A Correction, or a Prelude to a Recession?

Jeff Mortimer

While we believe equity markets should remain resilient and are poised to potentially reach new highs, we have decided to be prudent at this juncture.

My father is 86. My son is 19. Both are avid Red Sox fans. And in each of their lifetimes the Red Sox have won four World Series. Who do you think appreciated the first World Series win in 2004 more?

I think most would say that the win meant much more to my father than it did to my son. Certainly, most might assume that suffering through the lean times makes winning that much more special. My son expects the Red Sox to win every year; my father is more levelheaded, knowing that good times rarely last forever.

This analogy brings me to the recent ups and downs of the major U.S. equity indexes. Before the recent market volatility, the Dow Jones industrial average, S&P 500 index and Nasdaq Composite made all-time record highs.

But since then, trade tensions escalated between China and the U.S., the Federal Reserve cut rates for the first time in a decade, and the U.S. Treasury yield curve inverted. These developments have investors wondering whether we have seen the last of new market highs or if this is merely a correction.

Let's take a closer look at the history of market highs to see whether investors should be celebrating, or whether they should be more concerned.

The History of Market Highs

For many investors, the knee-jerk reaction to new market highs is to sell. After all, investing principles have taught us to buy low and sell high. So selling at market highs seems like a good decision, and, in hindsight, that's what some investors may be thinking about July's high. A deeper look into the history of market highs, however, shows us that this advice may be flawed.

This chart shows that after a new high, markets have a history of moving even higher. Two thirds of the time, the market is at least 2% higher six months after a new all-time high; 20% of the time, the market is at least 10% higher.

I have often discussed the role of momentum in asset returns and how markets tend to move in one general direction for long periods of time. We've been seeing this pattern, with a few pauses, over the past 10 years.

Since the first all-time high of this bull market — an index level of 1,569 on March 28, 2013 — the S&P 500 has nearly doubled, reaching daily all-time highs 218 times. An investor who sold on the date of the first all-time high would have missed out on significant growth.

And the recent market action, including a single-day drop of 800 points for the Dow Jones industrial average and subsequent recovery, may be suggesting that this drawdown is only temporary. Volume measures are consistent with a corrective phase either nearing its end, or at least signaling that the worst is behind us. Of course, only time will tell if this drawdown proves to be only a correction or something more sinister, but the market appears to be leaning toward the former.

Mixed Signals

While stocks have shown signs of resilience since the mid-August pullback, the bond market continues to signal that more trouble may lie ahead. Global bond yields have been falling throughout the year, due to slowing global growth and lower inflation expectations.

But recently, the U.S. Treasury yield curve has inverted a few times, with the yield on the two-year bond yielding more than the 10-year Treasury bond — a clear signal to the Fed that policy is too tight for a slowing economy.

An inversion of the yield curve raises worries that a U.S. recession is imminent given that, historically, it is predictive of a recession (occurring two years after the inversion, on average). However, these current inversions have been brief and not as significant as past inversions.

In addition, we have not seen the usual widening of credit spreads that signal a tightening of credit availability and often accompany an economic downturn. We believe these current inversions have been driven mostly by global supply and demand factors rather than a weak U.S. economy.

While there are certainly areas of weakness in the global and U.S. economies, mainly in manufacturing and business investment, we believe a sustained, slow expansion will persist. The U.S. economy remains healthy, and the labor market and consumers continue to be bright spots. In fact, jobs growth has rebounded in the last two months after a soft patch in May; wages are rising as well.

Consumer confidence remains high; Americans still have a generally optimistic outlook on the economy. More importantly, consumers are still spending, as evidenced by the five consecutive months of positive retail sales.

That is not to say this market is without risk, however. As we've seen, it doesn't take long for tensions to escalate on the trade front. With the back and forth rhetoric, threats of new tariffs and China devaluing its currency, it is harder to see the potential for a significant trade deal.

Add to that a growing chance of a no-deal outcome for Brexit, unrest in Hong Kong and the uncertainty of the U.S. presidential election, and investors can expect more market volatility for the rest of the year. However, with trade uncertainty being the biggest threat to global growth, any type of progress toward a deal could be a positive for the markets.

Avoiding Recession is Key

Whether or not equity markets continue to move higher depends on whether this long expansion can avoid a recession. A key cause of many prior recessions was an overheating of inflation due to the effects of economic growth or a spike in energy prices, which caused the Fed to pursue a tight monetary policy.

Today's oil prices hardly fit the description of a powerful upside spike to extreme levels, a risk mitigated by America's increased domestic oil production. As I've written many times in the past, it seems plausible that we won't have to worry about inflation any time soon, either.

As widely expected, the central bank cut the federal funds rate by 25 basis points for the first time in a decade at its July meeting. While it remains to be seen how aggressive the Fed will be in providing additional stimulus, we believe this insurance cut by the Fed will help keep the U.S. economy chugging along.

We also expect that the Fed will continue to cut rates throughout this calendar year, with another two or three quarter-point cuts most likely. We continue to believe this economic cycle has further to go and do not foresee a recession in the next 12 to 18 months.

Positioned for New Highs, but Don't Overextend

Expectations for slower global growth, contained inflation and a pivot toward easing by central banks around the world should keep interest rates near historically low levels. These factors, in addition to reasonable valuations, make the S&P 500 an attractive investment vehicle. Although the S&P 500's forward 12-month price-to-earnings ratio (P/E) is around 17, slightly higher than its historic average, P/E ratios relative to interest rates and inflation are well below their historical long-term averages.

While we believe equity markets should remain resilient and are poised to potentially reach new highs, we have decided to be prudent at this juncture and act more like my skeptical father. It is not because we fear new highs, but because we feel risk and return at this part of the cycle are more balanced.

A neutral stance in equities, we believe, is the most appropriate positioning due to our expectation of a slowdown in economic and profit growth and the potential volatility that trade and geopolitical uncertainty may bring. Given the strong equity market performance to date this year, it is also prudent for investors to rebalance portfolios to their target weights in order to reduce any unintended risk as portfolios may have drifted.

My family continues to root for the Red Sox, but like the market, this franchise may have its share of ups and downs before reaching for its next title.

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