The actions of the Federal Reserve since the Financial Crisis have been directly related to their efforts to sustain inflated assets valuations in the investment markets, and have led to a series of asset bubbles. People come to see investing as a game Wall Street plays for its own benefit. In fact, it is anything but a game. To most people, investing should be about growing their assets to provide a comfortable life in retirement. Wall Street (and the financial world in general) should create earnings and value companies based on those earnings, and not game the system to the point where valuations get incredibly stretched and then the bubble pops. It kills the average investor who happens to buy late in the cycle and then gets scared out of the market at exactly the wrong time when volatility increases.
OK, so what does all this mean to you and me?
Well, it muddies the investment waters again.
- Despite the Fed turning more visibly market centric, they DID NOT explicitly say they WOULD pause the rate hikes or slow the reduction of their balance sheet.
- Economic growth around the world is clearly slowing – in Europe many of the economies are already in recession, or on the edge, here in the U.S., the Q4 GDP 2018 numbers have yet to be released, but they will likely slip beneath Q3’s.
- The New York Federal Reserve published its U.S. household debt and credit report yesterday. It revealed a record 7 million Americans are at least 90 days behind on their auto loans. It further revealed that private debt scaled a record $13.5 trillion in last year’s final quarter.
- That same Federal Reserve Bank of New York gives a 21% chance of recession within the next year — its highest reading since 2008.
- A Bloomberg survey of economists has it at 25%… the highest in six years.
- Finally, JPMorgan estimates a 35% chance of recession this year — up from 16% last March.
Why Earnings Per Share Matters
Corporate earnings are clearly slowing – we may even see negative earnings growth in the 1st quarter of 2019 – the first time since 2nd quarter of 2016, and earnings estimates for all of 2019 – which were expected to be in the range of 8% to 10% just a week ago, are now hovering down around 1.5% to 3% in the most recent estimates. Why is earnings per share (EPS) growth important? Because valuations are not cheap, and current stock prices discount future earnings per share growth.
If you have a company that grew its EPS at double digits last year, but is only expected to see low single digit growth next year, and it’s trading at a high double digit valuation – uh oh, the price is probably going to come down.
So, without any “stimulus” by the Fed to the financial system, in this economic scenario you would expect stock prices in general to be weak. But, if the Fed steps in to add liquidity – either by allowing their balance sheet to remain at elevated levels – or even adding to it, or maybe even cutting rates again. Then we would likely see a short-term “sugar high” rally in equities as that additional liquidity is invested and drives prices higher in spite of slowing EPS.
The “R” Word (It’s Not Different This Time)
The similarities to the situation we saw in 1998 are interesting…Like today, many parts of the world were in distress. In response, the Federal Open Market Committee or FOMC (this is the branch of the Federal Reserve Board that determines the direction of monetary policy) shifted from a tightening bias to an emergency rate cut in a manner of weeks. The principal effect, was a two-year melt-up, or sudden surge, in stock prices that eventually led to the dot-com crash, in which the S&P 500 dropped by 45% and the Nasdaq Composite plummeted by 78%…
If global growth continues to weaken, it’s possible the Fed may decide to cut rates in the second half of 2019 as U.S. exports weaken and delayed effects of previous rate hikes take full effect. That would be received as good news by Wall Street, but in actual fact could be one of the strongest signals yet of a recession hiding in the forest, ready to spring upon us. Think about this – the last three recessions all started within 4-6 months of a Fed rate cut following a rate tightening cycle.
A New Reality
Bottom line, the Fed’s most recent about face could help stocks see a short term bump – and it’s possible the January bounce we saw from the year end lows is part of that liquidity bump – how much more, we will have to wait and see.
But, eventually the economic reality of slowing growth and the possibility of recession coming will weigh on stock valuations, causing more volatility and very likely a move lower for the market.
My advice is to use this recent bounce to re-allocate from any equity overweight – if you find yourself 75%, 80% or more in stocks, you’ve been given a window to make some changes and re-allocate some assets into high quality income assets. On that front, the yield curve is very flat, so there’s no reason to go out farther than just a few years in term, and don’t chase yield buying lower quality bonds because if we do see any kind of sharp economic weakness, or a rise in rates, companies with slim margins and poor credit will see rising default risk.
Most importantly, if you don’t have a financial plan – get one done. Having a sound plan in place will help you stick to your discipline when things get a little uncertain.
Randy has more than 15 years of experience managing financial assets for individuals, retirement plans and businesses. Randy joined YHB | Wealth Advisors in January of 2018 and serves as the Director of Wealth Management. Prior to entering the professional wealth management field, he enjoyed building entrepreneurial business ventures from start-up to eventual sale and providing accounting services for public and private firms.