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Caution Signs for Investors

12/31/2018 5:00 am EST


James Stack

Founder, InvesTech Research

Notable signs of deterioration have developed in the current situation. The U.S. housing market is in trouble, Margin Debt is starting to tank, and most critical of all, our Negative Leadership Composite is deep in bearish territory, cautions Jim Stack, money manager, market historian and editor of InvesTech Research.

Despite this condemning evidence, we cannot say with absolute 100% certainty that we are in a bear market. Here’s why — a number of key economic indicators remain at or near their most optimistic levels in more than a decade.

Consumer Confidence has rarely been more ebullient, with recent Conference Board survey results at the most positive level in 18 years. Although this indicator is considered to be leading and usually rolls over before a recession, it’s interesting to note that past stock market peaks have frequently coincided with excessive levels of consumer optimism.

One of the most explicit measures of speculation in this market is Margin Debt, which represents the willingness of investors to borrow money to purchase stocks. Last January we stated, “For now, confidence in this bull market appears to be supported by the willingness to borrow, but when this greed shifts to fear it will amplify losses as this lofty leverage is unwound.”

Margin Debt has fallen sharply since its peak in January and recently experienced its largest one month decline since the collapse of Lehman Brothers in the 2008 Financial Crisis. While a decline of this magnitude does not guarantee a bear market, the fall has intensified our focus on this very important warning flag. A further deterioration could exacerbate investors’ concerns and lead to additional stock market selling.

Nothing has been more effective in killing bull markets than a deteriorating monetary climate and rising interest rates. Since 2015, the Federal Reserve has raised the discount rate nine times. Correspondingly, short-term interest rates, as highlighted by the 2-year Treasury Note in the chart at left, have increased dramatically, reaching levels last seen over a decade ago.

Historically speaking, the yield curve is an indicator of the market’s expectation for future growth. In that regard, the yield on the 2-year Treasury Note continues to climb upwards, while the yield on the 10-year T-Bond remains persistently low.

A large difference between the 2-year Treasury and the 10-year T-Bond tends to occur when market participants believe future growth will be strong. However, as it stands today, the yield difference between these two fixed income securities is only about 0.15%, indicating that future economic growth expectations are depressed.

The combination of a declining growth outlook and an increasingly negative monetary climate has generally had dire consequences. Out of the past 11 tightening cycles, nine have resulted in a recession, while only two led to an economic soft landing. Based on history, the current investment landscape is tilted towards a negative risk/return relationship as equity prices remain susceptible to future downward pressure.

This journey for investors has been emotionally treacherous, yet we have pursued a disciplined and increasingly defensive strategy, incrementally moving from 82% invested in January to our current 55% stock market exposure. This is the most defensive position in the Model Fund Portfolio since the last bear market.

While 2019 will undoubtedly continue to see volatility, and future Fed action remains a wild card, we are well positioned to handle the unknowns. Thus, any near-term trade recommendations will likely be focused on maintaining a defensive and proactive sector balance.

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