Will the bull market continue in 2019? The market extended the bull market for one more year in 2018 (although as I write this post, the market is melting down by 800 points!), but it was a much more volatile performance than we had been accustomed to. So, where is the market headed in 2019? If we had a crystal ball and could see where the market would end up in a year, we could make a fortune. Since we can’t do that, we can do the next best thing, and spell out the risks to the market that could possibly bring the bull market to a halt. Tracking these macro events can provide some foresight, and help the individual investor cope with volatility and risk that we have seen enter the market in the second half of 2018.
The U.S. is currently in the midst of one of the longest running bull markets (since 2009) and there are fears that the market may have gotten exhausted. Compounding the exhaustion, a slowing economy, rising interest rates, and fighting trade wars all may contribute to slowing down the market. Bottom line: the easy days of a slow and steady increasing market appear to be in the past. On the other hand, corporate earnings growth was robust in 2018, and the market did NOT reward that growth . . . rather, the P/E ratio shrank. So, that is potential upside if companies continue to growth their earnings and the P/E ration grows.
Below are my big concerns for next year.
The Fed will likely increase the Fed Funds rate one more time in December. These Fed increases are beginning to really impact the interest rates that companies and individuals are paying in the U.S. This has already had a dampening effect on housing where mortgage rates are now over 5% rather than the previous 3.5%. Corporations also are beginning to rethink issuing corporate bonds or bank loans as costs have increased for these as well.
More disturbing is the lag effect. Most economists will tell you that the real impact of a Fed increase (or decrease) takes 10 months to work its way through the economic system. So, the last three increases have yet to take full effect, and more harm to the economy could be the result. As we enter 2019, there will be significant headwinds from these increases holding back economic growth.
Another impact of higher rates is that fixed income investments can now compete with equity investments as a viable alternative. Back when a CD was offering investors 1% return, there was no competition for stocks. It made more sense to invest in equities. Now whether government bonds or CD’s, investors can park there money in virtual risk free investments and earn over 3% returns. With money flowing into these investments, it will reduce demand for equities (and with the basic laws of supply and demand) and should reduce stock prices.
Finally, there is the dreaded inverted yield curve, which has become the favored harbinger of both recession and bear markets. A yield curve becomes inverted when yields on long term government bonds fall below the yields of shorter term instruments. Usually investors demand higher yields for longer term bonds, but in the rare times that the yield curve has inverted, the economy has usually gone into recession and the markets have gone into a bear shortly afterwards.
This brings us to the economy. Similar to the stock market, the U.S. economy has gone over nine years without a recession. This expansion is also one of the longest in history. While it has been long, it has not been marked by overheated excessive growth. Rather, it has been slowly and steadily climbing at 2-3% growth during this time. This lack of explosive growth has enabled the expansion to continue for as long as it has. Now, however, there are new challenges. Can we continue this bull market in 2019?
As discussed in the previous section, interest rates have risen this year. As the Fed has tightened, segments of the economy that rely on borrowing have experienced harder times. Housing Starts has taken a hit, auto sales have slowed and these are often the drivers of economic performance.
Last year, the U.S. economy got a boost from the fiscal stimulus of the Trump tax plan. But this year will most likely not see the same type of stimulus and the net effect of the tax plan will have dwindled this year. So, really, from both a fiscal and a monetary standpoint, there is no stimulus in the pipeline to boost economic performance.
Additional storm clouds come in the form of a global slowdown. China, Europe and Developing countries have also seen their economies slow. As our closest export and import partners stagnate that has taken away another engine of growth.
But as you can see from the Leading Index (below chart), the economy has not thrown in the towel quite yet. There are so many negatives though, this should be a major factor to watch early next year to see if the we can continue the bull market in 2019.
Starting in the past year, the U.S. has embarked on re-calibrating our trade with foreign countries. The current method employed by our government is to threaten tariffs, and if we don’t get progress, actually slap tariffs on a range of goods.
Tariffs have a way of backfiring and randomly striking companies and industries that you least expect. Companies can be adversely affected a number of ways that are not necessarily apparent. For example, when we tariffed steel, that had very negative ramifications for the Auto industry which consumed that steel. The higher input costs resulting from the tariffs led to much higher production costs which ultimately led to GM’s announcement that several auto plants will be closing down.
Additionally, the most immediate impact of tariffs is that the other countries retaliate and slow down our exports. Companies like Caterpillar, Archer Daniels Midland, and Boeing have all been impacted by the recent round of tariffs, as the Chinese slap retaliatory tariffs on these industries. Unfortunately, there is nothing they can do in the short term, and they just watch international revenues dry up.
The best scenario is that the trade wars are resolved with better and more fair trade agreements. The worst case, however, is something that we should be monitoring. And right now, this could be the most likely market killer.
If you have followed Chaikin Analytics, you know that we have examined market volatility during major political events like assassination, World Trade Center, and other major events. Our belief is that the market tends to shudder for a few days, but then it bounces back.
This could be a little different depending on how many times the Russian investigation, Brexit, EU Debt Crisis impact the news cycle. Rather than a single blow that the market can quickly recover from, there seems to be news release after news release. This may lead to more volatility, but even with that, we feel that it won’t have much of an impact on the overall market.
An Earnings Slowdown:
We have had two exceptional years of earnings growth. 2018 should end with over 20% growth in corporate earnings (for the S&P 500). Obviously, this pace is hard to keep up, and analysts have begun to mark down estimates for next year’s earnings. While still good, the pace has throttled back to 7-9% earnings growth. Even the company’s themselves have been foreshadowing a slowdown when the provide forward looking guidance.
How will the market react to this good, but not excellent, earnings trajectory? What has been interesting this year is that a key valuation metric has fallen even during these bullish earnings. The composite Price / Earnings ratio has fallen significantly this year and has dropped from 18% to under 15% on a forward looking basis. The P/E represents the Price that an Investor would pay for a dollars worth of earnings. Usually, in growth times, that P/E ratio increases as investors are willing to pay more because earnings are growing.
So next year is a critical period, how will investors react to the slower earnings? Can companies actually hit these lower estimates? Remember trade wars and higher interest rates can throttle earnings very quickly. If Q1 earnings come in as expected, I think investors will be able to feel comfortable with the earnings outlook. As the composite P/E has been lowered this year, this might even represent possible upside to the market.
Summary: What Could Slow Down The Bull Market in 2019?
I wrote this article last year, and it really had a different feel. Even though I highlighted the risks at the time, I didn’t really feel any were particularly likely. This year feels very different. There are multiple storm clouds surrounding the market and all of them have real potential to create a bear market and real pain for investors. Couple that with increased market volatility, and you can understand why investors are nervous.
It does seem that the first quarter will provide many of the answers to these questions. So buckle up. It may not be the worst idea to purchase some portfolio insurance to help insulate your portfolio from extreme drops.
I look forward to writing this post again next year, when everything has cleared up, and risks again turn marginal.