December has been a particularly ugly month for stocks. The S&P 500 is down -11.7% for the month, -9.6% for the year, and -17.5% from its peak on September 20, 2018. This has certainly been a not-so-gentile reminder that stocks are volatile.
So what caused this selloff? Are we in a recession? There has been a lot of talk that we might be entering into a recession next year. But if this is the case, then why the sudden mass exodus? Why not sell earlier this year?
No, we are not currently in a recession, but we have been experiencing slower economic growth. There are few different reasons why we are seeing this selloff, including a flattening/inverting yield curve, leading composite indicators in a downward trend, a hawkish Fed, and the global trade war. Note, that we are experiencing an expanding economy, albeit at a slower pace. If you are not currently prepared for this market environment, we recommend that you remedy this. Until the leading indicators improve and we have a more dovish Fed, things will likely get worse before they improve.
Are we in a recession?
As best we know, we are currently not experiencing a recession. A recession, as defined by the National Bureau of Economic Research (NBER), is “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.” These observations were first recorded by Wesley Mitchell in 1927. By looking at historical records, we can conclude that there are 4 factors that tend to decline together, marking a recession:
On some occasions, there may be a temporary dip in one or more of these factors. However, the co-movement of all four is needed for an official recession to occur. All four of these factors tend to feed into each other. During a recession, people will lose their jobs (decline in employment). This will lead to a decline in income. As income declines, so will sales figures. As consumers buy less, output will decline and so on and so forth. During an upturn in the economy, this cycle also feeds into each-other, driving the economy higher.
Though, by watching the recent performance of the stock market, it my may feel like that one is imminent. After all, doesn’t a bear market (a 20% decline) indicate a recession? No, an economic recession is not necessary for the stock market to decline by 20% or more. There have been 14 post-World War II bear markets and only nine were associated with a recession. This brings to mind a favorite quote of mine:
The stock market has forecast nine of the last five recessions. – Paul Samuelson, 1954
This is important to note as 1/3 of bear markets have occurred without a looming recession. However, there has been an economic growth slowdown for every bear market on record. Remember, these slowdowns are cyclical and they are to be expected. Since the Great Financial Recession of 2008, there has been three full-blown cyclical downturns in economic growth, associated with at least four double-digit stock price corrections. (ECRI – businesscycle.com) All of these corrections have occurred when economic growth was easing.
Our Portfolios: Defensive
As many of you know, we invest only in index funds and we weight our asset classes based on market risk. Our investment philosophy is purposeful and based on rigorous academic studies (read more here). As economic conditions began to deteriorate and as equity valuations climbed, the 5 Bull Oak portfolios were shifted from a normalized allocation to a defensive allocation. As such, our portfolios have fared extremely well in this environment.
If your own portfolio is not prepared for such an environment, or if you would like a portfolio review, please feel free to reach out to us. We would be more than happy to offer a complimentary review.
Leading Indicators: Downward Trend
As indicated before, there are a few different reasons driving the equity markets lower. Primarily, it is a slower economic growth rate. This slowdown is finding its way to equity prices. Though, there are certainly other major contributors, including a flattening/inverting yield curve, falling leading indicators, and the Federal Reserve.
Flattening/Inverting Yield Curve
A yield curve is a curve that shows interest rate points across several maturity dates. Most commonly plotted chart is the US Treasury bond yield curve due to its importance in the economy (after-all, it is the largest and most widely-held security in the world).
A normal yield curve will show a normal risk appetite among investors (lower rates among shorter maturities and higher rates among longer maturities):
However, the yield curve has been flattening, meaning that the gap between short and long-term treasury rates has narrowed.
Leading Indicators: Downward Trend
There are many leading indicators, but one of the most reliable is ECRIs U.S. Weekly Leading Index, which has been in a downward trend since earlier this year.
The Federal Reserve just hiked interest rates to the range of 2.25% to 2.50%. While Coincident and Lagging Indicators suggest a healthy and robust economy, Leading Indicators are suggesting that all is not stable. As more evidence becomes apparent that inflation figures are dropping and not rising, a hawkish Fed is likely doing more harm to destabilize the economy, not stabilizing it. Furthermore, government and BBB corporate debt set to mature next year can pose a serious problem if borrowing costs become too high. As mentioned before (Tightening Conditions), the Federal Reserve has missed a lot of great opportunities over the years to raise interest rates. The Fed Funds Rate should be double what it is today. However, it is too late to be raising interest rates as the Fed could inadvertently be destabilizing the economy. If anything, the Fed should be holding rates where they are and waiting for a more opportune time to hike.
Economy Still Expanding: Slower Rate
I want to emphasize that the overall economy is still expanding and there is no evidence of a recession. However, we cannot rule out the possibility of a bear market in the near future. As long as the leading indicators continue to decline and we have a maladaptive Federal Reserve, the risk of a bear market continues to exist. Furthermore, if economic conditions continue to deteriorate, we might be faced with a recession.
The risk of a bear market will continue to be present until the economy shows signs of higher growth rates and the Fed moves from a hawkish stance to one that is more dovish. Investors should take this into account when allocating their portfolio and when planning for their future.