The risk budget is again unchanged this month. For the moderate risk investor, the allocation between bonds and risk assets is 50/50.

Why is the stock market falling? Is it fear of a trade related slowdown? Or of an overly aggressive Fed hiking rates too far and killing one of the longest US expansions on record? Or is it more directly political, fear of what the Democratic surge in the mid-terms says about future policies? If you’ve been reading these missives for more than a little while, you won’t be surprised to read that I really don’t know – and neither does anyone else. The markets are giving us hints but it seems pretty obvious at this point that the cause of the selling is not obvious. Markets are nothing more than groups of people and while there can be a wisdom of crowds, they can also be just as confused as any individual investor trying to read the runes of the market. And confusion reigns right now.

Crowds are also subject to herding behavior and I think mostly what is going on right now is that the herd has become a little less organized. A lot of the selling has been concentrated in the FAANG stocks, a group of stocks that were so popular they had their own acronym and the NASDAQ is in actual correction territory as I write this, down over 10% since the beginning of October. With the market leaders under pressure – and the reasons are interesting but probably irrelevant – investors are casting about for the next big thing and not really finding it.

It isn’t just the FAANGs that are under pressure though. The biggest news since my last update is the crash in crude oil prices. The S&P 500 may be taking its time getting to a correction but crude just skipped the correction part and when straight to the bear market, down over 20% in just the month since my last update. The crash in crude has had an impact on inflation expectations but curiously not real growth expectations. It also appears to have had an impact on Fed rhetoric with multiple speakers hinting at a pause last week.

There isn’t anything in our indicators that warrants a change to the portfolio. We have been light on US stocks for quite a while so the latest bout of selling hasn’t affected us all that much. Foreign markets have held up pretty well all things considered. Emerging markets are actually outperforming the S&P 500 by quite a bit since the beginning of October and other asset classes have stepped up. REITs and gold are both positive over that time frame and while crude has been smacked, other commodities have fared better and the Bloomberg Commodity index is only down a couple of percent over the last month.

There are, however, some worrisome signs emerging, mostly in the credit markets. High yield spreads have widened recently and are breaking out of the previous channel to the upside. The selling is mostly confined to the energy market so far and that makes it a little easier to sit tight. The 2014-16 slowdown was also led by energy and spreads widened considerably more in that period. That episode also induced changes at the shale companies that should make this one easier to navigate. A lot of the weaker players either filed bankruptcy or were bought out by larger players and banks forced tougher terms on those who survived. Hedging forward production is looking smarter now that prices have come back down.

The potential slowdown in the energy sector and the emerging slowdown in the housing market are the biggest worries for the economy right now. The last energy slowdown wasn’t enough to cause a recession and we are better prepared for this one so I doubt it will either. As for housing, while there has been a considerable recovery in building activity, it is no boom. Housing starts around current levels are similar to the low end of activity in previous cycles. So no boom and no bust. Residential investment today is lower than Q1 2017 and hasn’t had much impact on GDP in some time.

The consensus these days seems to be that the next bear market will only come with the next recession. Media coverage of indicators like the yield curve and credit spreads are much more widespread than at any time in my career. I’ve been doing this a long time and one thing I’ve learned is that when an indicator or strategy or whatever becomes too popular it stops working; just as the FAANG stocks have recently. Could we get a recession that doesn’t include an inverted yield curve? Absolutely and that is why we pay a lot of attention not just to whether the curve is inverted but more how it is changing. Could we get a bear market without a recession? That’s the one nobody expects and the answer is definitely yes. I’m not saying that is where this is headed but it wouldn’t surprise me either.


Yield Curve/Rates

The yield curve is basically unchanged since the last update and the long term trend is still down. Both 2 year and 10 year note yields have come down in concert recently.

The 2 year note yield had probably moved higher too quickly, investors possibly a little too exuberant about future Fed hikes. Several Fed speakers last week, including Chairman Powell and Vice-Chairman Clarida, hinted that Fed funds are approaching neutral. A hike in December is still considered a near lock but after that is much less certain.


10 year yields backed off the highs quickly, a function of a rough stock market, some weak economic data and a less hawkish Fed. I think we may have seen the highs for this cycle but I am struggling with the cyclical versus the secular. Rates may have peaked for this expansion but I am also beginning to believe we’ve seen the lows on a secular basis. I keep looking at the economic policies we have in place – and the ones we’re likely to get with a split Congress – and thinking it all looks inflationary long term. An economic slowdown would still likely pull rates lower short term but any rally may be capped by structurally higher inflation.

The most interesting market right now is, by far, the TIPS market where real rates have not followed nominal rates lower. The 10 year TIPS yield is still right near the recent highs while nominal rates are down nearly 20 basis points. I generally think of real rates as indicative of real growth expectations and those have not budged despite the sell off in the stock market.

What that means is that inflation expectations have fallen. That may be the reason we heard so much dovish cooing out of the Fed last week. As I said, it is very interesting to me that inflation expectations fell but real growth expectations remained steady. It is a small difference at this point but definitely worth monitoring.

Credit spreads have widened by 30% since the lows and are breaking out of the previous channel. We are also, as you can see, way below the spreads we saw in the last oil patch slowdown. I’m worried but not excessively so.

The dollar moved higher since the last update, a high for this bull move. I am skeptical of the move but it is supported by those stubbornly higher real rates.

Stocks tried to rally off the late October lows but that is looking more and more like the proverbial dead cat bounce. This was a classic technical pattern, a bounce that failed at a declining 50 day moving average.

From a longer term perspective, if we close the month near these levels, we will have a momentum sell signal on the monthly chart. If that is confirmed by month end, I would expect to visit the 50 month moving average in the low to mid 2300s. If we do, it would get us to bear market territory, down about 21% from the high. Assuming there are no signs of recession when we get there that would probably represent a big buying opportunity.


Foreign stocks have held their own in this correction although still lagging a little since the beginning of October. The short term downtrend appears to be ending. Sustained outperformance by EFA will likely require the dollar to resume its downtrend of last year. Could better relative performance of foreign stocks be heralding a weaker dollar?

Even more interesting I think is the outperformance of EM stocks during this correction. Yes, EEM is still down nearly 15% for the year but momentum appears to already be shifting back to EM.

Not only has EEM outperformed EFA but also SPY since the correction started in early October.

Japan has recently pulled back relative to EFA but the long term uptrend is intact. Japan remains my favorite market, a combination of cheap valuations and good earnings growth. I also tend to think of Japan is well positioned to benefit from any US pullback from China.


Commodities took a hit since the last update but while the S&P looks to be making a top, commodities look more like they are making a bottom. The downturn since the last update was almost entirely about crude oil.

Long term the BCOM is building a long base. If we are transitioning from a low inflation to a high inflation regime, higher commodity prices will probably be part of that trend.

Gold shows a similar bottoming pattern. Like commodities more generally, for gold to get in a sustained uptrend will probably require the dollar to do the opposite. It may be that gold is signaling a top in the dollar right now.

One of the most interesting developments of the last month was in the energy complex. As crude oil was falling into a bear market, natural gas was making multi-year highs. Reading the news one would think these things were entirely unrelated but I don’t believe in coincidence. It appears that someone – a hedge fund probably – made a large bet on a crude/nat gas spread and it blew up on them. Last Wednesday crude fell 7% while nat gas rose 18%. That reeks of a liquidation, a margin call that required selling crude and buying natural gas. I suspect we’ll be reading an article soon about some fund that lost a boatload of their investors’ capital betting on the energy markets. This is one reason the widening of spreads in energy junk bonds doesn’t bother me that much. Liquidations like this are often at the end of a move so a rebound in crude should be expected here.

The big drop in crude had a bigger impact on the GSCI than the BCOM. The GSCI has a much higher weighting to crude.

Gold’s uptrend relative to the Bloomberg Commodity Index is intact as gold has outperformed recently.

Longer term bonds have rallied during the stock market correction. To all those who keep asking us why we own bonds, well here’s your answer. Bonds are still a good hedge against stock market volatility. However, if I am right and we are transitioning to a higher inflation regime, that may be less true in the future. But in that case, the real assets in our portfolio should provide some protection. For now though bonds have done exactly what we expected.

The correction in US stocks continues as I write this but the reasons for the selling are a bit murky. I tend to think it is mostly related to the trade rhetoric – and policies – of the Trump administration. But that is more likely my own bias showing through. After all, if that were the cause wouldn’t we see real growth expectations fall? Wouldn’t we also see inflation expectations moving higher? In both cases, we have the opposite. Interest rates and fear of the Fed? If anything the Fed has gotten more dovish recently and expectations for more rate hikes next year are waning. Politics? I suppose but again, if markets are worried that the change in the House is negative for the economy it should show up in the bond market – and it doesn’t.

With the big technology companies taking such a large hit one is tempted to blame the correction on fears of regulation or other blowback on the social media companies like Facebook. But that doesn’t explain why so many stocks in the S&P 500 that have nothing to do with technology are already in their own personal bear market.

Maybe the simplest explanation is that this is exactly what we should expect from a reversal of QE. After all, if QE was all about raising the price of risk assets – and that is exactly what Bernanke said it would do – then it was folly to expect the unwind to be benign. I know there are good reasons to doubt a direct link between QE and stock prices but the only link needed is psychological. If enough people believed that QE would raise stock prices then it would be so. Now that QE is reversing it only takes a sufficient number to believe the opposite to get the ball rolling downhill. After that herd behavior takes over.

If the reason for the selloff is rooted in the unwinding of QE, it may take an announcement about the balance sheet to stop it. The Fed’s balance sheet expansion was always expected to be temporary. What happens if they have to stop and the expansion is seen as permanent? Could that be the trigger for a shift to higher inflation and higher interest rates? I don’t know but we may find out soon.