February 11, 2019
We believe it is now confirmed that the business cycle is definitely slowing down, more seriously in Europe than in the US. This has been our view since early 2018. Now that everyone is on the same page regarding the slowdown, let’s focus on the next critical question for markets: whether or not economies in Europe and the US will only experience a temporary slowdown or a more serious recession.
Europe seems to be in a recession already, while the European Central Bank (ECB) seems to have serious limitations in terms of conventional monetary policy to rekindle the economy. Although the US scenario is very different and for now, better than our European counterparts, the fate of the US economy lingers in the hands of the Federal Reserve (FED).
We understand why the FED ought to increase rates and there is no argument against it. They must bring rates to a reasonable higher level to be able to use monetary policy when economic growth slows down too much and prevent the economy from going into a recession. We do not want the FED to be in the same position the ECB is now, facing a recession with negative rates. But in order to get the job done, we do not want the FED to drive the US economy into recession either. We are at an extremely important crossroads because a recession may bring a deep and perhaps even lengthy bear market, while a slowdown usually brings less severe and shallower stock market declines. Needless to say, the recovery of financial markets and investment portfolios in one scenario is very different than the other. Food for thought: The next presidential election is approaching fast. Should we be concerned about political bias in the FED? Although the FED should be apolitical, we have seen some political action before (**cough, cough** Janet Yellen).
As we accurately estimated on January 7th, the battlefield between “Bulls & Bears” is taking place between S&P500 levels 2600 to 2750. From a risk management and capital preservation perspective, we always estimate the worst possible outcome without dismissing the best scenario either.
Below are some of the macro moves that caught our attention last week:
- Volatility, although at the low end of the range, remains at support levels refusing to once and forever break down.
- Volume has been dropping on Up days and increasing on Down days. We would like to see the opposite: higher on Up days, lower on Down days.
- S&P500 Index and Nasdaq Composite both failed to break above their 200-Day Simple Moving Average (200-D SMA), a widely followed level of resistance which should be broken and held in bull markets. Furthermore, only the defensive sectors of the economy such as consumer staples, utilities, healthcare and real estate (a bond proxy, more on this later) were able to move back above their 200-D SMA and remain there. This is not healthy leadership in a bull market.
- Gold and US Dollar (USD), both strong and moving in the same direction from time to time without giving up any significant ground. This is important because gold thrives in low yield economic environments, but usually moves in the opposite direction of USD. With negative yields in Europe and no clear Brexit strategy, the USD remains strong, still in an uptrend in our view, along with gold. The question here is why do gold and USD seem to be moving in the same direction? Safe havens, perhaps…
- US Treasury Yield (TSY). In healthy growing economies bond prices tend to move down and yields move higher, together with the S&P500. We find it interesting that while the S&P500 lost about -19.8% from its peak in September to its December low, similarly the 10 year TSY dropped about -21.1% from its high in November to its January low. The S&P500 recovered about +16.5% and lost about -1.1% to Friday’s close, while the TSY recovered only +9.5% and lost -5.9% to its Friday closing. There is a clear divergence in the behavior of these two indexes. While the S&P500 refuses to move down, the TSY is pointing at a lower growth economic environment. One index is right and the other is wrong. Which one is it?
You may ask why we focus on finding weak spots in financial markets and the economy to suggest a possible move down in stocks. Very simply said, because our proprietary process, which allowed us to avoid every significant pullback and bear market since the internet bubble, refuses to give us the green light to take on risk. It is subject to change at any time but for now, it indicates we should stay long TSY bonds, bond proxies and cash.
You may click here to access more information about our analytical quantitative and qualitative process: “The Roots of Our Process,” which allowed us to avoid the internet bubble, subprime crisis, a brief bear market in 2011, correction in 2015 -2016 and the current correction/bear market.
