THOUGHTS ON THE MARKET
I just got off the phone with a very smart advisor who wanted to know what I was thinking with regard to the current market gyrations.
Below are some bullet points from the conversation:
Why is the market going down?
Overall, it was overvalued. It isn’t overvalued now. Arguably, it is fairly valued. In fact, the S&P 500 is trading at about 14x 2019 estimated earnings. And that includes some expensive mega-caps skewing the valuation higher. There are areas that offer extraordinary opportunity.
According to Jeff Saut’s (Chief Investment Strategist at Raymond James) contacts, 150 or so hedge funds are being forced to close up shop. That’s a heck of a lot of forced selling that is now in the midst of occurring. And that forced selling is causing technical support levels to be breached, which in turn is causing additional forced selling. It’s a self-fulfilling prophecy, if you will. This will pass as it is systematic, and at some point the robots will turn back to being buyers. It will happen faster than anyone thinks it will happen. If you’re not positioned for it, you will miss it. It can also cause markets to overshoot on the downside, so don’t be a hero—be a risk manager.
We’ve long talked about the huge move into passive ETFs as being a major market risk. That move is being unwound, as we’re now in the midst of the largest number of redemptions from mutual funds and ETFs in history! We’re seeing the emotional panic, and that usually happens at the lows. But when ETFs are sold, all of the stocks see selling pressure, even the good ones. This eventually creates opportunity.
The general overweighted positioning of hedge funds, portfolio managers, and individual investors has created significant selling pressure. Systematic trading strategies, especially Risk Parity, short-vol, and momentum, are being forced to rebalance out of stocks. Notice that “forced” is a theme here… This happened earlier this year (remember Vol-mageddon!) and how quickly the reversal happened.
Add a dollop of tone-deaf stupidity from our leaders (both sides of the aisle!), whether political, governmental, legislative, or quasi-legislative, and the stage was set for a correction.
We’re now at a point where there are an overwhelming number of sentiment and technical indicators at levels last seen during the 2008 and 2011 declines. Let me say it another way: Many, many indicators are telling us this market is washed out. It doesn’t mean the decline is over, but it does mean, in our view, that most of the damage has been done. Can the market go down another 5% due to more fear mongering? Yes. But for those with a year or more time horizon, I think it’s time to look for opportunity.
Remember, just three months ago the stock market could do no wrong and couldn’t go down. It did. Now, sentiment has shifted to despair that the market won’t go up. It will.
We continue to view this decline as a normal bear market within the context of a continuing secular bull market. You might say, “What does that mean?” It means that:
Economic growth, while slowing, is still positive. Ned Davis Research estimates that global real GDP growth will come in at +3.5% for 2019, while real GDP growth here in the U.S. should increase to 2.75%. Positive economic growth typically puts a floor under the potential severity of a market decline.
As we wrote last month: “Economic growth must continue. And anything affecting growth, including tariffs, Fed funds rate hikes, quantitative tightening, and even political partisanship around potential government shutdowns (what is wrong with these people!) are likely to have an outsized market impact given that economic growth is what this market requires for the next leg higher.” This remains true. If economic growth falters, we will change our tune.
Jeff Saut and his cadre of intellectuals again have another brilliant point (thanks Jeff!). He writes that the “Pension Rebalancing Model estimates there will be ~$90bn inflows to equities and out of Fixed Income from pensions over December month end… and the largest estimated inflow into equities since May 2012.” That led to 2013, which was a very good year for us.
China is addressing some of the world’s concerns regarding trade, as well as providing monetary and fiscal stimulus to bolster their economic growth. This is reducing the angst around one of the “triggers” for the market decline. Interestingly, Emerging Markets were positive yesterday (Thursday). A good sign, as we’re watching EM as a leading indicator.
Other positives are starting to crop up, with the Fed taking their foot off the brake, Italy getting their budget approved, slightly better economic numbers out of Germany, and less focus on Brexit (though it is still a significant risk in our view).
While U.S. corporate earnings growth rates are expected to slow in 2019, absolute earnings are expected to increase. In other words, earnings are increasing, just not as fast as in 2018—which is expected due to the corporate tax reform mostly impacting companies this year.
And, perhaps most importantly, REAL INTEREST RATES ARE STILL LOW.
Summary: As I wrote to another accomplished advisor yesterday, “Keep in mind, however, if our models shift—so will we. I’m not Pollyanna or Goldilocks, but I’m not Chicken Little, either, claiming the sky is falling.”
For us to become more constructive, we’ll need to see broader participation on the upside. We haven’t seen it yet. But what you don’t want to do is sell and never buy again. Successful investors must have a process and discipline that allows for both sides of a trade: the unemotional sell and the unemotional buy.
Please see Art Huprich’s latest “Technical Analysis Webinar” (on our website www.DayHagan.com) for more detail on support levels and indicators to watch for breadth thrust confirmations. Also, for more on the macro environment, you might enjoy our latest “Market Update Webinar” from last week—also accessible on our website. The Slides are available for both and may be downloaded from the company website.
Donald L. Hagan, CFA
Day Hagan Asset Management
PDF Copy of Article: Day Hagan Research Update December 21, 2018 (pdf)
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