Zeller Kern’s Investment Monitor

Is The Market In a Respite, or Has It Topped?

June 26, 2018

By Steve Zeller                           

The market continues its sideways trading range that it has been in for the last several months. As of the market close on Friday, June 22nd, the Dow Jones Industrial Average is up (including the reinvestment of dividends) +0.54%, year-to-date. The S&P 500 is up +4.01%. But the Nasdaq continues to be the stellar performer as the great tech mania continues, with the index +11.44%, year-to-date. The NASDAQ has also been accompanied by the Small Cap Index, with the Russell 2000 recent rally producing a current year-to-date performance of 10.38%

Most of the International indexes remain in negative territory for the year, with the MSCI EAFE Index down -1.73%. The MSCI EM Latin America index is down -13.74%, and the Hang Seng HSI Index is down -1.94%, year-to-date. Bond indexes are down as well, with the BBgBarc US Agg Bond Index down -1.95%.

The chart below, illustrates just how sideways we’ve been going since February. So far this year, the market has given us quite a bit more volatility compared to last year, with relatively little positive performance outside of the Tech sector and Small Cap Stocks.

The overall trend appears to be negative. This has caused our “Downside Protection Portfolios" to remain more in a defensive posture since February. However, our Dynamic Allocation Portfolios remain invested, with the growth portfolios notably outperforming the S&P 500, the Dow Jones Industrial Average, and even outperforming the NASDAQ, so far this year.

The question remains as to whether we are within a sideways pattern that will eventually breakout into new highs, or whether the high rendered in January was the final high for this current bull market that is one of the longest on record. A recent article in the Visual Economist, provides an informative graphical interpretation of the last cyclical bull markets since World War II.

The current bull market is now over nine years in length, and as you can see from the chart above, bull markets don’t last longer than ten years in duration. So, suffice to say that this current market run is in the late stages of its cycle. Also, keep in mind what it took to make this happen, which has been an unprecedented policy of central bank intervention, with trillions of dollars of money printing and asset purchases, which included the purchasing of treasuries, corporate debt, mortgages, auto loans, and even stocks. The Bank of Japan, reportedly owns 70% of the of the value of the Nikkei Index. Also keep in mind that we are within an era of unprecedented stock buy-backs with a large amount of U.S. corporations participating in aggressive stock buy-back programs. Throw in margin debt near all-time highs, the common investor disregarding risk, and what appears to be a period of very cheap money borrowing coming to an end, and we could be facing a significant correctionary period in the future for the equity markets.

The trend for interest rates and yields within the bond markets appear to have entered a period of rising rates. The economy is strong and the need for the Fed to buy assets to drive down interest rates has gone away. The Fed has shifted its policy to one of raising short term rates and moved to unload the assets on its balance sheet. However, this is a very tall order when you look at where they are, with a current asset balance of over $4.3 trillion, and where it was before 2008, when its balance sheet only totaled approximately $800 billion.

In the meantime, asset prices have accelerated upward in value in several areas, outside of the stock market. The housing market is now appearing to be within a bubble like situation, with home prices now up a stunning 75% from their 2012 lows. The average median home price is now at the $245,000 range. According to some reports, home prices are up 4.5% over the last year and appear to be accelerating. Flip through the guide on your television, and you’re likely to see a show on house flipping. Longer term, we’ll need a rise in real rages for these prices to be sustainable.

But all of this activity and rising asset prices have been accompanied with a debt mania. This is a cycle that has repeated itself throughout history, though not to this magnitude. John Mauldin recently published some past quotes about debt and how it was viewed. Here are some examples:

Rather go to bed without dinner than to rise in debt. -Benjamin Franklin
What can be added to the happiness of a man who is in health, out of debt, and has a clear conscience? -Adam Smith
A man in debt is so far a slave. -Ralph Waldo Emerson

We are in a period that is completely on the other side of the spectrum when it comes to our view of debt. Instead of a mindset of avoiding debt and getting out of debt, we seem to have embraced it and have become complacent about it continuing to rise. To put this into perspective, it’s one thing that the Federal Government is now $21 trillion dollars in the hole, but if you count all corporate, municipal, personal, household debt, it now exceeds $67 trillion!

According to a report published by the New Yok Federal Reserve, the total Household Debt and Credit is now above $13 trillion and continues to rise. As of the end of the first quarter of 2018, total household debt reached $13.21 trillion, rising by $63 billion. Balances increased by an increase in mortgages, auto loans, and student loans. Aggregate household debt balances increased in the first quarter of 2018, for the fifteenth consecutive quarter, and are now $526 billion higher than the previous high reached in the third quarter of 2008, which peaked at $12.68 trillion.
When debt expands as it has for the duration of this economic cycle, it injects money into the economy and increases consumer spending and overall consumption. However, when debt begins to peak and contract, it puts pressure on demand, inventories begin to swell, prices begin to decline when profits, spurring lay-offs, and recessionary pressures. Both lenders and borrowers become spooked, loans decline and liquidity vanishes, and does so very quickly. Debtors become strapped to service debt due to impinged cash flows and begin to default. This ignites a debt spiral and prices for assets begin to crash. This is known as debt deflation, and it is extremely destructive.
We are not certain, or have no way of knowing, when a contraction will occur or what the magnitude would be. But as debt expands, and just not domestically but globally, the likelihood increases and the potential for greater damage increases. Like all things, debt comes in style and goes out of style. When it does begin to go out of style, watch out.
Meanwhile, the economy is humming along, and a recession appears to be nowhere in sight. Unemployment is at a historical low, GDP appears to be solid, business confidence is rising, optimism appears to be leading people to believe that an economic slowdown is at least 2 years away. But that’s not how it works, slowdowns happen unexpectedly and market peaks do so as well. As we have reminded our readers before, bull markets don’t end on bad news, they end on great news. We do expect this economy to continue in a positive fashion, however, we don’t think it will last quite as long as everyone expects.
There are some other issues to deal with in the near future, such as a coming pension crisis. Why do we say crisis? Because State and Local governments refuse to do anything about it and haven’t offered any kind of reform. Meanwhile, baby boomers are accelerating the rate of their retirements, and flooding the demand of pension collections. Pensions are becoming more underfunded, and are increasingly producing instances of becoming late in sending checks to their recipients. This is a major problem that is rapidly picking up steam, and with our population rapidly aging, the birth rate declining as a result of the younger generations not forming families as well as the fertility rate is plunging, which they are not sure why.

This combination is unprecedented. Average life spans have increased to 80 and beyond, and birth rates have plunged to near or below replacement levels. However, as of a few years ago, life expectancy declined for the first time since 1993, according to a 2016 Washington Post article. This has been due to rising fatalities from heart disease and stroke, diabetes, drug overdoses ala the opioid epidemic, and accidents. But generally speaking, the rapidly aging population along with a non-expanding younger population is a recipe for a major train wreck for pensions if it is not addressed.
The forces of debt and a pending pension implosion are likely too massive to be prevented with any level of tax cuts, deregulation, or expanding economy. It is something to pay close attention to and consider when protecting your investment assets.
We’ll see how the market behaves here in the coming weeks. There is increasing pressure for the trends to move more into the positive territory, in order to remain in a sideway or favorable direction. Current technical analysis suggests that if the S&P 500 drops below 7350, that the uptrend from the previous lows from the year has been completed, and would have an increased risk of heading into a decline. From there, it would make it even more difficult for the market to head upward and break past its previous high. As of last week, the 200 day moving average for the Dow was at 24,250 – Consensus is that if the markets fall below the 200-day moving average, it drastically increases the probability of the market heading into a correction or bear market.
There are a lot of new headlines driving the market, currently and could change trends quickly, either way. A number of economic data points are released this week including, New Home Sales and the Dallas Fed Manufacturing Survey on Monday, Consumer Confidence on Tuesday, Durable Goods Orders on Wednesday, GDP Consensus Estimates and Jobless Claims on Thursday, and Chicago PMI and Personal Income Consensus on Friday.
On another note, it is becoming increasingly interesting to watch the economic activity on the International front. The chances of Japan heading into a recession appear to be increasing. As you may recall, Japan has gone all in on the policy of quantitative easing, and by some estimates, they already own roughly 70% of all the ETF open interest related to the Nikkei. Yes, we have been enjoying a period of economic growth here in the U.S., but conditions remain rather precarious within the balance sheets of the central banks. Japan will be a place to keep an eye on.

Best Wishes,

Zeller Kern Investment Committee