2018 September Market Outlook
The economy and markets are in good shape – for now. I watch the cable financial news channels (CNBC, Fox Business & Bloomberg) during the day and most of the guests (portfolio managers, analysts) are bullish, and they site the economy and markets for their bullishness. These investors, analysts may be too optimistic, so in this report I will highlight some contrarian views. Admittedly, it’s very difficult to predict the future, and nobody really knows what’s going to happen with our trade wars, conflicts with Iran, Russia and North Korea, the elections, the Mueller investigation. The market seems to not be factoring in the potential downside of these concerns and some of the bearish trends listed in the Bearish Case section below.
As usual I provide the bullish and bearish case for the markets, price targets, and a price/technical analysis.
- The economy achieved slightly better than 4% growth in the 2nd quarter thanks to tax cuts, deregulation and strong consumer and business confidence
- The economy continues to create more jobs
- Many participants in the markets remain bullish
- Earnings are very strong this year thanks to tax cuts and a growing economy
- Tax cuts are also increasing stock buybacks, mergers and acquisitions, and dividends. All three could help stock stability and support.
- Another support for the market are monthly contributions by workers to their 401ks. I wrote about this last year. Below is an excerpt from my November 2017 Market Outlook
- Last year I also wrote about the market phenomenon of new highs. When new highs are made, resistance/sellers are taken out and it will be easy to make new highs. Many markets are making new highs so we may see more new highs for the markets. See the Technical Analysis section below.
- The markets could get another boost if there are positive results from the current negotiations with NAFTA, China, North Korea, Russia, Iran and the EU. There have been news that some of the disputes with our trading partners negotiations stalled, but have been put back on track. No substantial trade agreements have been made and markets have over reacted on the upside regarding the trade news. The President has a habit of exaggerating his administrations accomplishments. Headline news is more important than the details.
- The last few months participants in the markets are not big sellers and are buyers on pullbacks
- Currently, participants tend to ignore bad news and rally on good news. This is very unusual this late in the cycle.
- Investors and business people believe we can win the trade wars and if the Republicans lose the house not that much will change as most of the Trump economic agenda has been accomplished.
- Most economists agree that the current trend of the economy is not sustainable. The biggest reason is the tax cuts mostly benefited corporations and shareholders and the multiplier effect for the rest of the economy is weak. I’ve written about this for some time.
- We have imposed tariffs against Canada, Mexico, China, and the EU. These countries have imposed tariffs against us. We also have sanctions against Russia, Iran, and North Korea. These fights with allies and foes could lead to a global recession.
- Global growth seems to be stalling. A hard Brexit (the British exit the EU) could contribute to slower global growth.
- Stocks and markets are expensive again. See Market Price Targets section below.
- Providing tax cuts this late in the cycle is risky, especially when we have large deficits, debts. Also, about 10,000 baby boomers turn 65 every day and many are applying for Social Security and Medicare. This is one of the main reasons why many economists and analysts are not bullish long-term. This year, the deficits may approach $1 trillion, much sooner than economists expected. The huge financing needs of the U.S. could push interest rates higher to attract investors.
- We are shifting from stimulative monetary policy (ultra-low rates, and the Fed using its balance sheet to buy long-term bonds to lower long-term rates) to stimulative fiscal policies (tax cuts, government and military spending, trade policies). This transition has risks, especially if interest rates rise to fast, or not fast enough. As mentioned in the first bearish bullet point tariffs could lead to a global recession.
- We are seeing many red flags and signs we are in the late stages of this economic and market cycle:
- Rising oil prices, inflation and interest rates
- Full employment and rising wages, both are good things but are creating inflationary pressures
- Markets again are overvalued
- Narrow market leadership and market rotation (leadership often changes)
- The market is developing a major reversal topping pattern (see technical section below)
- Signs of asset bubbles: FANG (Facebook, Amazon, Netflix, Google) stocks, bitcoin and pot stocks.
- The dollar is stronger this year and it could be a headwind making our goods and services in foreign markets more expensive. Also, when the foreign sales are converted to a stronger dollar this will probably lead to currency losses that could lead to lower profits. This is not reflected in analysts’ earnings and market price targets.
- The markets seem to be overlooking the Mueller investigations and the potential for more negative headlines. There have been 5 guilty pleas and two have already been sentenced. All five have agreed to be witnesses for the government and potentially against President Trump.
- There is a good probability that the Democrats could win the House in the November elections. This will make it difficult for President Trump to achieve the rest of his economic agenda. There could also lead to impeachment depending on the Mueller investigation’s final report. Charges could include obstruction of justice, money laundering, tax evasion, campaign finance violations, lying, and conspiracy against the U.S.
- We have not had a bear market for about ten years. I’ve been through many bear markets and they are painful emotionally and financially; investors forget this. The last three bear markets I’ve been better at getting out or hedging when stocks are expensive and buying aggressively when stocks are cheap.
- Black and grey events (low probability, but high impact) are always a risk
- The markets are normally forward looking, but not today where the current positive trends carry more weight. The market seems to suggest that a year from now the trade wars will be won by the U.S., Republicans will keep the House and Senate, the Mueller report will not reveal any criminal violations, oil, interest rates and inflation rises will reverse, the deficits aren’t a concern, global growth will come back, North Korea, Iran and other geopolitical tensions will get better. If the markets are wrong on some of these issues, the market could adjust downward and we could see P/Es contract.
One of the problems for investors late in a cycle is analysts and economist have a lousy track record of calling turning points (bullish to bearish and vice versa). Below are optimistic earnings forecast for 2008, 2009, the beginning of the last bear market and the start of the Great Recession.
Source, Barron’s, Dan Hassey database
In mid-2008, the earnings forecast for the Dow 30 was 877.28. Earnings forecasts were wrong and continually dropped and bottomed about one year later to 353.86. Actual earnings for 2008 dropped to 256.55. Analysts were way off. The markets were down over 50% for both 2008, 2009. You would see this at the end of every market cycle, 2001, 1991, 1981….
The forecasts for 2009 were 1044, the actual earnings for 2009 were 558.83. The point, analysts can be dramatically wrong, especially late in a cycle.
Below are the price forecasts for the markets:
Source: Barron’s, Dan Hassey database
The markets are currently overvalued. For 2019 the Dow is about fairly valued, but the S & P is overvalued. Remember earnings forecasts at the end of a market cycle could be dramatically off. This is why a lower multiple should be used. Also, because tax cuts are not organic to earnings growth, a higher multiple should not be used for non-operating earnings/windfalls.
Technology stocks were the favorites of investors for the last few years. Below is a chart of the QQQs (NASDAQ 100) that is heavily weighted towards technology stocks.
Most stocks and indexes were stuck in a trading range from 2014 to 2016. Since the breakout to new highs at the start of 2017, the QQQs are up about 56%; a big move.
There were a few consolidations (consolidations in rectangles) that are normal in a big move. Most consolidations are a pause in a trend. Notice that each move is less than the previous percentage move; this is normal.
If we drill down to specifics for example, Apple’s earnings essentially did not grow from 2015 to 2017 (their fiscal year starts in October). Earnings are expected to be up about 28% for 2018, but the stock is up about 70% since 2017. The stock appreciation is gone far more than earnings growth. Stock buybacks and Warren Buffet buying the stock has fueled the performance of Apple stock, not fundamentals. Buybacks are helping the markets.
The Dow 30 does not have heavy exposure to technology so it did not do as well as the QQQs.
Again, the QQQs are up about 56% since the breakout in 2017. The Dow 30 is up about 44% since the breakout.
2017 earnings were up about 12% in 2017, but the market was up about 38% in 2017. The market was up too much in 2017 so the market had to digest the strong move this year. Also stalling the markets are trade wars, rising inflation, interest rates and oil prices, geopolitical concerns, negative headlines… Earnings will probably be up about 25% for this year, and the markets are up about 9%. The markets are expensive according to many valuation metrics including: P/Es, earnings yield, dividend yield, market cap to GDP.
Most of this year trade war news was met with selling in the markets. This has changed recently; some investors and analysts believe that the Trump administration could win the trade war with China. We can see the difference in Dow 30 stocks like Boeing, symbol BA, in the chart below:
Last week’s trade announcements did not cause the markets to fall including BA, instead they rallied (circled area). Most indexes made new highs. BA almost made new highs. It now has strong resistance at the $370 area. Boeing is overvalued.
BA sales to China were about $11 billion for 2017, BA’s third largest customer last year. Recently the Trump administration announced that the U.S. would impose a 10% tariff of $200 billion on Chinese exports to start September 24. The Chinese immediately announced they would impose $60 billion on U.S. exports. Because the Chinese export a lot more than the U.S. the President believes the U.S. has the upper hand, in other words the Chinese needs the U.S. markets more than the U.S. needs China. Here are a few quotes regarding who has the upper hand:
The comment below is from the Wall Street Journal reader, it does represent the views of some investors and analysts:
“200 billion to 60 billion. The numbers speak for themselves. The only question is how much does communist China hurt their own people before they quit playing a game of chicken they can't win?”
Below is a comment from Chinese billionaire Jack Ma:
“This week, China’s richest man, Jack Ma, warned investors that the trade war is “going to be a mess,” predicting that it wouldn’t last 20 days or 20 months, but “maybe 20 years.”
So who is right? The outcome is probably somewhere in the middle. This means that the markets got ahead of themselves last week when they made new highs. I will analyze tariffs and trade wars in my next Quarterly Economic Update.
The market could continue to make new highs IF the Republicans keep the House and Senate, real progress is made with trade negotiations with NAFTA, the EU, and China, or if new agreements could be made with the Iranians, North Korea, and Russia. Also if the markets start to anticipate continued growth in the economy and markets. The markets seems to be want to go higher.
If the Democrats win the Congress/Senate and there is no progress with the many negotiations this administration is pursuing, the economy and markets could struggle in 2019. The markets are in a topping phase and are a normal sign of a market in its late stage of a market cycle.
Toward the end of a market cycle you will normally see asset bubbles, too much risk taking. We see this with both bitcoin and marijuana stocks, and FANG stocks.
Below is a chart of pot stock Tilray (symbol TLRY), the first U.S pot IPO:
The IPO was priced at $17 in July and quickly shot up. The high for the stock was $300 just a few days ago and has fallen to about $90. It is expected to fall more.
Bitcoin is another bubble that has popped:
Bitcoin was stuck in a trading range for several years, but late last year prices took off and peaked close to $20,000. The stock is now around $6,400, about a 68% decline.
Summary and Conclusion
- The economy continues to grow, and the markets are bullish
- Here is a contrarian view. The markets are not factoring in the many bearish trends that exist: rising inflation, interest rates and oil prices; rising trade tensions among allies and foes; geopolitical concerns; a slowing global economy and a hard Brexit could make it worse; midterm elections; Mueller’s investigation and report. If the market’s bullishness is wrong, the market will correct downward.
- The markets are expensive again
- We are seeing many signs of the late stages of an economic cycle: full employment, rising risk taking, rising rates and oil prices, the length of this economic and market cycle is way above the average cycle, narrow leadership and rotation in the markets, most indexes are developing major reversal topping patterns.
- One of the important lessons you learn about the markets is that the markets are inefficient in the short-run, but tend to get things right in the long-run. In other words stocks can get overvalued and undervalued in the short-run but overtime they tend to gravitate towards fair value. I always focus on stocks that get beat up by the market and fall to undervalued. Focusing on the beat up, undervalued stocks is my recommendation in this and all markets. Admittedly bargains are abundant in a bear market and are fewer at the top of a mature market.