What Will Trigger A Crash?
Nothing … but a vacuum.
Despite entering August, markets have retained the erratic character of the July chop. This is understandable given the mixed news that has hit the market this week: Chinese trade talks, AAPL earnings beats, a small tweak to BoJ monetary policy, FOMC upbeat account of US economy, Trump increasing tariffs, a benign ECB meeting, and a UK rate hike finished by a NFP miss. This conflicting stream of news is not only typical of July but important within the latter (or penultimate) phase of the stock bull cycle. Traders also tend to over-pursue non-existent trends at this time of year but arguably have too much time to over analyse a sideways market. The net result has been whipsaw consolidation and further dissipation of the overly bullish stock sentiment that characterised the start of the year (with the exception of NDX and FANGs). This succession of uncertain news stories, the resulting inflection ranges and the shift in sentiment is significant to how the market will eventually turn away from the euphoric uptrend of an apparent Goldilocks economy (high growth, low inflation).
This week’s newsletter updates our rigorous Fundamental Milestones in Mania that guided us through the eight year stock uptrend and seeks to explain what will likely trigger a likely stock blowout, top and crash and the resulting volatility in currencies, commodities and bonds. Our account of how news impacts markets is instructive in managing the latter stages of this cycle and will be the subject of next week’s article.
We have previously outlined how the fundamentals, intermarket relationships, technicals and sentiment (FITS) typically interact in any trend to explain how and why trends develop, mature and reverse. The uptrend from 2010 FITS neatly into very similar uptrends in the 1920s and 1980s in all four respects. One can track each pillar individually as a guide to where the market is within its trend and indeed the number of technical crash comparisons is testimony to the growing popularity of this approach. However understanding how they combine is far more useful in timing major moves.
The fundamental uptrend since 2010 bears a remarkable similarity to the 1920s and 1980s. Following a government inspired recovery out of recession, the economic expansion saw increasing government and trade deficits. These were not only important contractionary destabilisers in themselves but also led the US administration into confrontational policy decisions that undermined global economic stability notably tariffs and a devaluation of the Dollar that characterised the move into the stock top, turn and crash.
As governments helped reflate economies out of recession, mass production of a previously invented technology drove corporate earnings, economic growth and indeed bullish stock sentiment higher eventually to a saturation point where insufficient capacity (and lack of productivity gains) produced a growing gap between reality and expectation, between actual inflationary growth/earnings and stock prices. This gap could arguably been closed if there was enough spare capacity and/or the government or country had not built such a large potentially contractionary or destabilising deficit.
The resulting over-competition led to an increasing downward pressure on prices rises or inflation. Inflation therefore slowed during the second half of the uptrend until a mild increase in the last leg. As this again slowed as stocks found a top—consistent with the subdued inflation of the last year.
The saturation also accounts for flattening of economic growth that featured in the second half of the 1920s and 1980s bull markets. Again the very last leg was characterised by an increase in economic growth that we are now seeing, but the very top was marked by a downturn. The trigger could or should be a fall in the currently increasing US economic growth rate.
The problem with relying on GDP figures to time the very top is the lag in the collection of data and release. For this reason we have monitored PMIs as a more timely indicator of a potential top. The current flattering is consistent with that seen at the 1987 top and suggests the next GDP release could disappoint.
Although certain economic indicators started turning down into the stock market top, this was largely ignored by traders and central banks. It was crucially the expectation or fear of inflationary growth (as opposed to disinflationary growth) that fuelled traders and investors to buy more stocks and the Fed to raise rates. (Note 1980s tightening was much greater than shown in this direct comparison).
This tightening, as inflationary growth failed to materialise was, combined with increasing government and trade deficits, is the key to the turnaround, and features strongly in our comparison and crucial audit of the intermarket comparison.
Of course one could argue, quite topically, given Trump’s recent interest rate comments, that had the Fed not tightened so aggressively, the crash would not have happened. That is, rate rises were a sufficient but not necessary condition of a turnaround and do not necessarily need to follow the same pattern. But the likely further escalation of stock prices would not have been sustainable unless, with full capacity, there were significant productivity gains.
Although Trump has been keen to realign the US economy in favour of manufacturing, the time this would take to filter through into productivity gains is probably beyond the scope of this bull market, certainly since much of the current productivity gains come from the technology sector.
The main economic indicators of the 1920s and 1980s suggested, just like now, that the market was approaching a top.
But they were neither timely nor precise enough to have picked the very top. Indeed, as indicators they failed to encapsulate how sentiment combined with fundamentals to cause the turn, how stock prices continue to rise in a final blowout while the economy flattened creating a gap between reality and expectation and a vacuum that would be filled by the eventual crash.
The indicators that reflect both stock prices and fundamentals are the key to timing the top.
PE ratios have almost met our targets and argue that the uptrend has almost run its course.
However neither Price/Earnings (P/E) nor Cyclically Adjusted Price Earnings (CAPE) indicate a top until after the market has turned. In other words, once prices have turned aggressively P/E also turn aggressively lower. Given the flattening of both P/Es and CAPE before the final blowout in both prices and indicators, this strongly suggests we are yet to see the upward climax.
The most important and last fundamental milestone or condition for a stock market top is yet to be satisfied: dividend yields. The reason simply is something we previously underestimated. Prices needed and still need to rise almost exponentially while earnings flattened or turned lower.
In both 1929 and 1987 dividend yields collapsed below the equivalent of 1.75%. Although, in itself, this strongly argues in favour of a final shift higher in prices leaving dividend payouts behind, one has to be careful of direct comparison. The current market is being led by companies such as FANGs that do not pay much if anything in the way of dividends. It is the traditional companies such as IBM that comprise the large part of aggregate dividends.
Dividend make-up of DJIA
Quite a few of these companies are already struggling to maintain pace and is one reason why we believe the industrial sector (XLI) will be one the earliest to turn if it hasn’t done so already and why, besides a self-fulfilling tariff cause, DJIA will remain unfavored in stock index rotation.
However, where market leaders are a guide is through their earnings. This data is useful both as a reflection of an economy that is failing to keep up with the rise in stock price and also the difference with stock price rises that creates the necessary collapse in dividend yields. Although some FANGs have started to show a deterioration in earnings, the slowing needs to escalate more as price rise further. As the largest stock and market leader, it is hard not to believe AAPL’s earnings will be an important indicator. Clearly this week would suggest we are not yet at a top.
In conclusion, the global and particularly US market have followed the path set by the 1920s and 1980s uptrend. Most fundamental indicators have now been satisfied and argue we are close to a top, flagging GDP as a key indicator. But in the previous two cases, an aggressive blowout in price was necessary for the price related indicators to meet their targets and provide enough time for corporate earnings releases to reveal an economic deterioration that set the background for the crash.
The question is what will trigger a blowout that ignores the fundamentals so much. The answer that we will reveal next week … doesn’t have to be positive. Rather as a purely sentiment driven move, history shows it is the lack of a negative news—a negative negative.
“In life two negatives don’t make a positive. Double negatives turn positive only in math and formal logic. In life things just get worse and worse and worse.” Robert McKee
Here’s to making the very best.
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