but with good reason

Most newsletters we have written over the last two have referred to similar 1920s and 1980s stock bull markets that ended with a crash. Obsessed? Yes—but with good reason. When you see a train coming increasingly nearer, it pays not to divert your attention. We have closely followed the similar and typical interaction of the fundamental, intermarket, technical and sentiment drivers of any trend into what remains the final sentiment driven blowout.

We were perhaps ridiculed for calling such aggressive targets. Now they seem ridiculously conservative.

And as stock indices and related bond and currency markets have continued to follow the same historic path beyond our eight year targets in both time and distance, we have had occasion and necessity to fine tune our view.

January 2018 outlook

Certain factors explain what is actually a relatively minor (price and time) deviation in the scheme of this historic pattern. But what is truly remarkable is the deeper we have compared these three seemingly different eras, the closer the analogy appears. Often overlooked nuances to the 1929 and 1987 template are now widely regarded as important factors driving markets in 2018: trade war, international tension, domestic political uncertainty and possible Fed instability. Each brings its own news stream and narrative with varying impact in isolation and combination but each fits neatly into a very similar narrative.

In previous articles we have outlined in great detail how historic bull markets develop.

Over the next five weeks, we will outline update and develop each of the our main pillars have shifted. This week fundamentals. The three great bull markets of the last 100 years have all been fundamentally characterised by the universalisation (mass production) of a previous technology to a point where there is insufficient economic capacity to maintain the rate of growth. The current uptrend remains led internet commerce and social media stocks. The recent earnings shock of both Netflix and Facebook reflects an ominous saturation but doesn’t mean stocks have topped.

As the market becomes saturated and over competitive the downward pressure on real prices has reduces both the rate of earnings increase and economic growth. In all three decades, in order to maintain this rate of improvement this has led to both a financialization (mergers, share buy backs) and political tension both home and abroad (trade wars, currency devaluation, fed instability over easy vs tight monetary policy). The result has been a hopeful (sentiment driven) increase in share prices (blowout) while the economic data has failed to improve. The last leg of all three bull markets and the turn down into a crash has been marked a growing gap between overly optimistic expectations and a flattening (but not necessarily deteriorating) reality.

The difference between a flattening of economic performance and a recession is important. The top and the subsequent crash has not been led by a recession but caused it. The increasing number of recession led crash calls in the last few weeks shows how the market can be right but its timing wrong.

The economic background necessary for a recession is there. But the trigger isn’t. This week we show the measurable conditions most associated with an economic and stock downturn. Next week’s article will show what it will actually take to trigger a stock market crash and how we can best exploit it.

Conditions for a Recession

1. Long term Yield Curve

The gap between inflation driven long term rates and policy driven shorter term rates is widely regarded as a predictor of recessions. Although in next week’s intermarket article we will show that going negative is not a sufficient predictor of a crash.

2. Unemployment Rate.

The rate of unemployment started to increase just before the last two recessions.

3. Output Gap

The gap between the US economy’s actual and potential GDP has similarly fallen before the last two recessions.

4. Boom-Bust Indicator

Yardeni’s Boom-Bust Barometer that divides industrial input prices by unemployment claims has been an accurate predictor of recessions, falling before and during the last two recessions. It has now turned lower.

5. Housing Market

Housing starts and building permits have also led some recent recessions and have now fallen to their lowest level since last September.

6. Earnings Growth

Earnings started falling ahead of the last recession and are now showing signs of slowing even though they remain relatively high.

7. Exports

An important feature of the 1929 and 1987 top was a fall in exports partly due to the similar trade tensions. South Korean and indeed Chinese exports have also more recently be regarded as a reflection of global growth prospects and therefore a predictor of recession. South Korean export growth stopped in June and clearly the current trade war does not bode well for Chinese exports.

8. High Yield Spreads

When higher risk corporations appear overstretched during the period of saturation, the risk of default and credit spreads typically rise as they did in the run up to the 2008 recession. They have now started ticking higher.

9. Lower Yield Spreads

The difference between investment grade corporate bonds and treasury yields has rallied above 2 per cent during or just before six of the last seven recessions since 1970. They have just broken back above 2% again.

10. Misery Index

Last but not least as a recession indicator is the Misery Index that combines inflation with the unemployment rate. It has turned back up during 2018.

Just because the economic of fundamental conditions are ripe for a recession or stock market crash does not help time the downturn. And since we aim to profit from any upside stock movement in the interim and be short as the market turns, timing is everything.

Here’s to making the very best.

Good Luck

Ed Matts
Matrix Trade

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