Excessive stock valuations are a problem, but they are not in themselves sufficient to push prices lower. John Hussman explains how investor sentiment is even more important. Whether people are inclined toward speculation or risk aversion (i.e., greed or fear) is the primary driver. It also matters when central banks actually encourage speculation, as they are doing now.

Key Points

  • Starting conditions matter a great deal in portfolio results. If you begin at historically elevated valuations and look again a decade later at normal valuations, you’ll typically find the market “went nowhere in an interesting way.”
  • The S&P 500 total return since 2000 has averaged just 5.4% annually, and getting there took the most extreme valuations in US history.
  • In recent decades, achieving “normal” market returns has required a depressed starting valuation or a bubble valuation at the period’s end.
  • The present combination of high stock valuations and severely depressed interest rates suggests low future returns across the board.
  • Earnings growth is unlikely to keep exceeding GDP and revenue growth, as it has over the past decade.
  • Assuming 4% nominal growth in fundamentals and a historically normal valuation 20 years from now, the S&P 500’s average annual gain would be -1.0% for the next two decades.

Bottom Line: “What investors should avoid is embracing a great deal of market exposure in periods where both valuations and market internals are hostile. Those are the conditions from which market collapses like 2000-2002 and 2007-2009 have historically emerged. Those are the conditions we presently observe.”

 

Status Of China – US Trade Negotiations

China has already agreed to 80% of demands for a trade deal, such as buying US goods, opening markets to US investors, and making policy improvements in certain areas.

It is only the final portion of Washington’s demands, which have stalled negotiations so far:

  • Cutting the share of the state in the overall economy from 38% to 20%
  • Implementing an enforcement check mechanism
  • Technology transfer protections

Trump can set aside the last 20%, drop tariffs, and keep market access open in exchange for China signing off on the 80% of the deal they already agreed to. Which is precisely what Trump’s comments recently alluded to:

“Not surprisingly, as Trump said on Thursday, while he prefers a broad deal, he left open the possibility of a more limited deal to start.” – Reuters

That is code for: “Let’s get a deal on the easy stuff, call it a win, and go home.”

 

Felix Zulauf

I HAVE followed Felix Zulauf for years. He was a member of the Barron’s Roundtable until 2017. Barron’s wrote, “Simply put, Felix always knew—and still knows—better than most how to connect the dots among central bankers’ actions, fiscal policies, currency gyrations, geopolitics, and the price of assets, hard and soft.”

Like Ray Dalio, Stan Druckenmiller, Bob Farrell, Paul Tudor Jones, Mark Finn, and other investment greats, I want to know what Felix is thinking.

Bottom line: In terms of big macro moves:

  • Felix believes a September 2019 stock market peak will be followed by a 20% correction with the low coming in late December or early January. That will send the S&P 500 back towards the December 24, 2018 low near 2,300.  He believes interest rates are still headed lower and will bottom around the same time, perhaps making a long-term bottom.
  • On top of a slowing world economy and already very low real and nominal growth, the world is facing a sharply deteriorating liquidity condition because the US Treasury must replenish its account at the Fed from levels as low as $111 billion in mid-August, $156 billion in early September, and $196 billion in mid-September to near $400 billion. Draining $250 billion of liquidity within two to three months could shock the financial markets, even if the Fed cuts rates. (Steve here: In 2015, Congress mandated that the Fed keep $400 billion of cash in their piggy bank in case of a Government shutdown or a crisis-like event. Last December, the Fed’s balance went from $400 billion to $111 billion. That’s money that is injected into the system; a QE-like effect on markets. When they have to replenish the piggy bank, they sell more Treasury debt and put the cash proceeds back in the piggy bank. That’s like a quantitative tightening that pulls money out of the financial system. I believe the recent hit to the money market system is partially a result of the Treasury’s recent actions.)
  • As they did in late 2018 and early 2019, the Fed and global central bankers will respond aggressively, and that will put a floor on the downside. He believes this is a pattern we will be in for some time. Market support will be very much dependent on the Fed’s, central bankers’ and policymakers’ responses.
  • Like Dalio, he believes we sit late in a long-term debt cycle, and such cycles present significant challenges.
  • China, the engine of growth to the world, is the major driver of the global economic slowdown. Their private market debt has peaked, and they are stuck in terms of their ability to stimulate more growth. Trade wars are a concern.
  • He believes gold is in a secular long-term bull market but expects a short-term sell-off from recent highs. He likes gold on dips.
  • He doesn’t see a 2008-like crash, rather more of a range-bound equity market with big swings up and then down and then up again. An environment that favors active management over passive (Indexing).

Chart 1 – Credit Bubbles: The big picture looks like this: we are in a fragile territory where one major nation has once again overdone it in debt as a percentage of GDP by the private sector. First the chart, then the commentary.

 

 

It happened in Japan in the late-1980s early 1990s, and they suffered through a multi-year period of low growth. It happened in Thailand in 1997 and the U.S. in 2006/07, and it happened in the UK and Spain in 2012. Europe would have broken apart if Draghi didn’t come in with “whatever it takes.” They continue to buy bonds of all kinds today.

Now, we have it in China. This is meaningful since China has been the locomotive for the world economy since the 2008 recession. What this debt peak means is that China has entered a period of very low growth for a long time to come. China can no longer fulfill the function of driving global growth. Felix is not forecasting a major crisis around China. He is saying that China has entered a period of low growth that will remain low for a long, long time, and the world will feel it. He said, “In our view, China is where Japan was in the early 1990s when Japan realized that it was trapped, it could not escape, and that the problem it faced was much bigger than originally thought.”

Chart 2 – Trade Wars are an important topic: Today, exports from the U.S. to China is only .6% while China exports to the U.S. is 4%. While in a trade war, everyone is a loser. The relative winner is the one who is the large net importer which is the U.S.

 

 

This is an awkward position for China to be in as their growth is going down significantly.

Chart 3 – Imports: This shows that in 2012 and 2015 when the U.S. was slowing down, China’s stimulus balanced out the U.S. slowdown. Today, there is not the same stimulus from China. Now, you have a weakening U.S. and a weak China. That’s why the global economy is very weak and weaker than most realize.

 

 

Chart 4 – The stimulus does not work: When you over-invest and the returns on your investment go down, you have no response. Stimulus does not work.

 

 

Chart 5 – The sequence of events is classic: It begins with a peak of Leading Economic Indicators (peaked in December 2017), it is followed by a peak in GDP growth (peaked in mid-2018), and it ends with a peak in earnings-corporate profits (peaked in Q1 2019). We are looking at weakening corporate earnings into mid-2020, but stock prices will bottom prior (usually bottom six months prior to earnings low).

 

 

Mexico Job Growth Slows

 

 

Percentage Of Bearish Investors

As shown in the chart below, the percentage of bearish individual investors—according to the American Association of Individual Investors—has dropped to an extremely low level.

 

 

The chart also shows that a scarcity of bears has historically been a prelude to a correction in the markets. The only question seems to be how big the correction will be.

 

 

Germany

Germany’s economy appears to be in trouble. The September Markit PMI preliminary report showed quickening contraction (PMI < 50) in the manufacturing sector (the fastest pace of decline in activity since 2009).

 

 

And, it’s not just about Germany.

 

 

China

China’s service sector growth is slowing.

 

 

Market Data
  • Political will seems to be growing to open an official impeachment inquiry against President Trump. That would mark the 3rd episode in the history of modern markets.
  • Cisco, Corning, and Intel have yet to surpass the highs the stocks made in 2000…nearly 20 years later.
  • Consumers’ concerns. This month, U.S. consumers decided that the economy was headed for a rough patch, and stocks were likely to follow. To the greatest extent since 2011, consumers are expecting both stock prices and bond yields to decline.