Stock Market Tug of War

I.C. Angles Investment Post…

So far in 2015, the bulls and bears have been in a tug of war on the direction of the stock market. The first quarter has fluctuated between the S&P 500 posting new record highs and turning in a negative return for the year. Both sides have compelling arguments for stocks heading lower or higher in the near term. The bears argue stocks should head lower, because most measures of economic performance have come in below expectations. The economy rather than taking off, as was widely anticipated, is ebbing closer to stall speed. Obviously a recession would be a huge negative for stocks. On the other hand, the bulls have several reasons for why disappointing economic data should not stand in the way of stocks making new highs.

Bullish arguments include that weak economic data is actually a good thing because it encourages the Federal Reserve to continue with accommodative monetary policy and push out a rate hike. This pattern of weakening, although more severe than last year, also fits a pattern of winter weather slowing the U.S. economy, with an inventory build-up that now needs to be burned off. So, the bull case is that there is nothing new to worry about. However, the weakening is pronounced enough that if not an economic recession, an earnings recession (not helped by a stronger U.S. dollar) may already be underway.

The bull response on that note is that falling earnings are mostly about the energy sector and a decline in oil prices that should be transitory, as well as a strengthening U.S. dollar that is evidence of how much stronger the U.S. economy is versus the rest of the world. Some bears answer that the supposed benefits of lower oil prices for boosting retail sales have not manifested, and the negatives in terms of lower earnings, debt defaults, job losses and capex spending cuts are only getting started and will have broader implications. And I myself would argue that there are very big risks from a strengthening U.S. dollar to the global economy, which must service significant amounts of dollar denominated debt.

So who is right?

I moved into the bearish camp late last year for two reasons. First, as I have covered previously stocks, particularly U.S. stocks, are extremely over valued. That does not mean they are about to fall. But it does mean that when they do fall in a bear market, the decline is likely to be particularly painful. In my opinion, the potential risks are increasingly outweighing the likely rewards of owning stocks, especially with volatility having returned to the stock market. The second reason is a global environment that could very well generate more headwinds on a weak U.S. economy than it can handle.

I believe odds are good that China’s economy is headed towards a hard landing, as its enormous real estate bubble deflates, and this will be bad news for the global economy. I think odds are good that oil prices, are a harbinger of things to come, as commodity prices in general have been falling, indicative of a global economy exhibiting decelerating consumption and growth. Commodity producers are just the first getting hit. In addition if the U.S. dollar continues to strengthen it could spark a crisis around dollar denominated debt, as well as further hurting earnings of U.S. multinationals. On the matter of currency crisis, problems around the Euro also continue to simmer.

Then there is also the geopolitical environment. Forgetting about potential or outright conflicts in Russia’s near abroad and Asia, the Middle East is becoming increasingly unstable, with a three-way war having broken out, between Iran’s Shiite regime and allies, Sunni extremists now possessing their own country, and Sunni Arab states, who have formed their own military alliance. So far Israel has remained mostly on the sidelines, despite voicing concerns about Iran, largely shared by the Arab states. Whether it’s a Chinese hard landing, currency crisis or destabilizing foreign event, the odds of such an event occurring are rising, while U.S. stocks have risen too far and a weak economy is increasingly vulnerable to being pushed into recession. Although the evidence does not presently point to a recession and it is unlikely stocks will fall hard unless one transpires, the stock market may have become more volatile, because the evidence does point to risks having risen.

Maybe the bulls will win this tug of war in the near term. But the potential rewards are in my view meager, compared to the likely losses if the bears win. When a recession does occur, the stock market is likely to be cut more than in half. And it’s hard for anyone, even the Federal Reserve, to argue that the odds of that transpiring have not risen.

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