A Potential Road Map for the End of the Current Bull Market & Economic Expansion
History books refer to the last economic slowdown we experienced, triggered by the 2007-2008 financial crisis, as the Great Recession. Its impacts were so severe—the worst global recession since the Great Depression of the early 1930s—that central banks across the globe responded with an unprecedented emergency stimulus. But that era is now drawing to a close and, with it, the countdown to the next economic recession and bear market in equities has begun.
Economic, Market Cycles and Monetary Policy
Central banks raise interest rates when they feel an economy is overheating and they are more concerned about price stability (inflation) than growth. Central banks cut interest rates when their primary concern is growth. A natural question to ask is, “How do central banks know when to stop raising rates?” When something breaks!
Those who are the most leveraged with the weakest balance sheets are the first casualties when the Federal Reserve begins to raise interest rates and remove liquidity from the financial system. These are the entities Warren Buffet was referring to when he famously said, “It’s only when the tide goes out that you learn who has been swimming naked.”
As the casualties build and those naked run for cover, eventually the increased financing costs and slower economic activity culminate in a recession (in red).
With the Fed currently in a tightening cycle, many strategists are now wondering who the main casualties will be and when will we see one rate hike too many. This is sometimes not obvious until it becomes front page news BUT the historical fact that Fed tightening typically ends up with a financial crisis and/or recession tells us that risk management should be priority number one.
In a widely-read note, “Central Banks’ Reversals Signal the End of One Era and the Beginning of Another,” Ray Dalio, founder of the world’s largest hedge fund, made the following observation, writing just last week on July 6th:
Central bankers try to tighten at paces that are exactly right in order to keep growth and inflation neither too hot nor too cold until they don’t get it right and we have our next downturn. Recognizing that, our responsibility now is to keep dancing but closer to the exit and with a sharp eye on the tea leaves (emphasis added).
If Ray Dalio is communicating this in the open, you can be assured that many others are already moving closer to the exits or, at least, be planning a strategy on how to get there.
Barry Bannister’s Roadmap
A large part of this goes back to the Fed, and Barry Bannister, Managing Director and Chief Equity Strategist at Stifel Nicolaus, has shown that we are getting closer and closer to “one rate hike too many.”
As he explained in our Macro & Portfolio Strategy conversation with him in March (audio here, slides here), because of rising debt levels, every Fed rate raising cycle since the early 1980s has seen lower and lower peaks prior to recessions. The reasoning for this is quite simple: as debt levels increase, interest rates (borrowing costs) have larger financial impacts on the overall economy and, thus, it takes less and less tightening to throw the economy into recession.
This is important to understand as the last interest rate cycle peaked near 5.25% for the Federal Funds Rate and we are likely to peak lower than that given the record amount of debt accumulation in the last 8-10 years. Running a simple linear regression of the Fed funds rate from the early 1980s to the present shows that we are now moving towards the upper threshold of what the economy can tolerate (note: red dotted line indicates the Shadow Fed Funds Rate, calculated by the Atlanta Fed to include the effects of quantitative easing).
Given the above, we also wanted to know the following: how much did the Fed raise rates from trough to peak, on average, before it led to a recession and how long did it take before the recession occurred? If we look at the last six Fed tightening cycles, we see that interest rates moved 6.73%, on average, from trough to peak, with a recession typically occurring 9 months later.
Though this helps us to further define a possible roadmap for the end of the current bull market and economic expansion, as we all know, averages can be misleading because the stock market doesn’t neatly follow historical patterns. That being said, looking at the data further revealed something quite interesting.
Interest rates were in a long-term uptrend until they peaked in the early 1980s and have since been in a long-term decline. This plays a very important role when we look at the magnitude of Fed tightening cycles and how long before a recession takes place.
During the secular rise in interest rates, Fed tightening cycles were much larger, averaging over 9.5%, while the lag time before recessions was much shorter, averaging 3 months. However, during the secular decline in interest rates, we see just the opposite: Fed tightening cycles are much smaller, averaging 3.88%, with a lag time of 15 months. A summary of the data is presented below.
Let’s now consider the current Fed tightening cycle and how that relates to a possible market peak and economic recession. Taking into account the effects of quantitative easing, interest rates reached their ultimate low at -3.00% in 2014 (using the Shadow Fed Funds rate). This means the Fed has tightened a total of 4.25% given the current level of 1.25%. If we assume that interest rates are still in a long-term decline, according to the average of 3.88% during the last three cycles, we are likely far closer to the end of the Fed’s tightening cycle than the beginning, with a possible recession around the 2019 timeframe (~15 months ahead).
This is the economic forecast that Barry Bannister at Stifel is modeling; when it comes to the stock market, Barry’s work suggests that the Dow Jones Industrial Average may see a final peak around the middle of next year before declining into 2019. Barry’s roadmap is shown below:
If we do follow the historical script and Barry Bannister is correct with his recessionary window, then the remaining upside potential of the bull market is fairly limited and we need to instead turn our attention to the market’s downside risk. Looking at the bear markets that have occurred since the Great Depression, we see that the average decline in the S&P 500 is 45%.
This explains our shift towards greater risk management this year and in the months ahead, which has clearly been reflected in the asset allocation shift in our client accounts from stocks to cash and bonds, both individual bonds and actively managed bond funds.
Keeping a Sharp Eye on the Tea Leaves
As Ray Dalio suggested, central banks around the world are in the process of removing the punch bowl of liquidity from the asset reflation party and we need to watch the tea leaves to gauge whether or not Barry Bannister’s end-game scenario is playing out. One tea leaf we will be watching closely is the credit market and the message it is giving when it comes to general financial conditions.
To monitor the financial health of the US credit system, we look at the Bloomberg US Financial Conditions Index in which readings below zero indicate above average levels of stress while positive readings indicate a healthy market characterized by below average levels of stress. Currently the Bloomberg Stress Index is near the highs of the present cycle and why we feel an economic recession is not on the immediate horizon. It would take a move into negative territory to begin giving us cause for concern.
Our own recession probability model also paints a benign economic environment in which there is only a 9.5% probability of the US economy slipping into recession. It would take a move north of 20% before we became alarmed.
Time to Be Fearful?
“Be fearful when others are greedy and greedy when others are fearful.” – Warren Buffett
One of Warren Buffet’s favorite valuation tools to analyze the stock market is the market cap of equities relative to the economy as measured by GDP, which has been termed “The Buffet Indicator.”
It is currently at one of the highest readings ever, only eclipsed by the tech bubble of the late 1990s. By this measure, stocks are expensive as investors are greedily bidding prices above economic (GDP) fundamentals.
This is a time to be fearful while others are greedy and is why we have begun to decrease client allocations’ to the stock market. Following the rule of successful investing of buying low and selling high, we are decreasing our stock allocation due to elevated valuations by effectively selling high (valuations) and looking to buy low (valuations) when better opportunities present themselves.
Again, if we follow the business cycle script of the last 11 business cycles and assume a recession to occur late-2018, early 2019, as Barry Bannister’s work suggests, stock market returns will have limited upside from current levels. Given the average market decline of 45% during bear markets, risk vs. reward is in clear favor of a defensive posture, which is reflected in the asset allocation for our clients.
Smart Money Signals
We are not the only ones gradually becoming more “fearful” by beginning to reduce the risk of our client’s assets. As mentioned above, the world’s largest hedge fund manager, Ray Dalio of Bridgewater, says to start dancing closer to the exit with an eye on the tea leaves. In a recent interview with Barron’s, Daniel Ivascyn, Chief Investment Officer of PIMCO, who took over the reins from Bill Gross, said they are beginning to shift their bond fund to higher quality assets like US Treasuries while selling richly-valued US corporate bonds (source: “Pimco’s Daniel Ivascyn on Staying Ahead of the Fed,” 07/08/17). His feeling is that markets could get more nervous as the Fed begins to unwind its balance sheet and so the firm has been reducing risk over the past eight months.
Echoing the thoughts of PIMCO’s Ivascyn was JPMorgan’s CEO Jamie Dimon as highlighted in the following article:
JPMorgan Chase & Co. Chairman Jamie Dimon said the unwinding of central bank bond-buying programs is an unprecedented challenge that may be more disruptive than people think.
“We’ve never have had QE like this before, we’ve never had unwinding like this before,” Dimon said at a conference in Paris Tuesday. “Obviously that should say something to you about the risk that might mean because we’ve never lived with it before.”
Central banks led by the U.S. Federal Reserve are preparing to reverse massive asset purchases made after the financial crisis as their economies recover and interest rates rise. The Fed alone has seen its bond portfolio swell to $4.5 trillion, an amount it wants to reduce without roiling longer-term interest rates. Minutes of the Fed’s June 13-14 meeting indicate policy makers want to begin the balance-sheet process this year.
“When that happens of size or substance, it could be a little more disruptive than people think,” Dimon said. “We act like we know exactly how it’s going to happen and we don’t.”
Cumulatively, the Fed, the European Central Bank and the Bank of Japan bulked up their balance sheets to almost $14 trillion. The unwind of such a large amount of assets has the potential to influence a slew of markets, from stocks and bonds to currencies and even real estate.
As Dalio suggests, we will be focusing on the tea leaves intently in the months ahead. If financial conditions begin to turn negative and recessionary probabilities increase, our plan is to continue to reduce client exposure to the stock market and increase our allocation to lower volatility assets like cash and bonds.
Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.
Securities offered through Puplava Securities, Inc. Broker/Dealer, Member FINRA/SIPC. Investment advisory services offered through Puplava Financial Services, Inc. a Registered Investment Advisor.