Why was the stock market down almost 6% last week? I know what you’re thinking – has this guy been under a rock somewhere? But I’m serious. I know what all the pundits, commentators and talking heads are saying about the immediate cause. It’s about the China devaluation and the knock on effect in other emerging markets. It’s about global growth fears. Asian currencies are getting hit from the Singapore Dollar to the Malaysian Ringgit to the Vietnamese Dong. And yes, I know about the Asian crisis in 1998; I’ve got blue jeans older than most people in this market. And of course, I know about all the US dollar debts built up over the last few years in Asia and how those dollars will be harder to pay back with weaker currencies. But did we really just lose 6% on the US stock index because Kazakhstan devalued the Tenge? Seriously?

What I really mean with that question is why did all these things come to a head last week? Capital outflows from China were not news just prior to the Yuan devaluation. I wrote about it months ago so it surely wasn’t hard information to find. Falling Asian currencies are not news; more the norm recently I’d say. The US dollar debt boom in Asia has been written about ad nauseum in numerous publications. Brazil has been slowly deteriorating for months, a main course of recession and a political crisis for dessert creating economic indigestion. The rest of Latin America is its normal dysfunctional self, a dictator here, a socialist there. Surely it isn’t news to anyone that the Chinese economy has some problems; it isn’t just coincidence that the Aussie and Canadian dollars have been falling for months. So, why did everyone decide last week that these things matter?

Darned if I know. Just chalk it up to randomness. Nothing happened last week that I saw that should have had people, by Friday afternoon, panicking and wondering what the other guy knows that they don’t. It’s like those experiments you see sometimes where they are dropping grains of sand on a pile and suddenly that one extra grain sends the whole pile falling down. Then they repeat the exercise and this time it’s an entirely different grain of sand that starts the cascade. Randomness.

There were plenty of warning signs that this market was ready for a fall. The yield curve has been flattening, nominal growth expectations waning. Credit spreads have been steadily moving wider, first starting last summer and then starting to widen again this summer as the shale bust resumed. Valuations have been high for two years – at least. And of course, long term momentum has waned, something I’ve been writing about since the spring. But again, none of that is really news; only credit spreads recently generated a new sell signal. Indicators you can rely on, ones highly correlated to market outcomes – like the four mentioned above – are a necessary piece of the investment process, taking the emotion out of the decision making process. But they are only indicators and won’t tell you when that critical piece of information, that final grain of sand, will hit the market. Randomness can’t be modeled.

What is particularly interesting about this selloff is that if it is a result of waning growth expectations, the parts of the market that provide us with information on future growth must not have gotten the message. As a long time bond bull I have to say that I was at least somewhat disappointed with the action in bonds last week. If the stock market is right about waning growth, bonds should have had a bigger move last week, rates should have fallen further. In the TIPS market, real yields barely budged; real growth expectations in the bond market are basically unchanged the last couple of months. It is only inflation expectations that are falling according to the bond market.

Or maybe it isn’t that odd to see US stocks fall as emerging markets wake up to reality. Almost all the growth for US multinationals over the last decade has come from emerging markets. Remember the emerging emerging market middle class that was going to want all the comforts of the first world? So, as emerging market economies slow or contract, earnings growth for the S&P 500 becomes that much harder to find. But if the TIPS market is to be believed the loss of that earnings growth for a large slice of US companies will not have any impact on US economic growth. That’s possible I suppose but it sure seems unlikely.

Or maybe the sell off in stocks had nothing at all to do with China and emerging markets. Heck, I don’t know, maybe it was because Donald Trump drew a crowd of thousands down in Alabama (see The Weekly Snapshot). Despite amassing a pretty impressive pile of personal dough, the Donald’s understanding of economics is deficient even by politician standards. The fact that he is leading the race on the Republican side – I know, I know, it’s early – is at least a little worrisome. And with Hillary’s campaign spending more time talking about emails than policy positions, the draft Joe Biden movement is gaining. I’d just say to my Democratic friends that if Joe Biden is your fall back position you are in trouble. Markets do try to discount future events so maybe last week was building fear of a Trump/Biden match-up. The market knows what to expect from Hillary or Jeb. All we know about Trump and Biden is that they have a taste for their own shoe leather.

Investors should probably spend a lot less time on the news anyway. More often than not it is just a distraction from what is really going on. The indicators we follow are all still flashing warnings:

  • Credit spreads are still widening across the credit spectrum.
  • The yield curve continues to flatten but isn’t all the way to flat yet.
  • Valuations are historically high.
  • Momentum favors bonds over stocks.

From a short term perspective, the market is very oversold right now. Sentiment has turned very sour, very quickly. Put/Call ratios are high and the VIX is nearing 30. A bounce soon should probably not be a surprise. It may not happen before a deeper selloff; I wouldn’t be surprised if some margin calls went out over the weekend that could ramp up the selling at the open Monday. But we will get a bounce and unless some of those indicators above change for the better, it won’t mean anymore than last week’s selloff. It’ll just be randomness in the opposite direction.

Having said that, I am coming to believe that we have entered a bear market, that the recent highs will be the highs for this cyclical bull market. Those widening credit spreads are a big problem for an economy deep in debt. And the long term momentum indicator I use does not shift very often. The last two sell signals took three and two years respectively to reverse to buy. If that holds true this time, it is hard to imagine that long a period won’t have its share of down periods at least as bad as last week. It has already been 14 months with no appreciation in the S&P 500 and it may have been nothing more than frustration that boiled the market over last week. For now, until something changes for the better with our main indicators, I’ll be treating the bounces as opportunities to sell.

The wild card in this is, of course, the Fed. If they believe that a rising stock market was a boon to the economy, that the wealth effect was real and consequential, then will they see a stock market correction as a reason to act? Act how might be a better question. They can’t cut rates although they might delay the planned hike – I still don’t think they’ll hike this year – but are low interest rates the cure or the problem? And the St. Louis Fed just last week released a report that found no boost to the economy from QE. So, what exactly could or would they do? I don’t know but I think there’s a reason gold was higher last week. If this is the beginning of a bear market, that’s one move that won’t look all that mysterious with the benefit of hindsight.

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For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@4kb.d43.myftpupload.com or   786-249-3773. You can also book an appointment using our contact form.