the data on a daily basis. We do it for Stocks, Bonds, the U.S. Dollar, Foreign Currencies, Oil, Gold, and Foreign Stocks & Bonds. The late Richard Russell used to call it “listening to the language of the market.” He was right. Personally, I love the markets just as he did. They’re a fascinating place, but you have to have a repeatable process for understanding what it’s trying to say. It’s hard work and never easy.
I did take some action though. Due to the conflict I deemed it prudent to reduce the level of risk in client accounts by reducing exposure to stocks. I’ll end this missive by saying that I’m really looking forward to seeing how this situation resolves itself. Does economic growth surprise to the upside or do market signals begin to suggest a transition to winter? Time will tell.
So what’s next? We wait, we watch and we measure and record.
Angelo Gallo
Lifelong Wealth Strategies, LLC