If you feel like the Stock Market has been a roller coaster, you’re not alone. You’re also correct. 2019 has brought a pattern of basically two months up, followed by a month of sharp declines. That speaks to the adage that the Stock Market takes the escalator up and the elevator down. The declines came in March, May and August. Hopes for a September stock rebound have been realized so far with fresh monetary stimulus from the European Central Bank on Thursday and the expectations for another rate cut from the Federal Reserve next week. Growth has been slowing all year. It’s been much more pronounced overseas, but America is still experiencing the slowdown. The real question is whether this is a temporary phase like 2015-16, or is this decade long expansionary cycle coming to an end. Unfortunately, none of us will know until after the fact. Central banks aren’t waiting. The aid is coming.
Central banks around the globe continue to take rates lower and provide substantial stimulus. The approach has not resulted in their desired outcome however. They are unpleasantly surprised and noticeably perplexed. Inflation is benign and growth is slowing. Modern monetary policy tactics have taken interest rates into the negative. There is now $17 Trillion in negative-yielding debt around the globe. It is outside the US. Some think rates should go negative in America. It is anything but normal. The problem is, there are unintended consequences with low and negative rates over an extended period of time. The system needs to run its course in a natural way. The system has been artificially propped up, which has benefitted asset prices like stocks, bonds and housing. The US has been the prime beneficiary of this move. Demand for American assets is strong and has bid up these assets to very lofty prices.
A big concern of ours is the fact that central banks won’t have the firepower to address a crisis, should one develop. They’re already using it up. It’s a serious issue which is being masked with the current Stock Market rally. The Bond Market has been telling a much different story with declining rates. It reversed quite a bit this week as interest rates jumped higher, nearly as fast as they fell in August. Is it telling a different story now and if so, is the Fed listening? The Stock Market wants the Fed cuts and likes lower rates because it makes risk assets more attractive. The cost of capital is lower, which means more borrowing power and more investment. But lower rates usually go hand in hand with an economic slowdown and traditionally central banks cut them to stimulate growth and help exit a recession. Central banks rarely do things in advance, they’re always reactive. Besides, there are more signs that the US Economy is on firmer footing, with a strong retail sales report for August. The American Consumer accounts for nearly 70% of economic output. Should the Federal Reserve really be lowering interest rates while the US Economy is growing and the Stock Market is at all-time highs? It’s quite controversial and being debated with heat. The Market is no longer pricing in a 100% certainty for a rate cut by the Fed next week. There is now a 79% probability of a ¼ point cut, down from 100% a month ago. President Trump continues to hammer the Fed on the need for more rate cuts, this week referring to them as “Boneheads.” American Presidents have long criticized the Fed, but I’m pretty sure the use of that descriptive term was a first in public.
The DOW is up eight consecutive days. That had not yet happened in 2019. And 2019 has been a strong year. Things have changed in September. There has been a significant shift in leadership of late. Value stocks, left for dead in some cases, have exploded higher the last two weeks, while Growth stocks have slipped. This week saw the biggest divergence from Growth to Value since 2013. Growth has dominated this Bull Market, and Tech has been the undisputed leader here. The statistically insignificant DOW is more exposed to more mature value stocks. The DOW has been a laggard all year, but has taken a leadership role to end the Summer. After major sell-offs in May and August, both the DOW and S&P are within 1% of their all-time highs reached in July. The Tech-heavy NASDAQ is over 2% from its all-time highs. Being defensively positioned, for all the right reasons in our work, has been very difficult and very frustrating this year. We felt very good about it in May and August. Keep in mind, the S&P was at the same level in August that it was in January of 2018. There’s been very little progress, just a lot of rotation with steep dips and big pops. We are surprised at the price action in September, although it has benefitted many of our value investments. Volatility has been a key theme in 2019. The Volatility Index, otherwise known as the VIX, is lower, back below 14. The last time it saw this level, the August sell-off ensued as did the May decline prior. Fear is abating. Complacency is setting back in. These are contrarian indicators. We’ve seen this set-up before.
Every Fed meeting is significant. Next week’s meeting will definitely set the tone for the rest of the year. If the Fed cuts interest rates by ¼ point and indicates that might be it, a Stock Market sell-off would be very likely. And even though a cut is being priced in and highly probable, it is no longer 100% certain. A no-cut would be a surprise the Stock Market won’t like. If a trade deal is near, something we don’t believe, and the Fed cited the Trade War as a reason for accommodation, could it pause for more evidence since there is no perceived immediate crisis? We clearly don’t know that. I’m not sure if the Fed even knows what it’s going to do right now.
What we do know is September is historically a challenging month for investors, the worst on the calendar for decades. It marked a top last year followed by a massive decline to end the year. We don’t necessarily think a repeat is coming, but we wouldn’t be shocked if it did. At best, the Stock Market is near-term overbought. This could also be a longer-term topping process. We are sticking to our discipline and remain cautious as the facts have not changed. If or when they do, we will change our approach quite quickly.
Have a nice weekend. We’ll be back, dark and early on Monday.