What to make of the new equity highs? The evidence still shows that growth is slowing, writes Landon Whaley.
Let’s talk about bounces and the Gravitational Framework.
The U.S. equity market is currently experiencing its third, post-correction, bounce this year.
After the worst December since the Great Depression, the S&P 500 ripped the first four months of 2019, peaking at a new all-time high on May 1, and then proceeding to sell-off 7.5% over the next four weeks.
After bouncing off the June lows and minting yet another all-time high on July 26, the S&P 500 then experienced another 6.7% drawdown as markets turned ugly during August. This correction was followed by a second bounce, to yet another new all-time high on Sept. 19.
This newly minted all-time high was promptly rejected, and the S&P 500 declined yet again, this time to the tune of 5.6%. After bottoming on Oct. 3, the S&P has now bounced for the third time, and as of Wednesday’s close has printed yet another new all-time high.
Keep in mind that not everyone views this latest bounce in the same way. In fact, bounces are one of the hardest aspects of investing for investors to grasp. I’m talking about both countertrend bounces that occur in bear markets as well as last-gasp bounces of long-standing bull markets.
Most investors struggle to decipher whether a decline in a bull market is a buyable dip or the beginning of the next bear market. Similarly, is a countertrend bounce in a bear market a shorting opportunity? Or is it the beginning of the transition into the next bull market phase?
Well, if you’re hyper-focused on price like most investors are, then deciphering these nuances in markets is extremely difficult, if not downright impossible. Any price action, bullish or bearish, must be viewed in context to be truly understood. Our Gravitational Framework provides this context.
The Framework
We start by gaining insight into the economic and monetary policy backdrop of the market in question. We do this through our Fundamental Gravity. If a market in a bearish formation is rallying, or a bullish formation is declining, we ask ourselves: has any aspect of the Fundamental Gravity for the underlying economy shifted? If the answer is no, then the price is diverging from the underlying Fundamental Gravity. Such divergence is a regular occurrence in markets but rarely lasts longer than six weeks.
We believe that price offers no real value on its own and often tells lies, so we then turn to our Quantitative Gravity to gain insights into what’s happening beneath the surface of price. The Quantitative Gravity further clarifies whether the price bounce is a façade to be taken advantage of or the beginning of a phase transition to a new directional regime that needs to be respected and monitored.
Finally, the Behavioral Gravity helps us quantify whether the bounce has shifted investors’ perception of that market, and to what degree.
When you analyze a market utilizing this three-dimensional approach, it generally gives a very clear picture of what the price action means, and more importantly, whether the bounce is providing you with an opportunity to position yourself in markets with a better risk-reward set-up than before the bounce occurred.
The Data
The U.S. macro data continues to be downright atrocious. U.S. industrial production growth just turned negative for the first time since 2016, and now for the first time since the credit crisis, the United States, Germany, Japan, and the United Kingdom are all experiencing industrial production contraction at the same time. Durable goods growth and capital expenditures both slowed to new cycle lows, and into contraction territory, and Q3 GDP growth just slowed to +2.0%. I could regale you with a long list of additional data points to back my claim, but I trust you get the point.
At the micro-level, Q3 earnings results tell the whole story. Of the 498 companies in the S&P 500, 191 have reported an aggregated earnings growth rate of -0.40%. Of the 11 S&P sectors, five are currently in negative earnings territory, including energy (second straight quarter), technology (second consecutive quarter), materials (second straight quarter), consumer discretionary (second consecutive quarter), and financials. On Thursday, Amazon (AMZN) experienced its first decline on earnings in over two years, but apparently the consumer is strong.
The executive summary is that a third of companies have reported, overall S&P 500 earnings growth is negative, and four sectors are officially in an earnings recession. Oh, and historically, the lower quality companies announce results later in the season, which means these numbers will most likely deteriorate from here.
The Bottom Line
The key to successfully managing bounces is to contextualize them against a backdrop of the Gravitational Framework because it helps you identify where risks and opportunities lurk within the price action.
In contrast to everything being touted by the Old Institution, the microenvironment is garbage as earnings are not better than expected, the macro data continues to confirm that U.S. growth is slowing, and we are beginning to see an acceleration in inflation for the first time in 18 months.
Against this backdrop, our playbook remains to be long utilities, Treasuries, REITs, and gold-related assets, and with an acknowledgment that at some point over the next few months, we will transition into more inflation-sensitive asset classes.
Please click here and sign up to receive the latest edition our research reports as well as to participate in a four-week free trial of our research offering, which consists of two weekly reports: Gravitational Edge and The Weekender.
