The Market: September 2018

Investors came back from summer vacation and after a shaky start to September, rallied the market to new highs. The buying has occurred despite serious concerns over US trade policy with Mexico and Canada and a series of tariffs imposed on and retaliated by China. Bull markets are said to “climb walls of worry” and as such, stock prices have moved higher. Whether the market will begin to care about tariffs and trade remains to be seen. History seems to tell us that trade barriers are harmful to economic growth. The stock market is trading at 17 times earnings so there is definitely an expectation of growth. Should impediments to trade dampen growth, stock prices would be vulnerable. In addition to trade, the market seems to have ignored the rise of interest rates this month. The 10-year Treasury yield is back above 3%. Recently, the market has had “tantrums” when the 10-year has moved above this level. So far this time, there is little mention of the 10-year in the financial news. The market news, however, has continued to report on the Federal Reserve increasing the very short-term rates. The Fed Open Market Committee meets this coming week and the expectation is that another 25 basis point hike is in the cards. So far, the longer-end of the yield curve has not responded to increases on the shorter part of the curve. This has led to a flat-ish term structure of interest rates. A flat curve is a disincentive to banks to lend. Something to watch. Will tariffs, higher short-term rates, and a flat yield curve slow profit growth and create the disappointment that hurts a high P/E market? Remains to be seen. I suspect the Federal Reserve is aware that they can’t push too hard. If the Fed announces they will hold off after this week or after the December meeting, the market will likely take that as very good news. At present, this is the not the likely case. It is not the consensus view. Returning to stocks, bull markets can have explosive moves to the upside. However, there is a precedent that these moves lead to significant declines. I ran a simple regression of the S&P500 with a two standard deviation band going back to 1982, the beginning of the series of modern bull and bear markets. As a general rule, a two standard deviation move above a long-term average is a starting point for bubble territory. In my simple study, 3,300 on the S&P500 marks this area. That’s about 13% from current levels. I’m not saying that the bull market is about to end. Bull markets can go much further. There is no magic formula. What is important is that investors increase their caution. It’s easy to get sucked into the assets that are rocketing in the later innings of a bull market. Cannabis stocks are flying. We’ve seen Bitcoin run up and down. Private companies like WeWork are raising capital at big valuations. This is not a time for investors to lose their heads. Discipline is always an important quality to have, especially now. — Ian Green, Pendragon Capital Management