Broadly Based US Equity Indexes Turn to Negative Results YTD.

In the month of October, the DJIA, the S&P 500 and the NASDAQ fell sharply with an unusual degree of coordination. This has resulted in industrial equity averages falling into negative territory for 2018; the NASDAQ is about even on the year.

Pundits, bulls and retail investors dismiss the present decline as simply another buying opportunity on a dip. As a behavioral economist by training, an investor by profession, a skeptic by experience and an old timer in terms of market experience (having been through the crash of 1987 as well as through a myriad of supposed “soft-landings” that turned out to be bruising economic downturns), the current so-what attitude of the investment herd gives me great pause. In my considered opinion, this is not just another buying opportunity; this seems more ominous.

Bull markets inevitably end. Equity valuations, in general, offer an inciteful glimpse into the future for any economy. What stock prices are logically signalling is a forewarning of multiple economies at economic peaks. I’ve read opinions by technicians indicating that the current pullback is simply the result of “dumb money” panicking. Such pronouncements ignore one thesis busting fact; global equity values have fallen by more than $10 trillion in the past month alone. There just isn’t that much dumb money on the planet. It seems self-evident that the lion’s share of the selling is not dumb money, but rather smart money. Dumb money buys too much at market tops and sells entire portfolios at market bottoms. In October, persistent beating down of valuations in multiple sectors seems to be the furthest thing from knee-jerk reactions by panicky weak hands. Companies such as Facebook (FB-NASDAQ, $141.60) are down a whopping 37% from their 2018 high. That is not indicative of a standard correction. Plainly, such moves seem more to be institutional distribution, rather than the purported portfolio rebalancing.

Thus far in the current earnings season, industrial results seem to be coming in quite light. Companies such as Colgate (CL-NYSE, $58.53), 3-M (MMM-NYSE, $187.70) and Caterpillar (CAT-NYSE, $116.02) all failed to meet revenue and earnings expectations. These businesses are representative of the consumer products, industrial manufacturing and heavy machinery industries. Each of the aforementioned companies seemed perplexed as to why revenues came in light, expenses came in heavy and order books looked less than firm. For those willing to take the time to engage in a meaningful macro view from some height, the reasons for pause appear obvious. Things look great in America; they are less so in many other parts of the world. Investors are paying too much attention to reports of American economic growth and almost no heed is being paid to some glaring failures in other economies.

India has experienced a sharp currency decline and appears to be very light on foreign reserves. Brazil is on the verge of voting in a hard right candidate in order to deal with seemingly intractable corruption scandals. Argentina is, apparently, in need of an IMF bailout. The new leftist president of Mexico has just decided to cancel a badly needed modern airport outside of Mexico city based upon a rigged poll and claiming it to be the will of the people. Capital outflows from Mexico will certainly ensue when a government abrogates contracts on the basis of mob rule, rather than the rule of law. Italy has decided to stick a thumb in the eye of the EU and run a budget deficit beyond agreed levels. China is engaged in a growing trade war with America, has no interest in acknowledging a change in the status quo and is, in my view, preparing for outright expropriation of American interests in Sino-American joint ventures. Rising oil prices are once again taking their toll upon emerging markets economies. Governments in EU nations appear to have reached a conclusion that FANG companies (Facebook, Amazon, Netflix and Alphabet, the parent of Google) represent taxation opportunities and are starting to engage in a series of punitive and backward reaching revenue grabs. Once a new tax is created, it typically metastasizes. These tax grabs will impact future profits among key NASDAQ businesses.

https://finance.yahoo.com/news/uk-announces-groundbreaking-new-facebook-tax-raise-400m-170039863.html

Chinese manufacturing statistics for the month of September also reinforce the thesis of a global economy that is tiring. Officially, with a manufacturers purchasing index gauge of 50.2, China would still be in a growth phase. The worst kept secret in the world, statistically speaking, is the Chinese government’s preference to fudge numbers for the better. given the forward looking indicators mentioned in the report, it seems a foregone conclusion that manufacturing in China contracted in the 3rd quarter of 2018, and looks even worse today.

https://ca.finance.yahoo.com/news/china-feels-trade-war-pain-013043374.html

Samsung has also called for a capex slowdown and profit drop in the cyclical chip business. Semiconductor order books represent an important indicator of future business and consumer spending.

https://ca.finance.yahoo.com/news/samsung-electronics-posts-record-third-quarter-profit-warns-005400952–finance.html

Most importantly, interest rates have shot up sharply since the latter half of 2017. The US federal reserve has made it abundantly clear that expectations of a further series of increases in 2019 could add as much as .75% to the fed rate. The cost of borrowing for consumers and businesses is set to rise by (including bank profit margins on top of the wholesale increase) a further 1% by the end of 2019. Some investors consider a possible US fed rate of 3.1%, by the latter half of 2019, to be a picayune thing, considering that interest rates were far higher in the 1980’s and 1990’s. Indifference to upward moves in the fed funds rate is likely THE real danger to investment policy among fund managers and investors at this time. For the typical family in America, the rate increases will equal about 5% of 2019 discretionary income.

In summary; interest rates have gone up sharply from lows, economic cracks are appearing in the foundations of many national economies and energy prices are exerting negative pressure upon emerging nations that represent net importers of energy. Governments outside of the United States are starting to engage in direct tax grabs on individual companies in the technology service sectors; such actions are seldom framed as policy and are usually recognized by investors for what they truly are, punitive cash grabs. To top all of this off, the equity prices in the United States have been on a decade long, largely unbroken, ascension. At some point, the party always closes down.

Many investors, both amateur and professional alike, consider this pullback to be just another buying opportunity in the never-to-end bull market. They cite Trump tax cuts, rising corporate earnings, full employment and strong consumer confidence. I see all of these points as well, but merely point out that all of this is known and assumed to be persistent. If growth in corporate earnings does not persist because of further interest rate hikes, expenses that outstrip revenue growth, or punitive government policies, then the whole bull thesis can quickly collapse.

At the start of 2018, I wrote my belief that equity markets might be hard pressed to wind up even on the year. I stand by that point. I believe that the risk-reward for new money entering the market at this time is not favorable. This party looks very tired. Should the media start to use the term “soft-landing” in the coming quarter, in an effort to spin a slowdown, I’ll become downright frightened.