Research.LeutholdGroup

We wrote in October’s Green Book that “many once reliable seasonal market patterns have been out of sync in recent years.”

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Taking a cue from the White House, today’s market pundits seem more prone to declarative, unsubstantiated statements than we can ever remember.

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Whether or not they’ve risen for the “right” reasons remains up for debate, but the upward move in interest rates has hit the usual suspects very hard in 2018, like early-cycle industries and Emerging Markets.

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A couple of months ago, we (belatedly) observed that, in February the 10-year Treasury yield had bro-ken above its 10-year moving average. That simplistic tool has been a pretty good descriptor of yields’ long-term trend for more than a century, with few “whipsaw” signals along the way.

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Having devoted all of our professional lives to the monitoring and modeling of equity markets, we’re naturally ticked off that this year’s best stock market signals have in fact been rendered by bonds.

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We believe stocks have begun to discount a major inflection point in the economy and corporate profits for 2019 and 2020.

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During 2018, no major asset class has done well, and in most respects the opportunity-set available this year has been among the worst in the last 50 years.

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While this year’s liquidity squeeze has yet to exact the toll we ultimately expect on the U.S. stock mar-ket, it has certainly contributed to a sharp compression in P/E multiples.

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We’ll never know how world events might have evolved had Mitt Romney won the presidential election in 2012. But thanks to the wonderment of Emerging Markets’ underperformance, we can go right back to the last days preceding that fateful election.

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“Zombie” companies are being kept alive by low interest rates and generous credit conditions, and the number of them, worldwide, has risen significantly over the past few years.

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We’ll never forget the first time we read a SELL recommendation for a stock. It was nearly 30 years ago and we were two weeks into our first job with a small equity management firm.

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Throughout the spring and summer, the market could alternatively be characterized as “divergent” or “disjointed”—but until very recently it could not be considered “distributive.” Now, Mid and Small Caps have hit a short-term air pocket and breadth figures were exceptionally poor at September’s scattered highs in the DJIA and S&P 500.

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In the first week of October, the share of newsletter bulls topped 61% just as the NYSE percentage slid to 41%. Maybe it’s a seasonal thing… the last time that happened was October 2007.

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Our bearish stance could be tested by the arrival of the seasonally strongest six-month window of the four-year electoral cycle. Since 1926, November of the mid-term year through April of the pre-election year has produced an average un-annualized S&P 500 +16.4% total return.

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The longevity of this bull market is impacting tactical asset allocators in ways great and small.

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We should emphasize that our characterization of stocks as dangerously overvalued applies only to the U.S. market.

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“Three steps and a stumble” was the old rule of thumb for timing the impact of Fed tightening on the stock market.

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After a strong 2016 and a “Bridesmaid” (i.e., sector runner-up) performance in 2017, the Materials sector seemed primed to benefit from the “late cycle” character of the economy in 2018.

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We’ve previously noted the narrowing performance divergence between top- and bottom-performing Emerging Market (EM) countries in recent years.

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The S&P 500 finally erased the losses from its nine-day swoon in January and February.

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It’s been amusing to watch the narrative surrounding Fed policy evolve as the market has rallied.

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The S&P 500 has fully erased its January and February losses, but there’s probably a market message in the fact that it took so long to do so.

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Traditional breadth measures have yet to show end-of-cycle thinning of the ranks, but some secondary measures suggest that process may be underway.

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Many equity investors have suggested there’s no comparison between today’s expensive market and the bubble peak of Y2K, pointing out that today’s Technology titans are “real companies” with massive revenue underpinnings.

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While the bottom-line impact may ultimately be the same, there’s one thing we find more demoralizing than getting the direction of an asset wrong: getting the direction right and not getting paid for it.

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We previously mentioned the increasing focus on the real short-term interest rate as an important measure of the Fed’s policy stance. In truth, we wish the Fed had paid more attention to this measure during this cycle.

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A “moderate-risk” S&P 500 VLT BUY signal was triggered at the end of August, but it’s not all good news. Any upturn in the VLT while the indicator is in positive territory also sets up a pattern known to veteran market analysts as the “Killer Wave.”

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In late January we speculated how long it would take for the S&P 500’s bloated valuations to reach more reasonable levels. The S&P 500 now trades back where it was in January and the seven-month break included some of the best growth rates most have ever seen. We found ourselves asking: Did chubby Mr. Market shed any pounds as he pedaled away on his stationary bike?

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To summarize (and oversimplify), here are some of the frequent client responses to our prevailing “cautiously bearish” stance:

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The S&P 500 is on the verge of reversing its early-2018 losses and, if achieved, it would initially be accompanied by six “Red Flags”—which are based on key market indexes failing to record new highs in the 21 trading days preceding a new S&P 500 high. The last time the tally reached “six” was in May 2015—occurring at the final high before an S&P 500 loss of nearly 15% over the ensuing nine months.

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A few clients pointed out that the longest-ever recovery from an intermediate correction (Apr. 1994–Feb. 1995) became the base from which the S&P 500 would eventually triple over the next five years. We’re not equipped to address that possibility in an objective fashion, so we’ll let you be the judge.

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We’ve been reticent to draw links between the current bull and that of the late 1990s; we felt the last phase of the earlier episode was so extraordinary it was unlikely we’d see anything similar again in our lifetimes. But statistical parallels are on the rise, including the attempt by the S&P 500 to recoup its 2018 correction losses.

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How do today’s cyclical conditions stack up with those accompanying other stock market declines? 

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It’s difficult to knock a stock market in which Small Caps and major breadth measures are making frequent new highs, however, there are performance anomalies that suggest liquidity is no longer sufficient to “float all boats.” Recent underperformance of the Equal Weighted S&P 500 is a case in point, at the same time, the current dichotomy in market breadth pales in comparison to the 1999-2000 episode.

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We believe the U.S. free-trade initiatives of the last 25 years have been wildly bullish for the stock market.

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While service industries have minimal direct exposure to trade disputes, they will begin to suffer from knock-on effects if the tensions continue to escalate.

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It’s been popular to argue that U.S. government bonds are a bubble while U.S. equities are not. But even if we agreed, the potential cyclical total return losses in Treasury bonds are a fraction of those likely to occur in an equity bear market.

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Higher corporate leverage and rising short-term interest rates have not yet led to problems in the credit markets, but investors should be mindful of potential risks.

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The nine-year stock market “party” may not yet be over, but it’s getting pretty late.

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Yes, bulls and bears now hold their respective positions for the same reason—i.e., the U.S. economy is exceptionally strong. The stock market is accommodating this rare bipartisanship with sufficient reason to support either position.

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