A year ago I recommended investors adopt a defensive posture in regards to the stock market. Stocks were able to move higher, before chopping sideways and then selling off in this current period of volatility. Significant price swings have become commonplace and stocks have so far in 2015 delivered negative returns. My recommendation to underweight stocks was not based on predicting an imminent bear market. Instead, it was a declaration that the risks versus rewards of owning stocks were too negative to justify even a neutral weighting, and the potential for a bear market too high. For a long time, I had been writing about the risks to this current bull market, but that was the first time I recommended the more conservative, defensive posture that I continue to advocate. The reasons for that call are worth revisiting, particularly my worries about China, as they now seem especially pertinent.
A Chinese Hard Landing
Before it became the current big worry, I had written frequently on how the risks of an economic hard landing in China were higher than appreciated. All the way back, in 2013 I pointed out, “Despite all the talk about China shifting its economy towards consumer spending, increasingly inefficient industrial, infrastructure and speculative real estate continue to be the core, with investment outstripping consumption year-to-date as a driver of growth.” My concern sounded alarmist to many, but it’s not being lightly dismissed any longer. My big worry with China was that we would reach a point of creating zombie firms, where pumping more debt into increasingly economically inefficient companies does not equate into economic growth, but merely allows them to avoid mass layoffs, while continuing to payoff investors and creditors. In such an environment, painful restructuring is needed, a recession unavoidable and expansionary monetary policies, like the government pumping up the stock market, become ineffective. With China accounting for so much of global growth in the current recovery, this is far from a trivial worry.
Even if many market pundits dismissed my China concerns initially, commodity markets, including eventually the oil market, began to signal there were some real problems with China and by extension global growth. I differed from the consensus that initially celebrated lower oil prices, as a boon to U.S consumers and strong positive development for the economy. With supply trends largely known, it was falling demand expectations that were sending prices down (an ominous signal for global growth), while putting good paying jobs, created disproportionally during this recovery around the U.S. shale boom, in jeopardy and also sending shocks into credit markets, as so much of that industry has been dependent on debt financing. Unfortunately, for the economy my less rosy interpretation appears to be closer to the mark.
Falling Economic Dominoes
But if a Chinese hard landing was my favorite theory for what could cause a global recession and falling oil prices brought some decidedly negative implications, even I had to admit at the end of 2014 that the U.S. economy was in spectacularly mediocre state, with no strong signs of recession (or imminent strong growth for that matter). But that is changing in 2015. Yes, the U.S. consumer and service sector still appear to be chugging along, while employment and income remain decidedly mediocre. But the manufacturing side of the economy is now turning increasingly negative, with a source of concern also growing around wholesale inventories of which my colleague Jeffrey Snider has been covering in detail. Things have changed enough that a 2015 Federal Reserve rate hike that was seen as a near certainty has been both postponed and become less certain, due partly to worries about China’s impact on America’s economy.
Some argue the U.S. consumer is the most important factor, and as long as consumer spending remains healthy the economy and by extension the stock market will be fine. But if you subscribe to the theory a global recession will emanate in China, spread to commodities and the emerging markets and sectors dependent upon, like shale oil, before impacting manufacturers (first of related-capital items and related-export markets), before eventually wreaking havoc in credit markets…. Well under that theory, then the U.S. consumer would be among the last dominoes to fall, very possibly after quite a bit of damage is done in the stock market. So, waiting for clear signs of the failing health of the consumer might mean waiting too long. And the most worrisome aspect of this theory, where the last-to-fall U.S. consumer is giving false hope, is that so far it appears to be what is happening.
It’s About More than Malinvestments
Although it’s good to have a theory of what will happen, my recommendation to reduce stock exposure was not dependent on that scenario unfolding. In fact, I wrote a four article series in late 2014, culminating in that recommendations, and only one of those posts was focused on malinvestments, like Chinese real estate and U.S. shale investments. I also pointed out why valuations are too high and stocks are in bubble territory. In addition, I deconstructed how record corporate profitability is actually a negative, due to how it has been created in a weak economic environment through financial engineering and because corporate profits are mean reverting. In fact, in another more recent negative development, profits now appear to be falling back towards trend.
At the end of 2014, I also pointed out how after the last round of quantitative easing ended, the market was not looking as technically constructive, “And it is internal divergences within the stock market, as well as those without that are an increasing cause for concern. For instance, low beta defensive stocks are showing rising strength, rather than the high beta stocks that should lead a strong bull market. The advance decline ratio is also deteriorating, with fewer stocks making new 52-week highs, while others show weakness, including stocks that should lead a healthy rally. Correlations are breaking down between U.S. stocks and sectors, as the internal price action of the stock market becomes more negative, and negative divergences are appearing in terms of the Moving Average Convergence Divergence (MACD) momentum indicator. In addition, recent market volatility is reminiscent of price action at the 2007 and 1987 market tops.”
At my firm, concerns primarily around valuations, led to an initial underweight of stocks in our actively managed accounts. But in August of this year, as the stock market was putting in its most recent top, we further reduced equity exposure based on widening credit spreads, which were signaling potential trouble on the horizon. Today, those credit spreads remain in worrisome territory. In August, our momentum portfolios also moved away from stocks to favor bonds, in another worrisome sign for stocks. Maybe, credit markets will improve, momentum will shift back to favor stocks, markets will become more technically constructive and the global economy will weather these current China worries. Maybe this will all happen to favor stocks. I will be following the data to see if the concerns that led to my defensive call are off base or perhaps just temporary. It’s important to be humble enough to recognize when conditions change in ways you don’t anticipate.
But, with things progressing the way they are so far, my bigger concern is that my prediction for stock market trouble will turn out to be correct, thereby creating some very tricky waters for investors to navigate.