Still Bullish After All These Tears
Feb. 15, 2016 Commentary

Still Bullish After All These Tears


As our regular readers are aware, I have maintained a bullish stance on the global stock market for quite some time. I believe stocks in general will trade at higher prices, on balance, over a period of years going forward.

Now, before you throw this piece into the fireplace, thinking I am not aware of what has been happening of late, let me remind you that earlier this year I stated my belief the stock market was “due” for a 10 - 20 percent correction for some time. Additionally, I advised that price volatility was going to rise this year. I also advised investors at the first of the year to maintain “optionality” in their portfolios – maintaining structure so as to be able to take advantage of market weakness when it was to occur – such as now. But here we are – with the S&P 500 having declined by 14 percent from its all-time high. And yes, over the long term, I still like the stock market and remain a secular bull.

But shorter term, I continue to believe the market’s increased level of volatility may remain with us for some time.

Market Report Card

Let’s take a peek at some of the globe’s equity markets, and how they have fared lately. All data is price only index changes.

As noted above, the world’s stock markets have been in a serious swoon phase. The major European and Asian markets have not been spared from this downward shift in values. Note the declines we have witnessed from recent high prices for both the German and Japanese company stock prices. These returns make U.S. large cap stock price declines look tame.

Economic Recession on the Way?

While I have been expecting a 10 - 20 percent decline in stock prices (S&P 500), I don’t expect a true bear market to ensue at this time. What do I mean by a true bear market? A market in which stock prices decline by 20 - 60 percent. These are the types of markets, as we witnessed in 2008-2009, which shake the belief system of investors, and which have the power and viciousness to change lifestyles.

While a 10 - 20 percent decline in stock prices isn’t something to take lightly, a true bear market is something much more troubling. True bear markets, those during which stock prices decline by 20 - 60 percent have been accompanied by one of four events.

  • Tight monetary policies. Following at least three interest rate increases, the probability of the equity market experiencing a down 20+ percent bear market is high.
  • Economic recession. Tight monetary policies tend to lead towards economic recessions. Has the Federal Reserve, the Bank of Japan or the European Central Bank entered into a tight monetary policy? Of course not. But the probability of the United States, and the world, slipping into a recession over the next six -12 months is higher than normal. I will expand on this statement later in this piece.
  • Overvalued markets. Capital markets can decline by 20 percent or more due simply to the weight of overvaluation. Times in the past during which the S&P 500 has declined by more than 20 percent because of overvaluation include 1987 and 2000.
  • Acts of war. Think of 9/11. The stock market tends to decline – and at times somewhat rapidly – when acts of war occur. These types of acts tend to be non-forecastable.

Let’s take each of these issues on, piecemeal. While the Federal Reserve’s policies have taken a decided turn away from extreme ease, they are far from tight. While current valuation of the stock market isn’t cheap, stock prices aren’t terribly expensive. Currently, trading at roughly 15x expected earnings, the S&P 500 index is trading at a much more reasonable level than was the case last year, when stock prices were more buoyant. At that time, valuation was pushing 18x earnings. Finally, as stated above, an act of war is unforecastable.

So, that leaves us with the possibility of recession. Is the U.S. and the world’s economy entering a recession? If so, my forecast of a possible 10 - 20 percent decline in stock prices this year may look tame in relation to what may be coming.

Recession – The Weight of the Evidence

So, is an economic recession on its way, or are we in a recession I have failed to recognize? Some serious thinkers believe we are. The broadly accepted definition of a recession is measured by two, back-to-back quarters of negative GDP growth. The U.S. economy hasn’t registered one, much less two quarters of negative GDP growth. In 2015, GDP growth came in at a weak but still positive rate of 1.8 percent. The Atlanta Fed’s econometric model is calling for first quarter GDP growth of 2.7 percent. If this proves correct, not only have we not witnessed two quarters of negative GDP growth, but GDP growth would show some degree of acceleration.

What of forward looking data? There are three data streams which I follow closely as to the probability that we will see a recession ensue sometime over the next six - 12 months. None of these models are currently flashing recession. Although it is important to understand that all three models’ momentum is troubling as the momentum of all three has turned negative over the last three months.

So, I can’t say the U.S. economy has, or will, slip into recession this year, but the probability of this negative environment occurring has increased over the last few months.

20 Percent Decline – We are Due

So if the fundamental evidence isn’t present that we may see a 20+ percent decline in equity prices this year, do I think there is a possibility that stock prices may move into a true bear environment? It is possible.

  • Historical averages. Since 1930, the S&P 500 index has declined by 20+ percent every 635 trading days, on average. That equates to a 20 percent correction in stock prices once every 2.8 years. The last time the S&P 500 declined by 20 percent or more was during the Great Recession, in 2008-2009. It has been 1,563 trading days since the last 20+ percent decline. Even during historical secular bull markets, the S&P 500 has declined by 20 percent or more once every 1,105 trading days, on average. We are “due” to experience a 20 percent+ decline in stock values.
  • Slowing global economic growth. China’s economic growth rate has contracted. China’s high growth rate over the last few years has driven overall, global economic growth. If you believe the official GDP growth data from China (which I don’t), China’s growth rate has decelerated to 6.9 percent over the last four quarters, as compared to a reported 7.3 percent GDP growth rate during the previous four-quarter period. I suspect China’s true economic growth rate to currently be in the 3 - 4 percent range. Additionally, Europe and Japan are having a difficult time staying out of recession. The world continues to starve for economic growth. When the global economic growth is as low as it is currently, it doesn’t take a major shock to throw the world into recession.
  • Cyclical bear within secular bull. I have long held the view that we are experiencing the fourth secular bull market since 1920. Secular bull markets are long-lasting animals, during which stock prices rise rather dramatically. Secular bull markets are surrounded by secular bear markets, markets when capital is consumed by declining and highly volatile stock markets. One such secular bear occurred from 2000 – 2009, during which time the Dow Jones Industrial average declined by more than 52 percent. That is capital destruction.
    • This being said, shorter term, less vicious bear markets can, and will, occur during secular bull markets. If we look back at the last three secular bull markets (1921 – 1929, 1942 – 1966, 1982 – 2000) we see rather strong downward punctuations.
    • These shorter downward thrust periods – cyclical bears – have averaged declines of 19 percent over 238 trading days. Our current decline (from peak last year) has been -14.3 percent. The calmest of these cyclical declines was the first decline in the 1982 secular bull, when the market declined by 15.6 percent. The most vicious decline occurred in 1987 when the Dow Jones Average declined by 36.1 percent over two months.
  • Banking worries. What I’m referring to here are commercial bank worries – primarily outside the United States. Remember, the recapitalization of the U.S. banking system in 2009-2010? Well, during that period of global recession, few other countries’ banking systems went through the same cleansing actions the banks in the United States experienced. Banks in Europe and China are more highly levered than the United States, carrying more “zombie” loans than is the case domestically. Bank stocks have been punished recently as the market has come to recognize these structural problems.

I wouldn’t be surprised to see further stock market weakness sometime later this year. At this time, I don’t expect to see the start of a new, longer-term secular bear market. If that were to occur, our current secular bull market would go down in history as the shortest secular bull since the year 1900.

What Goes “Bump” in the Night

Some of my clients have asked me about my unwritten concerns. What goes “bump” in the night and keeps me awake.

As I have written rather consistently over the last couple of years, the world is starving for economic growth. Since the end of World War II, the U.S. economy has grown by an average of 3.2 percent per year (real GDP growth, after inflation). Since the end of 2009 (last recession), the U.S. economy has grown by an average of 2.1 percent per year. The 1.1 percent difference between the last six years of economic growth and the long term average represents a whopping $924 billion of total economic activity lost. This is serious money – and a “loss” of corporate profits and personal income on a macro economic sense.

What policy measures have been taken over the last seven years in an attempt to provide economic stimulus? The Federal Reserve’s quantitative easing actions have led to the Fed’s balance sheet ballooning upward in size by six times since 2008. The Fed isn’t alone in these actions. Major central banks, worldwide have also levered their balance sheets. The levering of central banks’ balance sheets has primarily been due to the efforts of central bankers to kick start economic growth by flooding their respective banking systems with liquidity. This action has driven asset values upward, and kept interest rates lower than what normally would have been the case.

If the ultimate goal of all of this leverage creation was to kick start economic growth, then these efforts have by and large failed. Some make the counter-factual argument that the world’s economy would have slipped into a depression, following the financial collapse of 2008. Maybe, but we don’t know. That is the nature of a counter-factual argument – we don’t know if it is right or wrong. What we do know is global growth has been significantly lower over the last seven years than has historically been the norm.

Eventually, the world risks running into a continuous period of very low, volatile growth accompanied by high levels of price volatility for most asset prices. Something else has to happen to kick start economic growth – global governments need to consider altering their policies to not feature just wealth transfer payments but also true infrastructure investment spending, perhaps in concert with private enterprises. I don’t believe the United States has more than 2-3 years to affect these types of changes. I suspect typical societal wealth creation, opportunity creation and overall economic well-being will continue to be crippled unless we as a people address this issue head-on.

What is Needed

Please understand, my statements below are not attacking one group of politicians or the other. But I believe we may be heading towards a period when standard partisan policies should not be tolerated. I believe the government has failed the country, in an economic sense. Something has to give which will drive the government to do the “right” thing – something which hasn’t been approached over the last 15 years.

If we as a country are successful at this effort, it should pave the way for a return to long-term social economic prosperity. If we as a country fail at this effort, we will continue to struggle with slow economic growth, low levels of social wealth creation and all of the social ills which come with this disease. Economic opportunity solves many social problems. Slow growth spawns envy and social unrest.

If my thoughts are correct, our country is coming to a point where leadership and non-partisan activities will be at a premium. When going to the polls in November, I urge all to think of the probable upcoming period of high risk. We need leaders in Washington who are able to work with others, not politicians who attempt to turn us against each other.

This past week I spent a few days seeing clients and friends in Oklahoma. My travels continue next week, seeing additional clients. Due to these travels, I won’t write a piece next week. I will be back in late February.



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