Some skeptics believe all this good news about the prospects for the economy supports the bearish, not the bullish, case for the equity market. They argue that the economy was already doing well before the fiscal stimulus provided by the tax cut. With unemployment at 4.1% and headed to 3.5%, the economy did not need any stimulus. It was already at full employment and the additional federal spending would cause the economy to overheat, resulting in higher inflation to and rising bond yields. They argue that those who are bullish on the market should hope for slower growth. My view is that this is an earnings-driven market and the improving profit forecasts will offset rising inflation and interest rates.
Some observers believe a 10% correction is enough, at least for a while. Valuations have come down to reasonable levels, the market is no longer excessively overbought and intermediate-term interest rates are showing signs of stabilizing. The Crowd Sentiment indicator has moved from close to 80 down to 61, putting it in “neutral” territory where we could see a short term rally. It would be nice if investors had to endure only two weeks of pain before the market headed higher again.
I believe the positive sentiment that provided the background for the decline has only partially been corrected. Consumer confidence is high, reaching levels not seen since the late 1990s, but the savings rate has dropped to 3.4% as consumer net worth has increased. The last time the savings rate was this low was two years before the 2008-9 recession. We know that the Federal Reserve is moving toward a more restrictive monetary policy and the European Central Bank is talking about tapering. Less accommodative monetary policies are generally not good for the equity markets. Consumer debt has risen sharply since 2009 as confidence has increased, but federal debt may be the real problem. According to Doug Kass and Larry McDonald, that debt was $9 trillion in 2007 and carried a cost of servicing of 4.75% or about $425 billion a year. (In 2000 it was only $6 trillion with a cost of servicing of 6% or $360 billion, but with a tax cut and two wars to finance, debt soared in the new millennium.) Today it is $20.5 trillion with a debt service cost of 2.25% or $460 billion, slightly more than in 2007. Think of what interest rates going above 3% would do to the budget deficit.
None of these issues make me bearish but they do make me think the correction is not over. I am bothered by the role that quantitative algorithmic trading and leveraged Exchange Traded Funds played in accentuating the rise in the market and its decline. These are basically trading tools, not investment strategies, and while it can be argued that traders contribute to market liquidity, I fear that these mechanical techniques have produced a certain level of instability in frenetic periods such as the one we just experienced.
I am on the record as saying I think the market is more likely to range than trend so I see more in Byron Wein’s views to agree with than disagree with.
I am also on the record as saying we are in the third psychological perception stage of this incredibly impressive medium-term trend since the 2008/09 lows. The impact of the tax cuts is real, it has contributed to valuations getting a one-time compression so that many of the overvaluation arguments are not as relevant today as they were in November. That is a powerfully bullish argument.
For the moment it is being counterbalanced by the recent memory of a swift 10% pullback and that is going to take time for investors to digest.
If bond yields continue higher as I, and an increasing number of others, expect, that will offer a headwind for the stock market. However if we are in the euphoria stage of the medium-term bull market many people will not care. If all this turns out to be is a range in the stock market, much less if Wall Street breaks out within the next week or two, then the real possibility of a return to an historically overvalued state, this time with a higher price, cannot be discounted. Acceleration in a rising interest rate environment would represent a significant trend ending characteristic.
One of the topics we discuss at The Chart Seminar, is that the trend often loses consistency at the penultimate high. The short, sharp pullback following a particularly consistent two-year advance was an undeniable inconsistency. That is why now is one of the most important times in the last decade to monitor the consistency of the trend and most importantly the ability of the February lows to hold.