- The U.S. economy grew at the slowest pace (1.9%) in Q3 this year, and despite the Fed fearing a recession, stock markets kept rallying.
- As markets party in bull territory, global investors continue pulling out funds per data as on 30 Oct. 2019.
- 2020 may yet see a bear market.
- Looking for a helping hand in the market? Members of The Lead-Lag Report get exclusive ideas and guidance to navigate any climate. Get started today »
The intelligent investor is a realist who sells to optimists and buys from pessimists. - Benjamin Graham
Economic events are unfolding at a crazy pace. The U.S.-China trade war seems resolved one day and escalated the next. Brexit has been postponed a bit and it is unsure how it will pan out, conflicts in the Middle-East are brewing, economy-related unrest is unfolding in many countries, Gen Z'ers and millennials are changing the rules of demand and supply, and many economists have started blowing recessionary bugles.
Then we have contrarians, business TV anchors, market experts, all betting on the bullish run continuing.
Caught in the middle is the average Joe investor whose confusion is getting compounded by the day, unlike his stocks.
Should he sell, hold or buy? Is a bear market coming in 2020, or will the bullishness hold?
Here is my analysis:
The Cyclically Adjusted Price Earnings (CAPE) Ratio
Here's how a high CAPE impacted the S&P 500 (US500) in the past:
The Dotcom bubble got pricked in March 2000. At that time, CAPE was ruling above 42. The market correction that followed was savage. The S&P 500 went into a free fall until the charts reconciled with the fundamentals.
Late 2007 (the global bust) was no different - CAPE was around 28, way above its historical average of 17. The market fell very hard and it took years for it to regain its 2007 highs.
So, how will the CAPE play out in 2019-20?
Currently, in Oct. 2019, CAPE is at 29.4, and we are being regarded as an expensive market by global investors.
To forecast how indices will react to a high CAPE, we need to predict how the forthcoming earnings seasons will pan out.
Before the earnings season began, FactSet estimated an earnings decline for the S&P 500 by 4.6%. However, 75% of the S&P 500 companies have posted results that have beaten expectations and that's eased growth fears. It does seem at the moment that the CAPE will either remain steady at 29.4 or move down a notch.
But what if future (the next quarter and beyond) earnings don't match up?
The Conference Board reported that the leading economic index slipped 0.1% in Sep 2019, and this happened second month in a row. Ataman Ozyildirim, Senior Director of Economic Research at The Conference Board is of the opinion that falling business expectations and manufacturing weaknesses are because of the industrial sector downturn and trade disputes. He adds that though the economy will continue to grow, it will be at a slower pace.
China too reported dismal GDP numbers (6%), this quarter being the weakest since 1992. The U.S.-China trade goods and services trade was a whopping $737.1 billion in 2018 (Exports $179.3 billion; Imports $557.9 billion) and any weakening of China's economy will impact the U.S.
The analysis is that if trade disputes and conflicts linger on, economic wounds will develop gangrene.
Funds Flow into the American Markets
The U.S. equity markets saw long-term mutual fund outflows in excess of $44,000 million ($44 billion) in the five weeks ending 23 Oct 2019. The IMF is of the opinion that the U.S. markets are overvalued. Analysts too expect the Fed to keep cutting rates until zero or underground - and this despite the Fed stating that it will pause.
On one hand, the Fed rate cuts are making investors sell bonds and invest in the risky stock market. On the other hand, the drooping LEIs and the trade war Mexican standoff is making global investors nervous. It's a dicey situation out there.
U.S. Corporate Debt and Consumer Sentiment
Total U.S. corporate debt stands at a mega $15.5 trillion, and this works out to 74% of U.S. GDP. The new Fed rate cut will further entice businesses to borrow some more, further inflating the debt balloon. The new 1.5% ̵ 1.75% interest range may fatten bottom-lines, but investors should pay attention to the tapering consumer sentiment.
Consumer sentiment fell in Aug. 19, recovered some in Sep. 19, but is still low. Though many uncertain and potentially bearish factors have encircled the markets, funding is available easy and at low rates! It does not make for sound economics.
This article was written by Michael A. Gayed. An author on Seeking Alpha and founder of the Lead Lag Report.
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