If you look at the last 40 years, there were four times we had bear markets without a recession and three of those times stocks dropped about 20%.- Ryan Detrick - LPL Senior Market Strategist
In LPL’s first Market Signals podcast of 2019, the LPL Research strategists discuss the whats and whys behind the current economic climate – including a possible bear market without a recession.
First up is the Federal Reserve Bank (Fed), which was viewed in a positive light for much of 2018. However, some confusion regarding policy has led to some market volatility since October. The strategists note that they expect to see a more “accommodative” Fed in 2019, a prediction supported by recent comments from Fed Chairman Jerome Powell about the Fed being more “patient.”
The strategists also note their belief that a recession can be a self-fulfilling prophecy. As concerns over a recession mount, spending and confidence can both sink. With the continuation of strong corporate profits and the benefits from fiscal policy, the strategists state they don’t see a recession in 2019.
History has shown that it’s possible to have a bear market without a recession. In the last 40 years there have been four bear markets in non-recessionary environments; three of those stopped right near 20%.
Finally, the LPL strategists point out that the fundamental backdrop remains strong. Recent manufacturing data came in weak, but is still expanding. More than 300,000 jobs were created in December, and inflation continues to be quite contained. This is a backdrop that fully supports GDP growth of at least 2.5% in 2019.
Bear markets tend to be worse when accompanied with a recession.
For the full rundown of what our LPL strategists have to say about the outlook for 2019, tune into the Market Signals podcast. And read FUNDAMENTAL: How to Focus on What Really Matters in the Markets for the full 2019 financial outlook publication.
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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual security. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. The economic forecasts set forth in this material may not develop as predicted.
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Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.
This research material has been prepared by LPL Financial LLC.
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John Lynch: Hello, and welcome back to the LPL Financial Market Signals podcast. This is John Lynch, Chief Investment Strategist for LPL Financial. And I'm here today back with my good friend and colleague, Ryan Detrick, Senior Market Strategist at LPL Research. Hello, Ryan.
Ryan Detrick: Hey, John. How you doing?
John Lynch: I'm pretty well, thanks. How are you?
Ryan Detrick: I'm doing well. Happy 2019 to you.
John Lynch: Yes, to you and yours as well. Hope you had a good holiday.
Ryan Detrick: We did. We were obviously just talking before we started recording but drove to Ohio. It's about 500 miles, so call it a 1,000 mile round trip with three kids, two dogs and a wife. But we made it.
John Lynch: Yeah, yeah. Well, we had our kids in town and then a very nice time. Did not have to endure that though, thankfully. And some day when you approach my stage in life you'll be able to enjoy some part of the empty nest during the holidays.
Ryan Detrick: Well, that'll be a change is all I can say.
John Lynch: Well, there wasn't too much to enjoy, right? It was a very, very difficult market during the time.
Ryan Detrick: Felt like we worked a lot.
John Lynch: Yeah, it was hard not to check out completely. And we know that was very difficult for our investors and our listeners. We wanna make sure today in the follow-up to our 2019 outlook, which was our last podcast, all that's happened since then. Wanna talk to our listeners today about what's been driving this weakness, can recession occur? Can it become a self-fulfilling prophecy, as we like to phrase it? Or can you have a bear market without recession? And then finally just reiterate what we believe to be the foundation of solid fundamentals whether it's growth in the economy, growth in profits. Not suggesting it's gonna be easy. We've experienced severe technical damage. You're more the technical analyst than I am but I'm the fundamentalist who, when all hell breaks loose, I just look at the charts and that's when I become a technical analyst. And we clearly have severe technical damage. It's gonna take a while to repair that.
John Lynch: But when you see that jobs report that we just experienced, right, the market responded favorably to that. Positive comments apparently from Fed Chair Powell in that most recent interview. We'll see how all that goes but clearly what we wanna emphasize today is what's been driving this, can recession happen or can you have a bear without recession? And then just reiterate why we still think we're gonna have recession someday, we just don't think it's gonna be 2019.
Ryan Detrick: No, that's right, John. Before we get into that I guess we'd like to officially announce this is our second season of our podcast. We finished our first season last year and we're calling this the second season. We made it. Apparently whoever makes that call said, for some reason they gave us a second shot at this.
John Lynch: We thank you, the listeners, and if this was video tape we probably would not be on. But since it's just audio, maybe that's why we're maintaining success for-
Ryan Detrick: Yes. Our face for radio, times two. That's right. John, let's get into it. I mean, driving the poll back we had approximately a 20% correction on the S&P 500 leading right up until Christmas Eve. I think Intraday we hit 20%, we didn't get there. Is it just the same old drivers? The Fed, the trade concerns, the economy. Has anything really changed from the last couple of months of us talking about the market volatility?
John Lynch: Yeah. Just what's changed is that sentiment has plunged. And we wanna make sure we're not splitting hairs but it's important to make the distinction. Now the Russell 2000 Index looks at small cap stocks, the NASDAQ Composite and a handful of S&P 500 sectors are in a bear market as long as a variety of regions throughout the world.
John Lynch: The S&P Intraday hit negative 20% on Christmas Eve but closed down only 19.8%. I say only, just I want our listeners to understand the close down 20% is key, right? 'Cause that's when buy programs kick in and that's what the algorithms are written on. And that's what traditional analysis is based on, a closing price down 20%. We don't wanna sugar coat things, this is clearly a bear market environment. And what's been driving it, uncertainty about oil, uncertainty about trade, uncertainty about the Fed.
John Lynch: And the ironic thing is that the very same policy decisions that boosted sentiment in the fourth quarter of '17, clarity on the new tax law, clarity on government spending, clarity on reduced regulation. All those policy decisions, a gradual Fed, all those policy things came into question after the mid-term election. And again, going back to the technical analysis of the markets, the S&P had a couple of corrections during the course of the year. Wages in February, a near correction in March and April when tariffs first came out. And then post-election. Yet when the S&P broke its triple bottom, which I think the number was, what? 2620-
Ryan Detrick: Around there.
John Lynch: On the S&P.
Ryan Detrick: Right. That range.
John Lynch: And we failed to hold that, that was the foundational crack in the market technicals that brought us down to Intraday maybe 2350 on the S&P 500. When you had that, it was a massive, ferocious sell-off that nothing appeared to stop it until Christmas Day, or Christmas Eve, when the market turned at the close.
Ryan Detrick: That's right. Just to put it in perspective, John, December for the S&P 500 was the worst month of the year. You go back in history, since 1950 that's never been the case. And it was the worst December since 1931. Usually December hangs tough but you're right, there was these other factors that clearly were playing in there.
John Lynch: If I may for a second, that was also the time when we released our 2019 market outlook. We release it the worst week of the cycle, 10-year cycle, and in the worst month of the past 87 years. Other than that our timing was excellent, don't you think?
Ryan Detrick: Exactly. I'll just say yes. Let's maybe dive into the Fed a little bit. Like you said, they're a big part. It was, I believe, October 3rd when Fed Chairman Powell made the comment at, it wasn't necessarily a Fed meeting but he was at a panel somewhere, I believe. And he said we're a long way from neutral. And if you look back, that's really when a lot of this market volatility started.
Ryan Detrick: We had a Fed interest rate decision in December. It was the ninth hike of this cycle. Market didn't really like what they say 'cause the Fed kind of gave the inkling maybe we were gonna hike rates a little bit more than what the market participants wanted. 'Cause he continued to roll off $50 billion a month on the balance sheet.
Ryan Detrick: But all of a sudden now, John, on this Friday, jobs Friday, there was a quote that came out. Let me read it correctly. Fed Chairman Powell said, "We will be patient," that's the part that really mattered. Markets really took off on that. It was the Fed changing their tune here, are they really saying the same thing they've been saying? What shall we take of all of this here?
John Lynch: I think they've been saying what they've been saying. I don't know if the market's been hearing. And what I mean by that is we've talked in the past about Powell's not burdened with a PhD in economics, much like Paul Volcker, so he's not gonna be married to the econometric models. Yet Powell recognizes that we are creating jobs and that wages are rising. And his mandate first and foremost is full employment and price stability. It's not market stability. It's not currency stability. He has to be mindful of the last two things but the former two things are most important.
John Lynch: But when he looks at the data, and I have to agree, for example when we look at nominal GDP, which is real GDP plus inflation. That's growing about 5%. The Federal funds rate right now, the upper bound is 2.5%. The Fed funds rate is essentially one half of nominal GDP. Historically it's 1% below nominal GDP. So when he looks at the data, policy's accommodative. But when investors have been used to, for a decade, free money, it's hard to apply, right? It's hard to gauge the push and the pull, the yin and the yang, of what he's messaging and what investors are hearing. We also have to keep in mind that while Powell can focus on Fed funds rate relative to nominal GDP, investors can focus on the fact that inflation adjusted Federal funds rate, the real Federal funds rate, is only, what? 30 basis points right now.
Ryan Detrick: Exactly.
John Lynch: Historically it's 4% before the economy slips into recession. We've gotta grow by a factor of 10, 12, 15 before we get there. Investors need to keep that in mind, and as Powell keeps messaging, I think the thing that really scares investors and what's different for Powell in a tightening cycle than all other Fed Chairs and tightening cycles, is that they also are allowing maturing assets to run off their balance sheets. That is having an upward pressure on market interest rates. I think he gets it, I'm not sure the market thinks he gets it. That he has to message yes two more times, potentially, in '19. Fed funds futures are suggesting a cut in early '20 so there's not, there's clearly markets in the Fed are not in sync. But what we believe is that they're gonna be less aggressive than feared, real Federal funds rate adjusted for inflation, very accommodative interest rates. And when he makes comments like he did recently about not being as threatening as people had feared, we think ultimately that's positive.
Ryan Detrick: Right. Now, John, one other thing that's happening out there, the government is shut down. We're reaching almost two weeks now, at the time of this recording at least, the U.S. government's shut down. History would say government shutdowns, usually markets take it in stride but also they usually last three to four days. This one's lasting longer. Now, I know only about 75% of the government is still working, still functioning, it's funded. At the same time, how much of a big deal is this? Is this playing into some of this volatility and uncertainty that we're seeing, do you think?
John Lynch: If a tree fell down in the forest and no one was around, would anybody hear it? Would it make a sound?
Ryan Detrick: No.
John Lynch: That's right.
Ryan Detrick: Or yes. I don't know. I guess that's one of those you think about forever, right?
John Lynch: Absolutely, absolutely.
Ryan Detrick: I've always ... riddle me this. I've always thought if you had a bar of soap and you dropped it in the mud, is it clean? I've always thought of that one.
John Lynch: That's an interesting one.
Ryan Detrick: I don't know. I don't know. Anyway.
John Lynch: Let's get back to the Feds.
Ryan Detrick: Sorry, the government shutdown.
John Lynch: That's right, government shutdown.
Ryan Detrick: Yeah. I really ruined you there when I said that.
John Lynch: Yeah. This has stretched out and unfortunately this is another thing affecting sentiment, which is again another catalyst why we broke that triple bottom. There is a complete lack of faith in policy. Whether it's the Fed or whether it's the government. We've got constant political bickering, we've got pandering. As we've said in the past we think both parties are closer together on trade and infrastructure. But they're a mile wide on immigration. And clearly any further scrutiny of the administration also will weigh on sentiment. To the degree that the government shutdown, you've done a lot of work in the past. Government shutdowns tend not to impact the markets. If they go on too long they can be a fractional hit to economic growth but we don't think it's gonna be too threatening for the markets.
Ryan Detrick: No, that's right. I mean, the last five times the government shut down the S&P 500 actually gained. That's important to know. You mentioned the word sentiment a few times, John. I'll just chime in with this. A year ago right now had we been doing this podcast we would have said, hey, S&P's up 15 months in a row total return basis, the longest streak in history. Profits are great. Everything was great.
Ryan Detrick: But what's happened the last 12 months? Well, stocks have been down, right? Now look at market sentiment now. Just quoting some recent data from Lipper, almost $76 billion with a ‘B’ were pulled out of stock in ETF funds. That's the largest monthly outflows ever. Various sentiment polls showing some of the most bears we've seen since either 2011 or 2016. Put to call ratio some of the highest levels we've ever seen in the options market. What I'm getting at is there's a lot of reasons to be bearish. A lot of scary reasons to be bearish. A year ago everything was great so if you roll up by low expectations with any good news it's tough to do right here but really there could be opportunity if we don't fall into a recession in 2019.
John Lynch: Well, that's the big deal, right? Because whether it's the Fed, whether it's trade or oil, we've talked about oil being more of a supply issue than a demand issue. We don't think it's a sign of slowing global growth. Trade, we wanna see progress. A path toward progress has been the line we've been using, right? I don't know if we're gonna see a complete resolution but we had a leading technology company disappoint on revenue recently, right? And that sent the market off quite a bit. When you see the Chinese stock market relative to the S&P 500 through at least the third quarter of 2018 the market had been signaling weakness in China all along. And I attribute this fourth quarter weakness and this weakness in the last eight or 10 weeks on the S&P 5 and the U.S. equities more sentiment driven than the data actually represents.
Ryan Detrick: That's right. John, let's move on here. Recessions. Let's talk about recessions for a minute. Can a recession be a self-fulfilling prophecy?
John Lynch: Absolutely. We can scare ourselves into one, right? And I think a good lead indicator there, part of why everything was great a year ago now, was because businesses had 100% immediate expensing and lower corporate taxes, right? If capital expenditures increased at a 10% rate in the first half of the year then all of a sudden we, the trade dispute escalated and businesses halted spending. Capital investment, capital expenditures.
John Lynch: If we saw 10% growth in the first half I think we only saw 80 basis points in the third quarter. And we're curious to see what the number is when the fourth quarter's produced and reported in a few weeks. If businesses stop investing and consumers see slower growth or less job growth, that's not been the case obviously with recent jobs data. At what point, whether it's political bickering or geopolitical tensions, trade, whatever it is, to cause investors or consumers rather, to pull in their spending. You suddenly have a self-fulfilling prophecy, right?
John Lynch: If businesses aren't investing, if consumers aren't spending, then suddenly you can believe yourselves into one. I think about the old Seinfeld episode when George said, "If you believe it, it's not a lie." If you're convinced it's a recession it can ultimately become a recession. However, when you look at the foundation of services, even with our recent manufacturing data disappointment, it was just a handful of months ago. Less than a handful of months ago where we were at a 14-year high in manufacturing.
Ryan Detrick: September, right.
John Lynch: Services still near an all-time or a cycle high. When you look at job growth like we saw recently, when you look at wage growth, when you look at profit growth. Profits are a great lead indicator for growth. You can have a self-fulfilling prophecy recession. We don't believe that's the case. In fact, we believe that it's more likely you'll have a bear market without recession.
Ryan Detrick: Right. And those are possible. Just this week, the last couple of weeks, John, we've taken a look at that. You go back 40 years, we saw there actually were four times where you had bear markets without a recession and three of those times stocks dropped right about 20%. You had in 2011, you had about a 19% correction, 20% Intraday. 1998, another about 20% correction. 34% correction '87 without a recession. Then 1978 without a recession was around 20% again. You think about that, that's three times went down about 20% without a recession.
Ryan Detrick: Now, we just went down about 20%. Now, '87's one a little different but obviously '87 we had a much different scenario where stocks were almost 500% from '82 lows of 40% for the year. In August the rubber band was stretched, it made sense that maybe that could snap back a little bit more. But what do you think? I mean, could we be in the lower end of this if we don't go into recession?
John Lynch: Well, let's take some poetic license and look at '11 and '15, right? Where we were near bears but we didn't quite slip into recession. You add those in also those were 17, 18, 19% pullback. You can have a bear without recession. And maybe that's what we need. With the recent jobs data though and the recent Powell comment, who knows? Maybe we won't get there. But before the jobs data and before the Powell comments recently, I was of the mindset, well, maybe this is what we need? Because the Russell's already there, the NASDAQ's already there. Too many S&P sectors are there.
Ryan Detrick: Half of all S&P 500 stocks as of Christmas Eve were officially in a bear market as well.
John Lynch: Stocks, yeah. Were down. Maybe you need that kind of washout, right? Because whether it's computer program buying, whether it's the algorithms, whether it's just investors saying, "Okay, well, multiples are so attractive now. We've got record profits growing at historically average rates. Yet we're discounting those profits at interest rates less than half their historical averages. That can be a buying opportunity."
Ryan Detrick: Right, no, that's true. John, looks like we've got about three or four more minutes here, maybe let's wrap it up like this. In our 2019 outlook we titled it, "Fundamental." Focusing on the fundamentals, what really drive long-term stock gains again, are the fundamentals. Now, we had two just recently. The ISM manufacturing data, you just mentioned that. That came out last Thursday. Largest monthly drop since October of 2008, down but it's still at 54. Bottom line is above 54, above 50 shows expansion just had a big drop. It was up over 60 back in September, the 14-year cycle high.
Ryan Detrick: Then fast forward to the jobs number that we just saw up over 300,000 jobs created, it beat, expected to be about over 180,000, the largest monthly beat we've seen since 2009. One thing saying, hey. Stuff's good. Others saying, maybe not so good. What's your take on the fundamentals here, John?
John Lynch: Well, it's interesting. We did have that five point drop. We've only had two instances in the last 100 years that were worse. That's how significant that five point drop was. But that very same day last Thursday when that number came out we also saw a private employment report data that was a blowout.
Ryan Detrick: Which everyone ignored.
John Lynch: Everyone ignored. Right? The market was down 2.5 or 3% last Thursday and then last Friday when the jobs data came out and Powell's comments came out there's a distinction investors always have to make between hard and soft data. Hard data can be lagging, like jobs, like manufacturing. But manufacturing's also kind of like a survey. Let's see what the industrial production number states which is more hard output, if you will. It's always the hard and soft data, the consumer confidence, CEO confidence, cycle highs. Does it come down from 10-year highs or 17-year highs in the case of consumer confidence? Things are slowing. But they're still growing. And that's a primary message we're getting out to our investors.
Ryan Detrick: Oh, great point. The ISM manufacturing number, John, came in at 54.1. I thought this was really interesting. If you look at that, that actually equates to a real GDP of 3.4%. Not saying it's spectacular but 54 manufacturing's still good. But again, it is the concern, it's slowing and a lot of the other parts of the globe are definitely well off their highs and some are actually breaking that 50 level, showing potentially, and definitely slowing around the globe.
John Lynch: Yeah, I'm glad you mentioned that because that's something our listeners need to pay attention to. And I think all investors need to make the distinction. You and I can pontificate all we want and say, yeah, but the data's good. Good doesn't matter anymore. Is it better or is it worse? And when you have technical damage like we've experienced, when you've seen investor sentiment crumble, good or bad doesn't matter. Better or worse matters. And I think that's something investors needs to keep in mind.
John Lynch: You and I can say, yeah, 3.4% GDP is consistent with my ISM manufacturing at 54. Yeah, but if people are more concerned about trade, if people are more concerned about the absence of free money or the Fed no longer supporting the market, those are issues that it's gonna take a while to recover. During that period of tumult for investors we still see 2.5% GDP growth in the U.S. economy. We see 3.5 or so in the global economy. We get paid to worry and we are not stressed over the inflation level because wage growth is still 120, 150 basis points below historical averages whereby Fed officials would get scared. Profits are slowing but there's still-
Ryan Detrick: All-time highs.
John Lynch: Off record levels, yeah. Growing average. Average pace off all-time highs. Again, discounted at below average interest rates. When you factor all that in, we're gonna have a recession someday. We just don't think it's 2019.
Ryan Detrick: Right. I guess my take is with all the sentiment is, as negative as it is, and only 10% of S&P 500 companies recently above the 200 day moving average, that's the lowest we've seen again since 2011 and the financial crisis.
John Lynch: Capitulation, yeah.
Ryan Detrick: We've got a very over-sold market. We just need some good news. And could it be the Fed, maybe their comments? My opinion, John, is what really got us into this trouble though, was probably some of the trade concerns. Seems like we're getting some high level discussion we're supposed to start up this week with China. I think we need to clear that up first. You think we can get that cleared up in the first quarter, potentially?
John Lynch: If you get clarity on, again, not resolution. But clarity on trade, clarity on a less aggressive Fed and a comfort factor that oil has been supply-driven rather than demand-driven, I think the confluence of those three events can help improve sentiment. And let investors focus on yet again earnings and interest rate compounded annually.
Ryan Detrick: Oh, that sounds good, John. Well, John, I think we officially are reaching the finish line for our very first podcast, first episode of our second season of LPL Market Signals. I had fun today. And look forward to the next one.
John Lynch: Thanks, Ryan. Always a pleasure to be on with you. And thank you to all our listeners, wanna wish you a happy and healthy 2019. And keep listening, we'll provide you with as much insight as possible on these financial markets. All the best and we'll talk to you soon.