Bears appear to be speaking up.  

The question we want answered after last week’s market rout is “who is dumping equities and driving the market lower”?  We believe that the selloff has been largely institutional money whose automated trading models trigger sells when specific targets are breached.  Those targets may be news, market momentum, market levels, market ratios, and a variety of other metrics concocted by managers striving to outperform.  As large swaths of equities are dumped driving the market lower ever more targets are breached causing more models to sell in a cascading effect.

Typically, there are sufficient buyers in the market to support these automated sells as investors hold a large amount of cash and are eager to buy equities at lower prices.  This time many of those long-term bulls seem to have given up.  The ongoing concerns over interest rates (specifically the possibility of the 2 and 10 year treasury yields inverting, more on that later) and fears of an escalating trade war with China have taken their toll.  Diplomacy by Twitter has already caused a large segment of the population to become fearful, even bearish and the remaining bulls are unable to keep the market afloat.

Ned Davis Research, one of our favorite sources of forecasting says we’re already in what will be bear market, and while we aren’t yet convinced we should explore what it means if they’re right.  If Ned Davis called it correctly we are only halfway to bear market territory and we’ve got another 9.5% down to go.  As a quick reminder a “correction” describes a market that drops more than 10% from a recent high (September 20, 2018 the S&P 500 hit 2930).  A “bear market” describes a 20% drop from a recent high.  This morning the S&P 500 is at 2,600 so we have officially entered into the second correction of 2018.  The S&P 500 would have to drop to 2,344 to change from a simple correction to a bear.

While some bear markets are long and painful the average length is about seven months.  Should we find ourselves in bear market territory, Ned Davis anticipates we’re find our way out around the 3^rd quarter of 2019 ending modestly up for the year.

We’re not ready to throw in the towel and call this a bear market yet.  The economic backdrop remains solid, earnings are good and consumers are spending.  The Federal Reserve appears to have retreated from its hawkish stance signaling perhaps fewer rate hikes are in store.  Finally the two major sources of worry which are China and inverted yield curves are perhaps not as dire as some believe. Let’s consider each:

China

The last time stocks were at these levels (three weeks ago, before the week of Nov. 26 – Nov. 30 where the market had the biggest weekly gain in seven years!) there was no handshake agreement between China and the US to place a 90 day hold on tariffs.  There have undoubtedly been mixed messages out of the White House in which Trump and Kudlow seem to point to talks going well and Navarro (a China hawk) suggesting that if no deal is reached by March 1^st higher tariffs are coming.  Unfortunately this doesn’t look like good cop/bad cop, it looks like no one knows what’s really going on.  Even so, we believe that Trump the politician wants a trade deal to run on (the 2020 Presidential election cycle begins Jan 1^st, 2019) and things look brighter today for a deal than they have prior.  Of course it could all fall apart and escalate, but we think the market may be too pessimistic.

Inverted Yield Curve

It stands to reason that interest paid on very short term loans should be less than interest paid on very long term loans.  The reasons are primarily twofold.  First, the longer the loan the higher the chances the borrower is unable to make payments due to hardship.  Second, the lender doesn’t have use of the loaned funds for attractive opportunities that may arise during the life of the loan, so the longer the loan the more interest a lender demands to compensate.  We see these concepts in practice at banks.  Banks don’t pay very much interest on savings accounts because depositors don’t have very much risk.  However, if you loan a bank your money and purchase a long CD, effectively tying your money up and preventing you from using it for other things the bank will generally offer you a higher interest rate.

These general principals apply to the US Treasury market as well.  All other things being equal one would expect to earn a higher interest rate on a 10 year treasury than a 2 year treasury.  Occasionally however the yield curve “inverts” meaning 10 years treasuries actually have a lower interest rate than 2 year treasuries.  What’s interesting about this phenomenon is historically when the 2 year and 10 year treasury yield inverts it serves as a very accurate predictor of a recession in the US economy 7 to 9 months out.

Recently the 3 and 5 year treasuries have inverted. The 2 and 10 year (a much more relevant comparison) yields have gotten very close however they have not inverted and may well not do so.  We believe that fears around the possibility of an inverted yield curve are senseless.  If and only if the curve inverts should that metric demand our attention.

Monarch Portfolios

With this information in hand, how are we positioning ourselves in this recent market volatility?  The short answer is the work has mostly already been done.  We’ve been raising cash by selling stock for months.  Our portfolios are custom tailored to each individual client so given our clients tolerance for volatility some portfolios have more cash than others.  While we sit back and watch the market gyrate for the first time in a while we’ve actually started to get excited about the market’s prospects.  We haven’t started buying equities outright and don’t intend to do so before year end as the bears seem to be in control. However this market needed a good shake up and we’ve certainly seen one.  We think it’s prudent to pause, let the bears have their way and start looking for opportunities these types of moves create.