What Could Go Wrong? Valuations and an Economic Slowdown

By Christopher R. English, President of Lumen Capital Management, LLC

You’ve probably heard the terms “bull market” and “bear market” thrown around by the media. In simple terms, a bear market occurs when stock prices fall and buyers disappear. Bull markets experience rising prices and increased demand for equities. The bullish case for stocks gets a lot of media hype and occasionally those that think the world is coming to an end also hit the airwaves. Both make for good headlines, even if reality often lies more in the middle. I am not currently bearish although I think we at some point are due for a correction. However, I think it is only fair share the bearish arguments, especially since I usually talk about the positive side of things. In a two part series this month, we’re going to focus on letting the bears share their side of what could go wrong in the markets and I'll give my counter-view to their arguments. 

Bears Versus Corrections

It is important to understand that at some point we will again experience a market correction. These are vastly different than bear markets. A typical market correction is a short-term event, usually lasting around two-six months. On average, market volatility runs around 14%, which means that in a given year, stocks will usually experience some sort of correction between 10-20%. Even though we haven’t experienced a correction in a few years, we shouldn’t ignore the fact that they occur and are a normal corrective part of the market’s process. A secular bear market, on the other hand, usually is a multi-year event where stocks historically lose 30-50% of their value, and we don’t always know when we’ve hit the bottom. To buy into the secular bear market scenario is to usually a bet on a significant economic shift. That is much different than your typical correction. I’ll be listing in the next two articles in order of highest probability by our estimation would could potentially trigger a secular bear market. 

Reasons For A Market Decline

We all know that markets are unstable, but in our current economic situation, what could cause a future market decline? 

Decline Due To Valuation

Markets have traded at elevated valuation levels now for years. Investors have justified this by pointing to the lack of alternative places to invest assets and the very low interest rate environment we’ve been in. But this year has brought rising interest rates, with the Federal Reserve announcing the newest quarter-point rate hike on June 14th.

Higher interest rates increase the possibility of cash leaving equity markets that are historically extended and looking for alternative places to invest if interest rates become more competitive. The bad news for the bulls is that a decline to market levels where stocks have historically been seen as cheap would probably today mean a correction of greater than 20%. That also assumes we’re not correcting because of a decline in earnings. In that case, markets could experience a much deeper correction.

My counterpoint: There is no gloss to hide the ugly truth that stocks are historically expensive. The counterpunch to that argument is currently, corporate earnings have been growing at the fastest rate in years. In addition, these earnings are muted by the depressed value of energy companies due to the global sell-off in oil. As long as earnings continue to grow, markets have the potential to advance. In regard to interest rates, probability suggests bonds will likely only begin to compete with stocks once we see the 10-year U.S. Treasury break the 3% level, while rates have been recently rising, we are not yet near that important level. 

Decline Due To A Slowing Economy

The markets could also sniff out an economic slowdown causing investors to worry that the economy is running out of steam. This would call into question corporate earnings and again could potentially impact valuations. There are some signs currently pointing to this, such as rising consumer debt and rising default rates, also student loan debt now has grown to over one trillion dollars, while new car sales seem to be peaking. 

We are close to what economists consider full employment, but wage growth has been tepid for many and consumers seem to be unwilling to spend like they have in the past. Based on some of this data one could make the argument that it wouldn’t take much to drop us into a stagnant or contracting economy. Additionally, rising interest rates could put the brakes on economic growth.

One of the best predictive signals for economic contraction is when short-term interest rates yield more than bond yields on longer-dated maturities. This yield curve inversions means investors will likely buy short-term bonds instead of bonds that don't come due for many years. For example, why lend money at 2% out 15 years when you can lend at 3% for less than five years? When this happens, investors have less incentive to lend money, starving the credit markets of the fuel that keeps the economy afloat. This has been a predictor of the previous seven regressions, going all the way back to the 1960s. We are much closer to an inversion today than we were a few years ago.

My counterpoint: The problem with this argument is that for every negative economic statistic there are others that show the economy is growing. Gasoline for example is as cheap this summer as we have seen in years and food inflation remains subdued. Housing starts are healthy and I would argue that rising interest rates at this point should be construed as a positive outlook on the economy. The cost of money typically doesn't rise if the economy is soft. Finally I continue to argue that many of our current economic statistics do not adequately measure growth or how our more knowledge based economy is evolving. To me then, probability suggests that economic growth is potentially stronger than statistics sometimes suggest

Regardless of what happens, remember that the economy always goes through cycles and if you are committed to a long-term strategy, you don’t need to lose sleep. If you are concerned about how your investments will fare if the markets undergo a correction or a dive, call my office at 708.488.0115 or email us at lumencapital@hotmail.com. We will continue this series below.

About Chris

Christopher R. English is the President and founder of Lumen Capital Management, LLC-a Registered Investment Advisor regulated by the State of Illinois. A copy of our ADV Part II is available upon request. We manage portfolios for investors, developing customized portfolios that reflect a client’s unique risk/reward parameters. We also manage a private partnership currently closed to outside investors. Mr. English has over three decades of experience working with individuals, families, businesses, and foundations. Based in the greater Chicago area, he serves clients throughout Illinois, as well as Florida, Massachusetts, California, Indiana, and other states. To schedule a complimentary portfolio review, contact Chris today by calling 708.488.0115 or emailing him at lumencapital@hotmail.com.

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