Elf on the Engine Block – an Allegorical Explanation of Market Movements

In our July market commentary, “Stock Market Indicators Flashing Yellow,” we wrote about a number of factors that made us concerned about the short market outlook. We recommended:

  1. If you have a substantial financial need coming up in the next year, let us know now. We’ll take the money out of stocks and put it in bonds or even cash.

  2. If you have money to invest, or you’re a new client, we’ll scale you in half or even a third of a time. Either the markets will pull back and we’ll get you fully invested at lower prices, or the markets will rise, but at least we’ll have the psychological cushion of some profits.

  3. For needs at least 5 years out, we’re still confident about long term stock market returns. We would never “go to cash” and then come back later. After paying taxes, transaction costs and market slippage, this is NEVER a successful strategy.

From July through September 20th, that concern seemed unwarranted as stocks marched steadily higher, setting several all-time highs along the way. Yet, in a mere 15 days, the S&P 500 shed 6.2%, or more than half the gains of the year (still up 5.1% through 10/12/2018.)

Rational people are frustrated, “Why are the downdrafts so violent, and why can’t we step aside just before, and reinvest just after?” Ah, but who said that the stock market was rational?

We often use this analogy to explain market movements. The stock market is like a massive truck engine block suspended in the air by thousands of piano wires, swaying gently in the breeze.

There’s an elf standing on the block with cutters snipping wires, sometime on this side, sometimes on that side.

Elf on an engine block2.jpg

As the support shifts, the engine block may twist or swing. Imbalances may build up and reach a catastrophic tipping point. The block jerks suddenly, wires break en masse, the engine rolls violently, tossing the elf off on his ass.

Eventually the oscillations settle down, a new equilibrium is achieved, the elf climbs back on and starts snipping wires again.

An observer standing at the side knows that the longer the elf snips, the more likely a violent adjustment. But the observer never know exactly which severed wire will exceed the tipping point.

Snipping piano wires

All summer, the elf was hard at work snipping wires including:

  • Inflation rising from near 0% in 2015 past the 2% Federal Reserve target and touching 3% in July

  • US Unemployment Rate declined to 3.7%, good for US workers but also stoking fears of wage inflation

  • Impasse in US-China trade tariff talks raising fears of a world-wide economic slowdown in 2019 (and also risk of boosting US inflation rates by 0.5%/year)

  • Rising US budget deficit, from a post financial crisis low of $440 billion/year in 2015, a projected $832 billion for 2018 and $984 billion for 2019.

  • Projected sharp slow down in US earnings growth from 2018 (high teens) to 2019 (6-7%)

The tipping point this time was a sharp shift in recent weeks to higher interest rates across the yield curve. The Fed has raised rates 8 times since December 2015, including the most recent increase (September 26th) to 2.25%. The Fed is expected to raise rates once more in 2018 and three times in 2019. The ten year would rise from the current 3.2% to around 4-4.5%, which actually would be “normal” after a decade of monetary intervention.

The ten year rate drives the cost of corporate borrowing and mortgage lending, so would chill both. As a result US GDP is forecast to fall from 3.1% in 2018 to 2.4% in 2019. However, we remain concerned that the trade tariff discussion between China and the US could go horribly awry, and we rate a one third chance of a mild recession (two quarters of negative GDP growth) in 2019.

What next for our investing strategy?

Here’s the funny thing about stock market pullbacks, corrections of at least 10%, and bear markets of at least 20%: investors NEED short term volatility and uncertainty to obtain long term high returns. If stocks were as safe and as invariable as T-bills, they would return only 2%. With a return of less than inflation, none of our clients could ever retire.

The way we manage investment risk is not by avoiding volatile but high returning asset classes like stocks. Instead, we make sure that we invest in stocks for needs that are at least 5 years away, shifting to bonds for needs over the next 1-5 years, and to cash for needs of 12 months of less. Thus, this pullback will have no affect whatsoever on the many client families who are relying on us for their monthly retirement draw.

We do, however, have an opportunity to invest, at least partially, some new families and cash deposited recently by current families. Though the market is off 6% from the recent high and the CNN Fear & Greed Index (our favorite contrary indicator)

is showing Extreme Fear, we’re not convinced that we’ve seen the bottom on this down draft. So we’ll put one third to one half to work next week, reserve the rest while we wait for clarity on market conditions.

End of the FAANG game?

For the last three years, 5 companies, Facebook, Amazon, Apple, Netflix and Google have dominated the financial news as “momentum plays” – stocks to buy because everybody else was buying. The game may be coming to an end. Apple is still hanging in there – down 5%, but still with a market cap over $1 trillion. Facebook has struggled all year with company specific issues, down 30% from its all time high. Netflix is down 20%, Google is down 13% and Amazon is down 13%. However, Amazon worries us the most. Amazon briefly was the second stock to surpass $1 trillion in market cap, but has already fallen back to $872 billion. However the stock remains “priced for perfection with a P/E of 182. Apple’s P/E of 20 is the same as the overall S&P 500, so quite rationally valued.

We still use technical analysis once in a while. Here is a chart of Bitcoin, which we refused to buy for clients last fall:

Bitcoin-chart-2018-1012.jpg

Through December, we see the “ballistic curve” as hordes of retail investors piled into the “sure thing.” The we see a peak in December, sharp sell-off, rally back in January that failed to hold, followed by a long series of lower highs and lower lows. For a while, Bitcoin will hold above $6000, but next year? $1000?

Here’s the chart of Amazon:

Amazon-chart-2018-1012.jpg

Not as steep a climb, which is supportive. Also, institutional investors such as index mutual funds and ETF’s MUST buy Amazon as a major component of all the indexes (S&P 500, Nasdaq 100, Russell 1000 etc.) However, we see a peak in August, a failure to make a new high in September, followed by a 15% decline. As we see, Amazon has recovered from pull-backs before, but given how the other tech stocks are doing, may not recover this time. We’ve been a net seller of Amazon, Apple and Google in our clients account in recent years and may well accelerate our sales of Amazon before year end.

What about the mid-terms?

With election day coming up in less than three weeks, FiveThirtyEight.com rates the Senate at “remains Republican” at 80%, with a likely gain of one senator for a distribution of 52 Republicans/48 Democrats. The Democrats, however, have an 80% chance to take control of the House, likely picking up 35 seats in the process, for a composition of 228 Democrats and 200 Republicans.

Meanwhile, despite record stock market levels and generational lows in unemployment, President Trump’s approval rating remains stuck between 40-44% since January, while his disapproval rating remains at 56-52% over the same time frame. What happens if the Democrats control the House of Representatives January 3rd? Do they immediately subpoena Trump’s tax returns and launch impeachment hearings? When does the Mueller investigation release its report on Russian collusion and obstruction of justice? What are Michael Cohen, Paul Manafort, Rick Gates, Michael Flynn, George Papadopoulos and others telling investigators under their plea bargain agreements? Will state attorneys general file lawsuits against Trump for tax fraud? Will Congressional Democrats succeed in their emoluments lawsuit?

We’ll circle back to politics in our January commentary as answers to these questions crystalize.

As always, reach out to us with comments and questions.