2019 is looking like a year that will require stock market traders and investors to adopt a very different approach from what has worked the past couple of years.
My focus – at least for the next few months – will be how much more damage the stock market can suffer and how long the suffering will last.
In this article I recap on 2018, analyse the key differences between this time last year and now, and discuss how I will be approaching the stock market in 2019.
Back in January 2018…
…stock market participants were relatively giddy, having enjoyed 24 months of double-digit positive performance in the stock market.
An it wasn’t just stocks. No major asset class lost money between 2016-2017. Stocks, bonds, gold – you name it! – all went up.
As a result of this, people had FOMO (fear of missing out). And we saw a pile of new money (~$100 bln) enter the market in January 2018.
We had a decent blip in 2018 when many of the short volatility ETFs blew up, but after that blip, stocks pretty much went straight up until September.
Fast forward to today…
…and the look-back period is VERY different from this time last year. This will have a great impact on the mindset of investors.
Think about it: All the new money that entered the market in January 2018 has lost value (on average). A LOT of money that poured into the market early last year went into FAANG stocks…which have been smashed. This is going to weigh on the collective psychology of all investors in the market – hedge funds, mutual funds and private investors alike.
Market participants have been timid and jumping at shadows virtually the entire bull market. This is one reason why I always wondered whether we had seen the ultimate top for this cycle. We never entered a period even resembling “irrational exuberance”. But if investors were timid last year, they will be downright cautious this year.
The Federal Reserve
In addition to more skittish sentiment, the markets now have to contend with the very real problem of the Fed.
The era of quantitative easing (QE) is long gone and we are now in the era of quantitative tightening (QT).
And this change in policy isn’t limited to the Fed either. Every major central bank (with the exception of the Bank of Japan) will be employing or switching to QT in 2019.
QE vs QT
As a reminder, QE is a policy designed to inflate asset prices. We are not talking about CPI inflation here, rather inflation of investment assets such as stocks and property.
QT is a policy designed to deflate asset prices. It is no coincidence that emerging markets (as represented by the EEM ETF) peaked within two weeks of the Fed beginning to run down the size of its balance sheet (which is the basic mechanism of QT).
There is understandably a lot of focus on the Fed and their plans to hike interest rates. We saw a heavy sell-off in December at the last rate hike, with markets demanding easier monetary policy and some sign of a “Powell Put”.
And really, 19 December 2018 was the first time in years the Fed told the stock market…we don’t have your back.
The stock market has grown so accustomed to having a “Greenspan / Bernanke / Yellen Put” that it behaved like a petulant toddler last month when Powell went ahead and raised rates d in spite of stock market volatility (whether this will prove to be a policy error is another story).
Maybe this display of petulance worked? Even though the Fed are still guiding to two interest rate rises in 2019, according to the CME FedWatch tool, the market is pricing in zero rate hikes for 2019 (and 2020). The market is essentially calling out the Fed on its guidance of two more rate hikes.
But even if the Fed does stop hiking rates in 2019, this does not mean QT will stop.
QT is not just rising rates
The runoff in the Fed’s balance sheet will continue, even if they stop hiking rates. Now we have never been in a period of QT before, so we do not know exactly how this will play out. But it seems reasonable to expect that where QE was a tailwind for rising asset prices, QT will likely prove to be a headwind.
The Fed shrinking its balance sheet will likely help to deflate asset prices and is a 180 degree reverse from the policy it has maintained since 2008. And all major central banks globally (expect the BoJ) will be employing policies that will generally deflate asset prices in 2019.
A rock and a hard place
The Fed is in a tough situation. The unemployment rate currently sits at 3.7% – a generational low. So the Fed are worried about the possibility of wage inflation. They have repeatedly reaffirmed that they will be “data driven” in their approach to interest rate policy and the data that they look at is not showing any sign of an economic slowdown. Accordingly, they feel as though they need to keep hiking.
Now the Fed doesn’t want to drive the economy into recession…but this is what their policies often end up doing at the end of the cycle. The data that the Fed looks at typically takes 6-9 months to work their way through the system and show an economic slowdown.
This leaves a data-driven the Fed with two alternatives: Either economic activity slows so the Fed can stop hiking or they keep hiking until tighter financial conditions cause an economic slowdown.
Neither of these alternatives are particularly bullish for stocks.
Indeed, it’s clear that companies like FedEx are already seeing signs of a slowdown:
Inflation vs the stock market
So which is the Fed more worried about, inflation or a falling stock market?
Any Fed-watcher in recent years might argue the latter. Hence the popularity of the term “Greenspan / Bernanke / Yellen Put”. Ever since the “tech wreck” the Fed has seemingly been quite prepared to cut rates whenever the stock market wobbled.
However these rate cuts have taken place when unemployment rate has been above the hypothetical Non-Accelerating Inflation Rate of Unemployment (NAIRU).
More recently, the Fed has warned of the dangers of managing a “high pressure” economy, where the unemployment rate is below the NAIRU.
The Fed’s dual mandate is to achieve price stability while maximizing employment. However if the Fed has to choose between hiking rates to curb wage rises (and hence inflation) and cutting rates to boost the stock market, they will stick to their mandate of maintaining price stability and keep hiking.
If they cut rates to boost the stock market when unemployment is at generational lows (and below the hypothetical NAIRU), there is a risk that inflation could become baked into the economy. And the Fed wants to avoid the 1970s horror show of “stagflation” at all costs.
Whither the Trade War?
The other negative force the stock market has to contend with is the ongoing trade war with China.
The recent Huawei situation shows how seriously the US is taking the situation and their propensity to stand firm against doing a deal at any price.
as financial conditions become more uncertain in 2019, there is a risk that both sides dig their heels in in order to appease their respective citizens. Watch for this situation to intensify before it gets better.
Back to the market participants
Almost all “buy and hold” type money managers will report negative performance for 2018.
Many hedge funds too will likely struggle. Hedge funds were the biggest owners of FAANG stocks and some have been chopped up my the recent oil and nat gas divergence.
Investors are going to be feeling outright fear as opposed to the FOMO they were feeling this time last year. This will lead to further outflows from equities.
Analysts around the world are paring back their 2019 eps estimaes. And as stock prices fall, eps estimates will fall further (if you thought eps estimates were a leading indicator of stock prices, I’m sorry to burst your bubble, but that’s not how this game works).
Tech stocks have tumbled, utilities stocks have been flat or even gained, the market is screaming “late cycle”.
Does the market have much further to fall?
This is, of course, the $64,000 question.
Last month the S&P 500 went very close to testing the long term uptrend line since March 2009. From this perspective, one could argue that the market has done all it needs to do – or close to it – for this correction.
What concerns me is we have seen some very important technical breakdowns but we have not yet seen any signs of capitulation. The VIX is nowhere near screaming panic and the market has not yet retraced a decent proportion of the prior upward move from Feb 2016.
In 2017, we saw a record 241 consecutive days without a 3% drawdown. In 2018 we have seen 7 drawdowns of 3% or more. We have also seen declines of 20% or more from recent highs in almost every major stock index. The personality of the market has definitely changed.
And the tide has turned. From 2008 to 2017 we have seen QE, falling rates, easy money and earnings growth. Today we are faced with QT, rising rates, debt becoming more expensive and earnings on bellwether stocks (like FDX) coming under pressure. The Pressure on the stock market is likely to be more downward in 2019 than in any other of the prior 10 years.
I think the best we can hope for over the next few months is continuing volatility and uncertainty has the market works its way through a protracted correction. We can expect more volatility as the market moves from extreme oversold to overbought levels in the short term. The worst outcome would be a bear market coinciding with a Fed-induced economic recession in 2019.
How to trade a market like this
Bear markets – or even correcting markets – are very different to trade than bull markets.
Bull markets are comparatively slow. You can hold through corrections and ride out the volatility and you can buy stocks breaking to new highs.
Trading a bearish stock market isn’t just simply doing the opposite of what you would do in a bull market because the personality of the market is so different.
Bear markets are faster. They turn more quickly and very often require you to take some heat on short positions. Stop losses consequently need to be wider. Bear market rallies can be ferocious. In fact, the biggest, most ferocious stock market rallies occur during bear markets (and we have seen one of those already!)
To trade a bear market successfully you will have to fight your natural human instincts even more so than in a bull market.
Sell when markets look better again and you fell your confidence returning. Buy when it feels like the bottom is falling out and all you feel is the collective despair of the market.
We will also need to shorten our time horizon and be more prepared to get in and get out.
I will be waiting for signs of a capitulation before changing this mindset.