I’m happy to welcome back economist David Hunter as today’s guest author.
Regular readers will recognize David as an expert in cyclical analysis with an encyclopedic knowledge of stock market history. His calling card is the ability to pinpoint exactly where we are in the economic cycle, so as to predict what’s likely to happen next.
So where are we today? David believes that the stock market’s multi-year rally is ending and that we’re on the precipice of a historic crash—worse than even 2008.
David is a truly independent thinker—a contrarian’s contrarian. So don’t expect to agree with everything you’re about to read. For instance, David expects deflation, not inflation, to spark the next crisis and wreck the stock market.
Whatever your personal take, I promise David’s analysis will make you think.
Managing Editor of The Casey Report
By David Hunter, CFA
I know, the definition of a bear market is one that has declined by twenty percent or more, and we’re only down about 4% today. That’s hardly a bear market. But I think we’ve seen the highs for this market cycle and are now heading for a decline far greater than twenty percent.
The stock market has not experienced a 10% correction in over two years. Each small correction has been quickly followed by a move to new highs. So it’s not surprising that most investors are viewing the current correction as another buying opportunity in a secular bull market—one that they believe has a long way to run.
The Wall Street consensus view is that the economy is gaining traction and will sustain its momentum even when the current monetary stimulus program ends in October. The general expectation is that interest rates will rise a bit from current levels but still remain relatively low well into the future. As the thinking goes, this steady-growth and low-interest-rate environment should be supportive of higher equity prices for a long time.
In other words, most investors believe that a bear market is nowhere in sight.
Needless to say, this contrarian completely disagrees with that consensus view. Not only am I suggesting that a bear market is near, but that the bear market is already underway.
Despite rather widespread complacency among investors, there are plenty of things to be concerned about. Certainly, the geopolitical landscape is full of potential risks that could prove disruptive to the capital markets. It’s not just Ukraine. It’s Iraq, Syria, Gaza, Libya, and the tensions in the South China Sea. And of course the Ebola virus outbreak. Many pundits assume recent market weakness is primarily due to geopolitical headlines.
No doubt events in Ukraine and the Middle East have played a role in the sell-off. But I think the market may also be starting to price in an economic downturn—one that could be triggered by all of this geopolitical turmoil. The global economy is leveraged and fragile and has little tolerance for adversity. Any interruption of the flow of gas into Europe, for example, would be very disruptive to the Eurozone economy. And let’s not forget that much of Europe is already in or heading toward recession.
Japan and China remain concerning as well. Both are highly dependent on export markets for growth. A weakening Europe or less spending by US consumers would be problematic for their economies, and for the global economy overall.
So it’s not necessarily war itself that the markets are worried about, but rather the impact that geopolitical turmoil could have on the world economy. It doesn’t take much to tip the balance when the economy is already struggling to sustain its growth.
It may seem premature to be so bearish when most of the major indexes are just off their highs. But beneath the surface, a lot of damage has been done. It started in the spring when the two leading momentum groups of this cycle, social media and biotechnology, sold off sharply. Both have rebounded from their spring lows, but neither has regained its highs.
More recently, bank stocks broke down, as did building and construction stocks, along with housing stocks. They all broke through their respective 200-day moving averages. In addition, European stocks and junk bonds suffered important breaks. These are significant reversals. When combined with the recent rollover in industrial and semiconductor stocks, they suggest that cyclical risks are rising.
Sometimes we overcomplicate things in this business. We don’t have to look very far for the reason for the market’s loss of momentum. The Fed is winding down QE; it has reduced purchases from $85 billion/month to $25 billion/month and plans to eliminate purchases completely at its October meeting. The elimination of QE is a substantial reduction in liquidity at the margin.
Both the hawks and doves on the FOMC now seem to agree that the time is right to end this round of monetary stimulus. Wall Street supports the end of QE, too. A large majority of Wall Streeters has long been critical of the Fed’s aggressive monetary expansion. They are happy to see QE3 ending. Much of the Street’s criticism has centered on the fact that all of this money expansion, along with the zero-interest-rate policy, has led to a misallocation of resources and has pushed investors to take on too much risk. Inflation is also a big concern. The point is that we are finally seeing the Fed and Wall Street on the same page: they both agree that additional QE would be counterproductive.
Everyone seems more than ready to see this round of QE come to an end; almost no one (except me) is voicing any reservations. Fed officials and economists alike want desperately to believe that the economy can sustain its growth without the aid of QE. Ironically, the global economy may be closer to a deflationary contraction today than at any time in the last eighty years. Yet, due to misplaced concerns about inflation, almost no one is concerned that the Fed is about to terminate its monetary expansion program just when it is most needed.
Add to this the fact that Japan’s monetary expansion is more or less on hold and that China is attempting to rein in its aggressive credit expansion, and we may be setting up the perfect storm for a deflationary bust.
Every bear market has a defining characteristic. In 1987, program trading led to a sharp sell-off. In 2000, the tech bubble burst. And of course in 2008, the credit bubble burst. I believe the liquidation of exchange-traded funds (ETFs) will play a defining role in the bear market of 2014.
ETFs have not been battle tested. While they did exist in 2008, their aggregate size today is more than four times what it was back then. If we get a sharp unwinding in the equity markets, investors who have built ETF positions over the last few years may decide to exit en masse.
A rush to the exits would, of course, hurt the market value of the ETFs themselves. But more importantly, it would force ETF managers to sell holdings to meet the liquidations. I think that could exacerbate the coming bear market and turn it into a historic crash.
Recent action in the high-yield bond market may have given us a preview. Due to large and concentrated outflows from high-yield bond funds, managers were forced to liquidate some of their bonds. When they tried to sell, these managers discovered that the bonds were not as liquid as they thought, because sellers outnumbered buyers. This occurred with only a four percent decline in the junk ETFs. Imagine the impact during a sharper bear market selloff. A herd of investors would stampede for the exits, and the impact on prices could be epic.
When Wall Streeters list their concerns, they usually start with rising interest rates. That’s because almost every bear market in the post-WWII era was preceded by a sharp rise in interest rates, usually in response to an overheating economy. As a result, most investors assume they needn’t worry about a stock market top until rates begin to rise sharply.
The fact that rates are currently falling, not rising, is leading to a lot of complacency on the Street. Unfortunately, investors are relying on a model that doesn’t fit this cycle. This market cycle is not likely to end as a result of an overheated economy and higher interest rates. Rather, we are potentially facing the first deflationary contraction in the post-WWII era—one brought on by excessive debt and some significant policy mistakes.
The global economy is already slowing despite aggressive monetary stimulus and historically low interest rates. I think interest rates will move even lower, accompanied by a broad-based decline in stocks, both in the US and around the globe.
Amazingly, we are on the verge of a global deflationary downturn and what could be a historic bear market, yet Wall Street prognosticators remain focused on the inflationary risks of excessive monetary stimulus. Their focus could not be more wrong.