Dividend Café

What to Make of this Market Correction - Oct. 26, 2018


Dear Valued Clients and Friends,

The market downturn of the last two weeks accelerated this week, led by a 600+ point drop in the Dow on Wednesday, and as of press time, we have only seen four up-days in the market all month (ay yi yi).  It is time to unpack what is going on, and why, and how an investor ought to be reacting.  Yes, the markets rebounded substantially on Thursday, but regardless of what the market does from one day to the next right now, this paradigm I describe below is at the crux of the matter …  So let’s get into it!

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Breaking it down – why are markets in turmoil?

There are two things I want to explain here, and they are actually quite correlated to one another.  Underlying the current market conditions are two realities:

(1) Weak global economic conditions, underpinned by a fear of the trade and tariff realities with China, and

(2) Tightening U.S. monetary conditions, which happen to be going head to head with the reality of #1

Why are U.S. monetary conditions tightening?

The Fed is slowly but surely working to get the Fed Funds rate to the “neutral” level, meaning, to the natural place at which that short-term rate would be without intervention.  That number is likely between 3% and 3.5% right now, and they are at 2.25%, meaning, there are still roughly four more rate hikes (of a quarter point each) needed to get to the “natural” rate.  Any rate beneath that is still considering accommodative policy (stimulating an economy that doesn’t need it), and any rate above that would be tightening.  This process is better called “normalizing,” assuming they stop at a neutral policy level.  And the reason for doing it is two-fold: (a) They need to have bullets in their gun for when (not if) an economic contraction comes, and (b) They need to try and slow down what could be excesses building up in the credit markets.

What, me, excess?

Perhaps the major theme I took home from last week’s New York due diligence trip was the reality of credit market conditions.  The investment grade credit market has grown by $4 trillion since 2009.  Middle market lending has grown by 131%.  The portion of the investment grade bond world filled with BBB-rated bonds has grown from just 32% to just over 50%.  Leverage ratios have gone from 2x to 2.5x.  Coverage ratios have come in from 9x to 8x.  Debt-to-EBITDA ratios in the S&P 500 are above pre-crisis levels.  The data points go on and on.  Credit markets are not bursting at the seams – and none of these numbers are catastrophic, nail-your-furniture-to-the-floor type numbers; they are just very reflective of credit markets that could and would turn quite quickly when recessionary conditions surface.  For now, the U.S. economy is humming along.  But no, the reality of business cycles have not been replaced, and the fear about credit frothiness is not about the present tense, but the future tense when economic growth slows down.

Corporate balance sheets have re-levered since the financial crisis, and that was all by design.  The Fed went on a mad mission to “add liquidity” to the economy.  Well, mission accomplished.  And now that liquidity is sloshing around the economy, and much of it/most of it productively so!  But risks have been heightened, and the Fed wants to rein in what could become problematic.

Well, where does this global stuff come in?

The problem with a U.S. economy performing better than the UK, than Europe, than Japan, than the emerging markets, etc. is that at some point the divergence becomes unsustainable.  43% of S&P 500 sales come from overseas.  The world is very inter-connected.  Yes, capital flows will come to the country performing better than the rest, and I am convinced our strong dollar and strong growth (on a relative and absolute basis) will attract capital investment.  But right now, the market is afraid that the weakness in Europe and China and so forth will spill into the United States, period.

And then the Fed?

Add the Fed’s normalizing on top of that global fear, and you get uncertainty, volatility, a recognition that the familiar Fed support of risk assets is taken off, and it is, well, it is what it has been.  A volatile and uncertain market absorbing great U.S. corporate earnings in the context of global weakness and monetary uncertainty.

Who will win?

We will.

Solid companies with less cyclicality and more stability that grow earnings, cash flows, and dividends in all market seasons.

Those who stick to their investment disciplines and maintain key strategic asset allocations.

Those who resist the fatal flaw of market timing.

Portfolios centered around quality, not momentum and hope.

When does the high Debt-to-GDP ratio become a problem?

I have written before about this ratio being highly dependent on confidence in the growth of the denominator – meaning, the GDP level itself (the size of the economy, and the organic growth of that economy).  We currently have a 104% Debt-to-GDP ratio, and frankly, 104% is high because it leaves very little room for error (despite how much higher other countries may be).

All of it comes down to the bond market:  If the bond market will finance your deficits, you have room for a high debt to GDP.  But the problem with a high debt-to-GDP in an ECONOMIC BOOM is that when a recession comes, the debt to GDP explodes (because deficits explode as revenue declines but spending doesn’t).  So you get higher debt, lower GDP, and a bond market that throws up doesn’t like it!

Trivia of the week, again

Last year of a midterm election, where one year later, the market was down:


Now, this statistic, like all backward-looking ones, has no predictive value at all.  But as we get closer to the midterms, and historical data abounds, it seemed fair to share this data nugget.

Is the systemic risk real?

Note what two-year swap spreads have done in recent past periods of genuine systemic distress.  And note where they are now.  Wide spreads indicate low liquidity in the financial system.  That is not the case right now.  So the bear case is that there are real issues (in China, Europe, etc.) – and the bull case is that there is ample liquidity to deal with them.

* Strategas Research, Oct. 25, 2018, p. 3

The perspective you need to close out this week’s commentary

Over the last 28 years, the stock market was up 53.4% of all days, and down 46.6% of all days.  Think about that – over 28 long, long years – the stock market has had just 500 more up days than down days.

And yet, it is up – wait for it – 660% in that time frame.  +660%.  Not counting dividends.  Not. Counting. Dividends.  Fourteen short days ago the market was at an all-time high.  Today it is down over 1,500 points from that high.  The long-term returns of equities takes work.  Whoever tells you otherwise, is lying to you.

(h/t Michael Batnick for these stats)

Politics & Money: Beltway Bulls and Bears

  • The market seems to me to be pricing in that the $200 billion of imports facing 25% tariffs in 2019 will happen.  The bad news is, the market may be right.  The good news is, if it doesn’t, the market will have to re-price its negative re-pricing.
  • The oddsmakers indicate the Democrats take the House, but it’s tight and tightening.  And they indicate the Republicans add to their Senate majority.  I am not convinced the actual results will create a market reaction, but I am convinced that they will have an impact of some variety.

Chart of the Week

Because it is our belief that the asset class which has been made the most attractive by the market activity of this year is emerging markets equity, I thought the following chart may be useful this week to illustrate the historical record in the space after a 20% decline has ensued:

* Ned Davis Research, 2018

Quote of the Week

“You don’t get what you want from investing; you get what you deserve.”

~ Bill Bonner

* * *
I am aware of how unpleasant weeks like the last couple weeks are, and I encourage our clients to reach out with any questions or needs you may have.  We get what downturns feel like, and we are committed above all else to empathetically advising and managing you through this process.  We are dedicated to properly managing our clients whether it be a great market, a terrible market, or the market we are in now.  The only thing we will not do is give you bad advice just because it will feel good.  We will tell you the truth, in a culture where very few will.  To that end, we work.

With regards,


David L. Bahnsen
Chief Investment Officer, Managing Partner


Content Sources: Strategas 2018

The Bahnsen Group

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