Given what’s been going on, I wanted to give you a sense for what markets are now pricing in.  We will get into greater detail in the 2019 Outlook which comes out next Tuesday, January 1st.  A brief synopsis of the selloff catalysts as I see it, in three parts:

  • The Fed left rates too low for too long, creating a large build-up of risky investments that investors didn’t intend on holding for the long term, but did as long as rates were zero.  The ECB went even further, buying sovereign and corporate bonds faster than they have been issued.  By the end of 2016, investor allocations to cash fell to their lowest levels on record, and equity valuations reached the 90th percentile of expensiveness vs. history, all of which we have documented before.  The inevitable rise in rates was always going to trigger a reallocation back into cash and weakness in housing, but given the unprecedented magnitude of the monetary experiment, it was impossible to know how, exactly, it would play out.  To be clear, I do not think the Fed is making a mistake, given normal levels of consumer price inflation, rising wages and shrinking excess capacity; equity markets are not in the mandate of the Federal Reserve.  And if there’s blame to go around, prior Fed chairs own plenty of it.
  • Slowdowns are occurring in China and Europe, where earnings revisions are falling sharply.  Last year’s Eurozone flirtation with 3% GDP growth was a mirage.  Despite 2.6 trillion Euros of ECB intervention, European equity markets are back down to 2014 levels.  2018 may be remembered as the year when the ECB was no longer able to offset the economic shackles of the Euro on France and Italy, which are headed back to 1% growth.
  • Unlike 2017, President Trump is now channelling the market-unfriendly policies of Andrew Jackson, Hoover, JFK, Nixon, Reagan and Bush, which we will explain further in the Outlook.   Given the status of the US$ as the world’s reserve currency, reports that the President inquired about firing the Central Bank Chairman is a disturbing sign for markets.  Erdogan (Turkey) and Kirchner (Argentina) are examples of autocrats that have done it.  P/E multiples in these countries are in single digits, since they are not trusted by investors.  I sympathize with FedEx CEO Fred Smith, who said this when cutting profit forecasts and international delivery capacity for 2019: “I’ll just conclude by saying most of the issues that we are dealing with today are induced by bad political choices.”

Observations on the bear market: pessimism is now priced in

  • For the first time in many years, markets are now pricing in pessimism instead of optimism.  The first table below shows how valuations for stocks and corporate bonds are below median, in stark contrast to where they stood a few months ago.  P/E ratios are a moving target as earnings growth weakens, but investors are finally being paid to take risk around current levels, as long they have a long time horizon.
  • More downside risk is possible given the rise of algorithmic trading to 70% (equities) and 40%-50% (options and futures) of total volume, and given the decline in fixed income liquidity and prop trading resulting from the Volcker rule.  Even so, what are guardrails against the 30%-50% equity market collapses seen in the 1970s and 2000s?  The improved capitalization/liquidity of the US banking system; the decline in global current account balances; and a world that is slowing, rather than heading into recession.
  • Since the 1920s, there have been twenty episodes of P/E multiple contractions of 20% or more.  In fifteen of twenty episodes, US equity market returns were positive over the next 12 months, averaging 12%.  A temporary rebound could be sparked by short-covering after a December surge in S&P short interest, one that also took place at a time of very thin year-end markets.
  • FAANG valuations have collapsed, and both tech stocks and banks trade at one of the smallest premiums to the market in history.  Metals/mining stocks and EM equities are understandably depressed given the secular and cyclical slowdown in China, but current levels are also pricing in high probabilities of a global recession in 2019 and a bad ending to the US-China trade war.  A lot is riding on whether a deal is struck with China, or whether the trade war heats up with Section 232 tariffs on $270 billion of US imports of European and Japanese autos/parts next year.  This is the most important binary issue facing markets in 2019, and it is unclear how an increasingly isolated Presidency will address it.
  • See supporting charts and tables below.

More to come on New Year’s Day in the 2019 Outlook.

Line chart showing that global economies are still expanding according to business surveys, but fewer countries are above trend.

Line chart showing the number of positive revisions less negative revisions as a percentage of total companies for the S&P 500, Europe, and China Offshore from 2010 through 2018.

Line chart showing the percentage of drawdowns, year by year from 1969 through 2017.

Bar chart displaying twelve-month S&P returns following a year in which P/E ratios declined by more than 20%.

Table comparing forward price-to-earnings ratios at 2018’s peak to current. The table also shows high-yield and high-grade spreads at 2018’s market peak to current.

Two-line chart showing yearly percentage changes in wages and inflation from 2007 through 2018.

This two-line chart notes similarities between the level of short interest in the S&P prior to the 2016 correction, and the level of short interest in the S&P observed between June and November of 2018.

Line chart showing the decline in cash holdings by households, non-U.S. investors and pension funds between 1980 and 2016.

Line chart showing the average forward P/E of FAANG stocks relative to the S&P 500 from June, 2012 through June, 2018.

Bar chart showing technology stocks’ P/E ratios relative to those of the S&P at the peaks of selected past market cycles and projected forward to 2020.

Bar chart showing bank stocks’ P/E ratios relative to those of the S&P at the peaks of selected past market cycles.

Line chart showing rise and fall in the price-to-sales ratio of the metal/mining sector relative to the market overall, from 1952 to 2017.

Line chart showing the rise in the absolute value of all country current account surpluses and deficits as a percentage of world GDP, 1980–2017.

Line chart showing the change in the U.S. tariff rate on total imports, 1910–2017.

This table compares the capital ratios, liquidity and loan-to-deposit ratios of U.S. and European financial institutions in 2007 and today, to show that systemic risks are significantly lower now than they were then.

Bar chart showing changes in market size and turnover, 2006–2017, for mortgages, municipal bonds, high yield bonds, investment grade bonds, and U.S. treasuries.