“If there are any certainties, one will be that this party will eventually come to an end,” James Stack, the president of InvesTech Research, said a year ago. “And when it ends, it will end badly, and with high volatility.”
Stack turned out to be right. He lowered his recommended asset allocation for US stocks from 82percent last January to 72percent in September, when stocks hit new all-time highs. He urged investors to raise cash in October, and at the end of November he recommended an even more defensive posture - including putting money in a fund whose value would rise when stock prices dropped.
That brought his recommended net exposure to stocks to just 55percent, the lowest since the depths of the last bear market in early 2009.
Stocks plunged in December, posting their worst monthly loss since the financial crisis and the worst December since 1931 and the Great Depression.
Yet most US economic indicators are benign. Unemployment is an exceptionally low 3.7percent. Wages are rising. Inflation remains below the Federal Reserve’s 2 percent target. The Fed raised rates a quarter point in December, citing “a very healthy economy”.
Given Stack’s track record last year, I reached out to him last week for his current views. Even though valuations have come down and macroeconomic indicators “have remained remarkably strong”, he said, he’s still defensive and hasn’t changed his bearish allocation. He believes that the worst isn’t over and that the Dow and S&P 500 will soon be down 20percent from their peaks, retreating into a bear market. (The Nasdaq Composite and the Wilshire 2000 index of small-cap stocks are already there.)
And that was before a revenue warning from Apple sent markets into another steep fall on Thursday.
“A lesson from history is that the market leads the economy by a lot longer than investors realise,” Stack said. If the economy is headed towards recession, as the latest stock market declines suggest it may be, “we won’t see the first economic warning signs until the first three to five months” of 2019. Among the leading indicators he’s watching for signs of weakness are consumer confidence, housing starts and unemployment claims.
On Thursday, the Institute for Supply Management manufacturing index, a leading indicator of industrial activity, fell sharply. That suggests that “serious cracks” are starting to appear in the economy, Stack said.
Stack is right that bear markets typically precede recessions by many months: CNBC calculated in 2016 that bear markets since World War II had begun on average about eight months before a recession. That means that if a bear market did begin after major indexes peaked last fall, a recession might not start until June or even later. Even then, recessions are often over before economic data confirms their existence. That’s when bear markets are, in fact, followed by recessions, which often isn’t the case. As economist Paul Samuelson famously said: “The stock market has forecast nine of the last five recessions.”
Since World War II, there have been 13 bear markets. They were followed within a year by a recession just seven times. As a predictor of recessions with just 54percent accuracy, bear markets are little better than flipping a coin.
Indeed, Stack’s data show that two down years in a row are quite rare: There have been only four instances since 1928, suggesting that stocks may well be in positive territory by the end of 2019, even if a bear market does materialise in the meantime.
Which is one reason Wharton economist Jeremy Siegel said that he’s bullish on the stock market this year. He predicts it could rise between 5 and 15percent, even if there is an economic slowdown.
Stocks are much cheaper now than they were before the December sell-off. The ratio between stock prices and projected earnings for companies in the S&P 500 is about 17, down from over 19 a year ago and the lowest in the past five years. Stack, however, argued that in the event of an economic downturn - or even a significant slowdown - “those projected earnings will go out the window.”
New York Times News Service