What is happening? How do the financial markets go from a model of strength to producing a highly volatile sell-off in the space of the three months since the last Outlook & Trends described the economy as very strong? Why do we continue to see such volatility when the economy is still very strong? In this edition of Outlook & Trends, we hope to provide a little more insight than can be gleaned from the news media’s talk of tariffs, government shutdowns, Washington personalities, and 20% bear markets.

The Economy

By all measures, the economy remains strong but may be moderating. Leading economic indicators continue to rise, although the rate of progression has slowed a bit. Last quarter’s GDP grew at an annual rate of 3.4%. The current estimate for this quarter is 2.7%. Purchasing managers suggest that business is still strong, reporting their index of economic activity to be 59.3, where any reading above 50 implies expansion. Unemployment, a lagging indicator, remains at a 49-year low of 3.7%. As we said in the last issue of Outlook & Trends, “It doesn’t get much better than this.” The problem is though, that if it does not get much better, then there is a good chance it will get worse sometime in the future. Presently, however, there is little that would imply an imminent recession or provide a short-term economic reason for market volatility. One can make the case, however, that there are plenty of reasons for intermediate-to-long-term weaknesses now built into the economy that could become visible at any point.

The Markets

Despite the economic strength, the stock market reversed during the last quarter. The S&P 500 average erased prior gains and closed 6.2% lower for the year. An even broader measure, including international stocks, the All Country World Index, was down 11.2%. Excessive volatility was a hallmark of the quarter’s performance. Volatility may be accentuated by computerized high frequency trading coupled with short-term trading decisions made by machine-based algorithms, as well as investors crowding into index funds, but the fact of the matter is that there have always been short-term variations in stock prices. They are simply less noticeable when the trend is strong. In a strong uptrend, everyone applauds the large short-term up moves that occur, and buyers step in to limit declines. In a strong downtrend, there is so much concern with the declines that few notice the sharp recovery rallies. It is when the trend flattens out that the ups and downs are magnified, and volatility becomes very noticeable.

Teddy and Grizzly Bears

A flattening trend is always present during a period of horizontal consolidation and typically can be seen before the onset of an extended decline in prices. Years ago, when we first started studying the stock market, different periods were dubbed corrections, consolidations and bear markets. Corrections occurred when rising prices got ahead of themselves and were brought back to a more reasonable level within an ongoing upward trend. Consolidations happened when an intermediate term (i.e. about 9 months or shorter) cyclical counter-trend slowed a rising trend down, causing the overall direction to become horizontal. A bear market signified a long-term down trend, which was as much a state of mind as it was a market phenomenon. Sellers created falling prices which reduced the collateral value for margin loans. Less collateral forced more selling. Selling created more selling. Eventually the entire over-leveraged financial structure washed out, until there was no one left who wanted or had to sell.

The definition that calls a decline of 10% a correction and a 20% fall a bear market was invented by the media sometime during those years. They have come to be accepted definitions by commentators but are arbitrary and miss the point completely. Corrections, regardless of the percentage pullback, while perhaps scary over the short term, are necessary for the markets to retain their health, as they bring prices back to a more normal level from which a renewed uptrend can occur. Journalists talk of stocks entering, leaving and re-entering corrections just because they pass the 10% mark in one direction or another. A correction, consolidation or bear market is not a point. It is a process, and, once it begins, as Yogi Berra said, “It ain’t over ‘till it’s over”.

Consolidations, or what we might call a Teddy Bear market, are periods when buyers and sellers have less conviction, regardless of whether there is a 20% drop at some point. Traders are competing to see whose vision of the future direction will eventually win out. Bear markets are a different story. These are times when selling feeds upon itself. Liquidity (the availability of new cash) dries up, and sellers find they must leave positions at any cost. We will call those bear markets the Grizzlies.

The Grizzly last made its appearance in 2008. It morphed from a consolidation that started in 2007 into a Grizzly in 2008 when failed mortgage loan derivatives sucked liquidity from the system and Lehman Brothers failed. The banking system came close to locking up. The government and Fed stepped in to provide additional cash into the banking system and economy. That, plus a change in accounting rules, eventually provided enough liquidity to re- grease the economic gears and allowed the stock market to bottom. In 2011, the Fed initiated a round of money printing (called Qualitative Easing), which kept a nascent consolidation Teddy Bear from growing that year.  In 2015, after the Fed ended its QE policy, the absence of new liquidity caused a new Teddy Bear market consolidation. Further deterioration then was reversed by the European Central Bank initiating its own QE policy. The Dow Theory, one of the oldest and most venerable set of stock market guidelines, was published in 1929 from the collected works of Charles Dow, editor of the Wall Street Journal. The theory posits that turning points in the stock market can be identified when Dow's average price of industrial stocks and his average of rail stocks (now more broadly transportation stocks) both turn up or down together, one confirming the direction of the other. There was no mention of 20%. Dow was concerned about the direction of the long-term trend. The Dow Theory has occasionally given false signals, and is usually somewhat late, but has withstood almost 100 years of testing. The bear confirmation occurred on December 19. Since 2009, asset prices have been propped up by one or more international central banks, and market-supporting liquidity continued to grow. The ECB has announced that it intended to end QE policy at the end of 2018. Is it any wonder that the markets have embarked on a new Teddy Bear market in anticipation of the removal of a primary prop under asset prices, even if the U.S. economy measurements are in good shape? It is no longer about current company profits driving stock prices. It has become about the availability of cheap money. Whether this Teddy Bear market remains a volatile consolidation or turns into a Grizzly may depend on central bank policy decisions and whether any pent-up financial instability is exposed by the current interest rate and liquidity reduction policies.

LFM&P

As we mentioned in the last issue, we suspended our long tradition of simply trying to provide information and perspective in Outlook and Trends with a minimum of self-promotion. Last time, we included a description of our retirement planning. This letter includes a similar sheet describing our investment services. It is possible that we may again return to a comfortable financial environment. It is also possible that a new reality will emerge before us, an environment where planning and risk-management become more important than ever. Predictions will necessarily be faulty. We will never know how market and economic events turn out until after the fact. However with the excess global debt, demographic changes occurring with retiring baby boomers, over-valuation, and a shift in central bank policies occurring, to paraphrase Bob Dylan, the trends they are a-changin’.

If you are interested in finding a fee-only, fiduciary investment advisor to help you manage your investment risk or develop a financial plan, please send an e-mail or call.

A Registered Investment Advisor and NAPFA-Registered Financial Advisor