Is a bear market looming?
We are currently in the longest running bull market in US history. The stock market is at its peak for various reasons and from a value standpoint is most certainly overbought in my opinion. If you don’t believe me, maybe the fact that Warren Buffet used Berkshire’s tax windfall to repurchase Berkshire stock (something he has never done before) and in the most recent filing, he went on to purchase stock in a Canadian energy company called Suncor.
A recession is coming. We all should know this if history is any evidence. There are a few reasons this bull market has gone on as long as it has and I will go ahead and discuss some of them.
- The Red Sweep in 2016: The republicans winning all three branches of the government most definitely drove the markets into the green. Most people expected deregulation of businesses and a possible tax legislation which would likely be easier to enact considering the control republicans would have in each branch of the government. While election is not a material change (like an earnings report would be), today’s market is full of speculators and the ease of trading makes the market sensitive to every piece of news out there.
- The Tax Overhaul: The republicans slashing corporate taxes was a huge catalyst breathing a new life into an aging bull market last year. US corporations received a massive windfall that they could now choose to spend however they want. I will inform you that a larger portion of this tax windfall was used by corporations to buy back their own stock compared to capital expenditure as the republicans indicated. The motivations for doing this are quite simple. CEOs report to the board of directors who in turn represent the investors. This means that the CEO indirectly reports to the investors. So if someone gave a CEO $1 billion and asked them to spend it whatever way they see fit (make capital investments such as new factories, products etc. or buy back stock to drive up the stock price) which one do you think makes a smart choice? If they choose to make capital investments, there is a decent chance they might get a return on those investments a few years down the line with a boost in revenues and profits which would be recognized by investors and drive up the stock price making their investors (aka their bosses) happy. However, if these capital investments do not pan out into increased revenues and profits, they might have to write the investment off and take a loss and a hit on the share price possibly getting fired in the process. Stock buybacks present no such risk. Businesses need R&D or some capital expenditure otherwise, they risk their products getting disrupted and the company losing relevance down the line. So CEOs likely take the safer bet of buying back stock on most of the $1B while spending a smaller chunk of the windfall on CAPEX and R&D. This way, the stock price goes up in the short run beefing up their own paycheck and no-one can fault them for not investing in innovation or not looking out for investor interests. By the time they get disrupted for not investing in long term success, the CEOs have already made enough money to retire early. There is practically no incentive that drives the trickle down economics story to fruition.
- Strong Earnings and guidance: This is the most legitimate reason for the stock market to actually stay strong however, a lot of investors use past performance as a strong indicator of the future. Markets move massively on earnings announcements and forward moving guidance. Usually, this guidance is for the next quarter or the year, which in value investing terms is a very short period. For speculators though, this is all that matters so overall, strong past earnings continued to drive the market higher making stocks more and more expensive.
- Interest Rates: Until December, the Federal Reserve consistently kept increasing interest rates. The economy was overheating due to the factors above and the Fed was taking steps to reign it in. If I was to explain this via an analogy, I would recount an incident from my childhood. I once tried to run down a steep hill as fast as I could. As I was running, I realized that my little legs were no longer able keep up with the inertia of of my body assisted by gravity. Eventually, the body just got ahead and I landed face first into the dirt. To prevent an economic face plant (rampant inflation), the Fed started hitting the brakes by raising its benchmark rates. These rate hikes and trade concerns over China started slowing the economic forecast for 2019 causing the investors some worry.
A bout of panic set in around December 2018 that saw the market almost reach bear market levels (usually a 20% drop off the peak denotes a bear market). The market bottomed out however on Christmas Eve and the Fed’s willingness to take a more cautious approach has since once again driven the market near peak levels. The problem however is that nothing has fundamentally changed since December. There is still no trade deal with China or a real drop in interest rates that could fundamentally explain why the market should back to its current levels.
What does exist however is a lot of promises being made over Twitter. Unprecedented levels of market moving fodder being dispersed over social media leaving investors to figure out what may happen in the future. There has been at least 3 instances where a trade deal with China has been projected to be imminent and then the comments rescinded. The market in my opinion prices in a trade deal that will take relations with China back to normal as well as a rate cut that may or may not happen at some point.
I get the feeling that something is about to happen. Stocks simply seem to be too expensive and investors too overzealous. This peaking market seems to be built on speculation that has too many fundamental cracks at its base and an avalanche seems to be the only way that the balance shall return. I don’t think this is going to be nearly as bad as the Great Recession but a correction is coming. My prediction is June 2020 or earlier if the political landscape changes.