MR. CEMBALEST: Good morning.  I'm recording this podcast from Berlin, where I'm attending around international council meetings.  I wanted to share some thoughts on what's been going on with the equity markets globally over the last month or so.  


In our Labor Day Eye on the Market, I outlined a few things that I thought would contribute to P/E Multiple's falling.  Rising fed policy rates, the end of Central Bank intervention, rising import tariffs, slowing growth outside of the U.S., rising budget deficits.  And we also showed how the elevated level of market concentration was concentrated in a handful of tech stocks. What I might have underestimated was how much multiples would contract and how the forces I just ticked off would offset the benefit of continued U.S. earnings growth and stock buy-backs.  And, this is just a brief podcast.


There're two things I want to highlight that you can see in today's Eye on the Market.  First is, how do business cycles end?  And, this is a really critical question.  Most people that are still very optimistic on the business cycle are pointing to earnings growth, but that begs the question, how reliable is earnings growth as an indicator that the cycle has legs? 


During the last two business cycles, earnings--corporate earnings--economic growth in equity markets all rose and then at the end of the cycle, declined at the same time.  But in the prior five business cycles, before the last two, equities peaked around a year before economic growth started slowing, and a year before earnings started to materially weaken.  And so that's why, it's important to understand that rising earnings and rising economic growth are not necessarily reliable predictors--that the cycle still has legs.


There were five cycles in a row from the sixties to the eighties where markets peaked before you started to see weakness, either in profits or in economic growth.  Adding to the level of risks for the market at this stage, there's--and this is the second topic in this week's note--we have the Lord of the Flies aspect of Central Bank withdrawal.        


We're going to go through this more in the 2019 Outlook, but I can summarize it like this.  For the last twenty years, investors like us have benefitted from behind the scenes intervention by Central Banks around the world, whether that was developed world Central Banks engaging in quantitative easing and the purchase of 14 trillion dollars' worth of long-duration security since 2009, or emerging economy Central Banks, that were purchasing developed world financial assets as part of their FX reserve management.  This sounds pretty arcane, but for the last twenty years, the markets have rarely gone--had to survive without the benefit of Central Bank intervention. 


For a variety of reasons, next year looks like a Lord of the Flies moment, where the markets are going to be left on their own.  The first extended period for the next couple of years, when the Central Banks will not be intervening aggressively, not in the United States and not in the emerging world.  So, that's another factor as we start to think about where to go from here.  In July, I gave an interview to Barron's that talked about all of these risks and why I thought it was the right thing to start playing more defense in portfolios. 


Now, after the correction we've just had, let's be clear, you know, sometimes the cure for over-expensive assets is a correction.  P/E multiples have fallen from around 17 to 15 ½.  They're  still a little bit on the high side versus history, but not as high as they were.  And, I do expect equity markets to bounce back a little bit here as they did after the ten percent decline in, you know, in February of this year. 


All that said, based on concerns about Central Bank withdrawal and all the other risks we've talked about related to rising budget deficits and rising interest rates and issues around what's going on in Europe, the reflexive buy the dip mentality, which has worked so well since 2009-- there have been about 16 corrections, and buying the dip has been the right call each time. 


I think that reflexive buy the dip mentality is a lot less compelling right now.  So, take a look at this week's note and again, I think after the last few years, this has been one of the most spectacular runs in the history of the U.S. equity markets.  We've had a 14 percent compound return over the last decade.  That's only happened a few times since 1940.  It's been a great run, and all things argued to me, that it's time to--as we said earlier this year--play a little bit more defense in portfolios. 


We will communicate with you again right after the mid-term elections, as we take stock of the results.  Thanks very much.

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Click above to hear J.P. Morgan Eye on the Market's "How business cycles end: implications for investors" podcast episode and subscribe via Apple Podcasts or Google Play.

In our Labor Day Eye on the Market, I concluded that rising Fed policy rates, the end of central bank intervention (see accompanying chart), U.S. import tariffs,1 slowing growth outside the United States (particularly in Europe2), rising U.S. budget deficits and elevated levels of market concentration in a handful of tech stocks would cause equity P/E multiples to contract. What I might have underestimated was by how much they would contract, and how these forces would offset continued U.S. earnings growth and stock buybacks.3

Part of the investment discipline at the end of business cycles is to understand what such periods look like. One critical question is this: How much lead time do investors have before asset prices peak? When the last two business cycles ended, corporate earnings, economic growth and equity markets all collapsed at roughly the same time.4 As a result, if earnings growth looked good, the cycle still had legs. But in the five business cycles before the last two, equities peaked around a year before economic growth slowed, and before earnings started to materially weaken. If so, what we are now witnessing could be the final stages of what has been one of the best-performing U.S. equity markets since the Great Depression in the 1930s.5

The table shows the difference between equity returns and economic growth in the 12 months following an equity market peak in seven market cycles.
An added risk for markets: the Lord of the Flies aspect of central bank withdrawal. In 2019/2020, for the first time in almost 20 years, financial markets will probably be left on their own, without the benefit of intervention from either developed economy or emerging economy central banks.6

This line chart shows the yearly value of G4 assets purchased by developed and emerging market central banks as a percentage of world GDP, 1975–2017.

In July of this year, I gave an interview to Barron’s, which cited the risks mentioned above as reasons to start playing more defense in portfolios.7 To be clear, the 9.5% S&P 500 correction since August 2018 has taken some of the steam out of extended U.S. equity valuations, which have fallen from 17x to 15.5x 2019 earnings estimates.8 I also expect U.S. equity markets to rebound a bit after such a steep decline, as they did after the 10% selloff last February. Nevertheless, a reflexive “buy the dip” mentality, which worked so well during the 16 corrections of 6% or more since 2009, appears less compelling right now.