Zeller Kern’s Investment Monitor

It’s Not About Trump, Interest Rates, or Tariffs, It’s About the Cycle

January 16, 2019

By Steve Zeller                           

2019 is being kicked off with a high level of uncertainty for many investors. Many headlines and pundits on the financial channels are mentioning or blaming the declines on Trump’s tariffs, the shutdown of the government, or the Fed’s increases in short term rates. Although these factors might be contributors to solidifying the direction of the equity markets and the economy, it isn’t the main reason for declining stocks, especially Tech Stocks and the “Bear Proof” FAANG stocks. The reality of it is that it is due to a shift into an economic cycle of slowing growth and slowing inflation, in our view. It may be helpful to gain insight on the direction of things by studying the data, and getting a handle on what it is telling us, and where we might be heading with the markets and the economy.

But first let’s recap the market activity that occurred in the last three months of 2018. For our readers that may remember our stance on the market at the end of 2017, it was a bullish view, but we were concerned that the party was getting a little too out of control with complacency, bullishness, and once again investors were ignoring the potential market risk that was looming. Let’s face it, the behavior of investors made the run-up of tech stocks reminiscent of the tech bubble of 1999/2000 market top. From the FAANGs, to Pot Stocks, to Bitcoin, complacency towards risk and the appetite of speculation was once again in place. The additional ingredient to form a perfect storm was earnings peaking and then to begin to weaken, especially with Technology Companies. The earnings that were posted by the end of Q2 in 2018, hit record levels. Earnings had never been better. Stock prices for the market and tech stocks hit record levels by August, and if prices reach record highs and earnings hit record levels and then begin to decline, what do stock prices begin to do? Yes, that’s right – they begin to decline.

S&P 500 - 2018 Chart

What’s more important, for asset prices overall, is what is the overall direction for the economy? Based on the data that we utilize, it was telling us that we were heading into a period of slowing growth and slowing inflation. The average investor would have no inkling of that, it certainly didn’t feel like things were slowing at that point, but the data was telling us that it was, and when big investors realize that the data is deteriorating off of a market top, watch out! Things can get ugly in a hurry, and they did.

To recap the damage as of the low of the correction on December 24th, the S&P 500 was off approximately -20% from its high posted on September 20th. The NASDAQ was down approximately -24% from its high posted on August 20th, and the Russell 2000 Small Cap index was down approximately -27% from its high that was reached on August 31st. There was a bounce off the lows printed December 24th, and for the year, the S&P500 was down -6.24%, the NASDAQ was off – 3.88%, and the Russell 2000 Index was down -11.01%, excluding dividends. The market is attempting to make a rebound, and will probably continue to do so, even when the overall trend is down, which at this point, we still think is the case.

If you want to gain some clarity on the direction of the economy, look no further than the data. The data has been slowing since the beginning of Q4 of last year. The ISM Manufacturing Index slowed to 54.1 in December, from 59.3 in November; The ISM Services Index slowed to 57.6 in December from its peak print of 61.6 in September of 2018; and ISM Prices slowed to 57.6 in December from its peak print of 64.3 in November (source: Tradingeconomics.com). Based on these numbers, as well as many other data points, GDP could come in below the consensus for Q4 of 2018. Earlier, the consensus estimates were in the area of 2.5% to 2.8%. Actual GDP may come in below 2% for Q4, and possibly even as low as 1.5% to 1.6%.

Other data points in the economy are showing signs of weakening, particularly in housing. In Seattle, for instance, inventory of houses and condos in King County (Seattle and Bellevue) surged 148% in December, compared to December of the prior year, according to an article recently posted on Wolfstreet.com. The article mentioned that there were 4,017 active listings, according to the National Association of Realtors.

The chart for the Silicon Valley/ San Francisco area is almost identical. Housing inventory listed in San Mateo, Santa Clara County, and San Francisco County, surged by 113% in December compared to December of last year, to 2,691 listings. That’s the highest number of listings for the area, for the month of December since 2013. As a result, the number of properties on the market with price cuts in Silicon Valley and San Francisco combined, soared by 455% from a year earlier to 444.


And just when homeowners thought that the prices for homes in the Bay Area would never decline.

But the symptoms of slowing growth and inflation extends well across the globe, with Industrial Production slowing across major markets in Europe. Industrial Production for Germany declined -1.9% in November, along with France’s Industrial Production declining -1.3%, and Italy declining -1.6%. Italy’s GDP was negative for Q3, which is the Euro zone’s third largest economy (source: Mishtalk.com). It is expected that Germany and France will soon follow.


So, it is becoming quite apparent that the rate of growth is slowing along with inflation. Typically, the Fed is late to respond, so it wouldn’t be surprising to us to see the Fed to hold or even begin to lower short- term rates towards the end of Q1 of 2019. The predicament with the Fed is that they’ve been committed to reducing their purchased assets on their balance sheet. At the height of their asset purchases, which occurred primarily during the Obama administration, the Fed bloated their balance sheet close to $4.5 trillion, which is truly unprecedented. Unfortunately, Wall Street and other investors that became addicted to dirt cheap money, and the Fed propping up asset prices, have been screaming for the Fed to stop. The Fed started to unwind its balance sheet back in October of 2017. It didn’t seem to bother anybody until October of last year came along and asset prices began dropping.


So, it will be interesting to see the Fed’s policy in another two months or so. We’ll see if they break away from their commitment to normalize interest rates and continue to unwind their balance sheet, or will they come to the rescue of investors that are sitting on their FAANG stocks, pension funds that are loaded up with stocks, risky credit investors, etc., or will they stay the course with the unwinding of their balance sheet?

We expect volatility to ramp up again, shortly, and for stock prices to likely head lower even though the market is in a rebounding mode. Investors should also beware of lower quality corporate credit, as that sector of fixed income tends to get hit hard during a period of slowing growth and slowing inflation. Investors should continue to see their leveraged loan mutual funds get hit. It is estimated that there is $1.3 trillion in leveraged loans issued by “junk-rated” companies. These loans wind up largely in mutual funds and ETFs. During the turbulence in the month of December, these funds experienced a record outflow, in the week ended December 26th, of $3.53 billion, according to Lipper. Additionally, over the past 9 weeks, an estimated $14.8 billion had been withdrawn.

This is to be expected in this type of market cycle, as U.S. Federal Treasury Bonds and bond funds will most likely out perform due to the investor’s flight to quality.

The week ahead will have a substantial impact on the continuation of the bear market. Earnings will begin this week with most of the concern around the major banks, as economic reports will not be imperative. Overall, it is just the beginning of the earnings season, and the heavy releases don’t kick into full gear until the week of January 28.

Economic releases this week are for the most part immaterial with the exception on Tuesday with the release of the producer price index, which could give some insight into the future actions of the Fed. The rest of the reports are focused on consumer and housing elements of the economy, which are not likely to be influential. All focus will be on the bank's earnings reports.

Looking back on last week

Market indices had a strong week with the S&P gaining 2.6% writing for the third straight week extending its rally for the year to show a 3.6% gain. The Dow Jones gained 2.4%, and NASDAQ composite gained 3.5%, and the Russell outperformed them all leading the way up by 4.8%.

Also All 11 S&P 500 sectors finished higher with industrials (+4.1%), real estate (+4.0%), consumer discretionary (+3.7%), energy (+3.4%), and information technology (+3.4%) outperforming the broader market.

Most of this rally was characterized as short covering after being deeply oversold and triggered by the stronger-than-expected December employment report. Also, it was widely accepted that the comments from Chairman Powell suggested that the Fed would take a more patient approach to raise rates.

Similarly, last week it was reported that there were positive discussions between the US and China trade issues. These events influenced the by the dip traders to come back in along with the all the rhythms that drove many of the sessions higher.

The Federal Reserve released its minutes from its December policy meeting. The minutes revealed a view that the path of U.S. monetary policy is "less clear" than before and a contention that the Fed can "afford to be patient" about future rate hikes.

Last week’s action saw the S&P trade as high as 2597.82. The critical level on the S&P 500 is 2603.55.

Five weeks ago on December 3, we had a similar inflection point at 2815.15. This level was not penetrated as the S&P stalled at 2800 and then the S&P 500 traded down to the low that was reached on December 26th at 2346.58.

The current configuration is a very similar inflection point and should a close be rendered below
2524 this week, and this will set the tone for a move down to the objectives of 2282 2134 levels over the next 6 to 8 weeks.

The above pattern is the most likely configuration that will unfold unless the S&P 500 trades above 2603.55.

The critical level on the downside today is 2582.75 if penetrated a decline toward 2569/2551 will be likely.

On the upside today, the critical level is 2603.55 penetration would indicate that a larger sideways trading pattern would unfold.

Best Wishes,

Zeller Kern Investment Committee