What goes up must come down. That's what Sir Isaac Newton suggested anyway in his Universal Law of Gravity. It is easy to think in watching the stock market since the end of June, however, that it does not adhere to the law of gravity. It has gone up, and stayed up, with only some minor dips here and there that have been bought quickly. The flotation device it has used in its run to record highs has been monetary policy. Specifically, it has been the notion that the Federal Reserve, and other central banks, aren't going to take away the punch bowl anytime soon. The conviction of that belief will be put to the test with the September 20-21 Federal Open Market Committee (FOMC) meeting and perhaps as early as the coming week when Fed Chair Yellen provides a keynote speech at the Kansas City Fed's Annual Economic Symposium in Jackson Hole. A hawkish surprise from the Fed Chair might not sit well with the market, which is far from fully convinced that there will be another rate hike at all this year. That got us thinking about what some potential spoilers would be for this bull market -- the type of spoilers that could force it down with some true gravitational pull. We've identified six and will expound on them here.
(1) A spike in interest rates
The stock market has feasted on the persistence of low, and declining, interest rates. They have forestalled valuation concerns for many and have fueled a run into higher-yielding equity securities and higher-yielding fixed income products where price risk has been overlooked in the pursuit of income generation. A spike in long-term rates would be a destabilizing factor, primarily because it is not expected, but also because it undermines the bid to seek yield outside the Treasury market and the complacency surrounding stretched valuations. What could trigger such a spike?
- Tightening from the Fed that is earlier, or more aggressive, than expected
- An acceleration in inflation rates
- Foreign central bank selling in an effort to defend currencies
- Mass selling by money managers and/or speculative traders growing increasingly anxious about concentration risk and valuations
(2) A recession
It is said that bull markets don't die of old age, but that they can be killed by a recession.
The Fed's economic framework doesn't project a recession hitting the U.S. anytime soon and such an occurrence is still seen by many economists as a low probability. Still, a recession isn't anything this bull market would want to see given the hope it has wrapped up in the idea that earnings growth and economic growth are on the cusp of an acceleration.
The effects of a recession transmit negatively to the equity market in the following ways:
- Earnings deteriorate
- Cyclical sectors underperform
- Earnings prospects for banks weaken as loan growth wanes, loan loss reserves increase, and net interest margins compress with a flatter yield curve
- Stocks with high valuations get reined in
- Investors seek the safety of government securities and/or cash
(3) The consumer holes up
Consumer spending accounts for 69% of GDP, underscoring just how important U.S. consumers are in driving the world's largest economy and, arguably, the world economy. It has been clear to see in recent years how weak income growth and debt repayment efforts have crimped discretionary spending and have kept the economy from hitting escape velocity.
Business spending has been another major headwind. It has been weak on account of businesses lacking conviction in aggregate demand picking up to justify investment in new structures and equipment.
It is the consumer, however, that matters most.
The second quarter GDP report produced some green shoots of optimism on that front as personal consumption expenditures increased at a seasonally adjusted annual rate of 4.2%. That was the strongest pace since the fourth quarter of 2014 and comfortably above the prior 10-quarter average of 2.9%.
A recent acceleration in wage growth and consumer credit, coupled with rising home values, low gas prices, falling savings rates, and record stock prices, have forged a belief that the U.S. consumer is going to continue to be a robust growth engine for the U.S. economy.
The latter is why the consumer "holing up" is a risk to the stock market. Such a development could go hand-in-hand with an economy that slips into recession, but at the least, it would run counter to the expectations for the consumer that have helped the market run to record highs despite S&P 500 earnings per share declining on a year-over-year basis for four straight quarters
What might lead the consumer to hole up?
- Newfound angst about job security and income growth prospects
- An act of domestic terrorism
- A correction in the stock market and/or bond market
- Inflation rates that exceed income growth
Terrorism is a risk factor that we hope never comes to fruition, but it does, as the world was reminded with the terrorist incidents in Europe this year.
Those terrorist acts were tragic from a human standpoint, but the objective fact of the matter is that they didn't unnerve the stock market in any material way.
The reason being is that those terrorist incidents were not seen as having any material economic impact on the global economy.
As much as we hate to say it, terrorism as a risk factor for the market probably doesn't register in a material way until it is regarded as having a measurable impact on the global economy.
How might something on that order of things manifest itself?
- An incident falling on the scale of 9/11 in one of the world's major economies
- Smaller, but regular, acts of terrorism at social venues in the U.S. that are foreign to our way of life and would ostensibly create a nesting effect, like that which was seen after 9/11
- A biochemical attack on important sources of water supply
Remember how the year started for China? The Shanghai Composite plunged 6.9% on its first day of trading in 2016. It would ultimately decline as much as 25% in the month of January alone. The upheaval there spilled over to global equity markets, including the U.S., where the S&P 500 declined as much as 8.4% in January.
Worries about a devaluation of the yuan and the rise of currency wars around the globe played an important part in that decline, as did fears that China's economy was headed for a "hard landing." And then things died down.
The Shanghai Composite is up 18% from its low, Chinese authorities have pledged that competitive devaluation won't be used to enhance export competitiveness, and the Chinese economy is slowing in a carefully managed pace, according to official (and questionable) reports from the country.
Even so, there are still rumblings in the market regarding a credit bubble in China and the potential for a debt/banking crisis to unfold that is worse than the one seen in the U.S.
It's some unnerving talk, yet it's a background issue it seems for the U.S. stock market now that the early-year losses have been recovered and then some. China, though, still has plenty of potential to be a source of upset for the stock market should its credit issues start to boil over and/or the devaluation of its currency heats up again. At the same time, its protective territorial claims in the South China Sea are becoming an increasingly sticky point on the geopolitical front because they are deemed credible by China and China alone.
The risk of an armed engagement in the area may not be high, but it isn't zero either and can be considered a tail risk.
(6) Fiduciary duty
It will sound hyperbolic to suggest fiduciary duty is a downside risk factor for the stock market, yet vestiges of that orientation have started to avail themselves in remarks from some well-heeled, and very successful, fund managers who have decried the condition of both the stock market and the bond market.
For instance, DoubLine Capital Founder Jeffrey Gundlach said he feels as if he should "sell everything," stating that the stock market is too complacent in the thought that nothing can go wrong and noting that his firm went "maximum negative" on Treasurys on July 6 on account of risk-reward being horrific at the time.
Stanley Druckenmiller, George Soros, Bill Gross, and Paul Singer have all sounded warnings of some kind or another in their words, or in their positioning, that speak to a belief that risk-reward dynamics are not attractive at current prices.
The basic definition of a fiduciary is as follows:
An individual in whom another has placed the utmost trust and confidence to manage and protect property or money. The relationship wherein one person has an obligation to act for another's benefit.
To be fair, there are other well-heeled and successful money managers who feel less bothered than the aforementioned individuals do about the risk-reward trade-off. That is of course what makes a market.
Suppose, though, more and more fiduciaries begin to think it is their fiduciary duty not to be as exposed to the stock market and/or bond market because they feel the most prudent way to act in their clients' benefit is to lower their allocations and to sit with cash (to the maximum extent their investment mandates allow them to).
Group think can be a powerful market-moving force when it gets going -- both to the upside and the downside. If these fiduciaries all start to think they're seeing an asset bubble that they don't want to be a part of, demand will fall and supply will go up, and when supply goes up, prices go down.
What It All Means
It's never a bad thing to be aware of your risk factors. They are always scary sounding; otherwise, they wouldn't be called risk factors.
The six-pack of factors discussed above is not an all-encompassing list. You might have picked up that we didn't even mention politics. That was intentional. We have no interest in stoking any partisan fires, yet it's fair to say, based on the articles we've read, that politics is part of the risk mix.
Knowing your risks, and your own tolerance for risk, is essential not only when making investment decisions but when making exit decisions as well.
So, maybe crack open a six-pack of your own this weekend and contemplate how much risk you are willing to assume with stock and bond prices near record highs and the risks of monetary policy right there with them.
Patrick J. O’Hare, Briefing.com
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2016-28016 Exp 8/2018