e believe that the oil price war that has broken out between Saudi Arabia and Russia makes a bear market in the US virtually inevitable. However, we expect a “good” bear market that simply corrects the excess exuberance priced into equity markets in 2019.
If we are correct, then this bear market will be limited to a reversal of last year’s 30% increase and we are about 2/3rds of the way through a painful but necessary market correction. We do not believe that equity markets are on the verge of another global financial crises or that equity markets will descend to the distressed valuation levels seen in 2008.
We tend to classify bear markets as either good or bad. Bad bear markets tend to arise from opposite extremes: either out of control inflation (e.g. the 1970s) or a potential deflationary spiral caused by too much debt (e.g. the Great Depression, 2007-2009). The fundamental economic problems that cause bad bear markets take time to resolve and can depress economic growth and equity markets for an extended period.
Good bear markets, by contrast, occur because investors have pushed equity markets higher in anticipation of strong earnings growth.
Equity prices fall when those growth expectations are subsequently disappointed. A good bear market is over once equity prices have been “right sized” for actual earnings growth and does not typically lead to a sustained period of depressed economic growth or equity returns.
US equity markets climbed more than 30% in 2019 despite virtually no earnings growth. Investors pushed equity prices higher based largely on the hope that a truce in the US/China trade war would make 2020 earnings growth better than 2019, with the Federal Reserve’s aggressive interest rate cuts and quantitative easing policies providing fuel for this burst of optimism.
The coronavirus epidemic cast doubt on these high hopes for earnings and the oil price war has virtually eliminated them, in our opinion.
The S&P 500 responded to rapidly diminishing earnings expectations by falling more than 15% in the last two weeks, briefly testing and bouncing off technical support at about 2770 (the green line on the chart below). The 2770 level corresponds to the lows of last summer and represents about a 20% correction.
If this support level breaks, and we suspect that it might, the next support level is about 2400 (the red line on the chart). At 2400, the market will have retraced its 2019 gains and experienced a 30% peak to trough decline. A 30% pullback is about the average for bear markets over the past 120 year and compares with the 54% decline experienced during the 2007-2009 financial crises.
Our forecast that US markets will experience a “good” bear market that simply adjusts market prices for a realistic earnings outlook assumes that the Coronavirus epidemic will be contained within the next several months.
As more countries adopt China’s draconian quarantine procedures, we expect the rate of new infections will eventually fall to the inconsequential levels currently reported by Chinese authorities (see chart below). We believe that China is probably reporting accurate infection numbers simply because its prior strategy of minimizing the problem backfired so spectacularly for the Communist Party leadership.
These quarantine measures are likely to have a substantial negative impact on growth, but we believe the strong position of the US consumer can prevent a repeat of the 2008 downward economic spiral. US consumers entered the 2008 recession with a record level of mortgage debt and the highest debt service obligations ever recorded (see chart below). As unemployment rose and home prices fell, escalating mortgage defaults nearly crippled the US financial system and the US economy.
Over the past decade, a combination of substantial loan defaults during the financial crises and falling mortgage rates has dropped consumer payment burdens to the lowest level seen since the early 1980s. Although falling interest rates and oil prices are bad for corporate earnings, these price declines put more money in consumer pockets through reduced mortgage payments and fuel costs.
We therefore believe that consumers are in much better shape to endure an economic slowdown than was the case in 2008.
Consumer spending accounts for about 70% of overall US economic growth and a strong consumer could allow the US to avoid recession despite the coronavirus and an oil price war.
The debt problem this time around for the US economy is with the US government and US corporations. Unlike consumers, politicians and corporate leaders have quickly forgotten the lessons of 2008.
However, the Federal Reserve’s quantitative easing program essentially prints money to finance the federal government’s deficits. The Fed has just increased the money printed under its quantitative easing program from $100 billion per month to $150 billion per month.
That increases the potential size of the federal deficit being financed from $1.2 trillion (the current 2020 projected deficit) to $1.8 trillion. Such aggressive quantitative easing shelters the US government from the short term consequences of its heavy borrowing requirements, in our opinion.
We expect the economic fallout from the coronavirus and oil price war to increase corporate defaults. Corporate borrowing has been particularly high among lower rated companies and we believe that investors in high yield debt should be cautious.
Energy companies and manufacturers that supply the fracking industry could prove particularly vulnerable, and continued problems with the Boeing 737-Max could exacerbate the impact the Coronavirus will have on the airline and aerospace industries. Corporate defaults may not impede economic growth as much as mortgage defaults did in 2008.
Like it or not, we believe the US government would likely act to limit the short term economic damage from too much corporate debt by engineering bailouts like the 2008 bank bailout and the 2009 GM and Chrysler bailouts.
The recently declared oil price war between Saudi Arabia and Russia, combined with the Coronavirus epidemic, has forced investors to reassess their optimistic 2020 earnings forecasts. We expect the current market correction to be a “good” bear market that reprices equity market for more realistic earnings expectations.
We do not think that current equity market volatility signals the more systemic economic problems associated with a protracted “bad” bear market. Irrespective of future economic conditions, we are concerned that current yield levels will result in extremely low longterm returns from bonds. Despite the current market volatility, we believe equities provide much better long-term potential returns.
