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December 21, 2018
We're gonna need a bigger ladder!
What a way for stock market investors to end a year. The much hoped for Santa Claus rally, even if it does show up over the next few trading days that we have left this year, will help too little and will come too late to change the sour investor sentiment that's become so pervasive. The so-called wall of worry that stocks need to climb is getting a lot taller as this year comes to a close, and investors shouldn't be blamed if they think it's gotten too high to climb.
You see, when people are happy and confident about stocks, it generally means that they're heavily invested. That leaves less cash to go into stocks because, presumably, that cash has already been used up. So, if investor sentiment turns negative, you get a wave of selling. On the other hand, each investor worry is a reason to feel pessimistic about stocks. If the worries pile up, it's presumed that investors have sold out of stocks and stashed their cash in a money market fund; cash that could be reinvested back into stocks as each successive worry goes away. In other words, when sentiment turns positive, it creates a buying wave.
2018 has become a year that exemplifies the transition from investor optimism to pessimism; stocks fell down the wall of worry this year and a new, taller wall of worry now stands before us, to take this analogy a little further.
What I want to do here is answer two questions; "have investors gotten too negative?" and "are we really in a recession or an abrupt slowdown in the economy?"  
By all counts, the U.S. economy is healthy; with low inflation and strong employment. That's why most economists conclude that they don't see enough economic weakness to drive the U.S. economy into a recession anytime soon. But a slowdown is in the works for many parts of the economy; from housing and automobile sales to lower commodities prices for copper and oil. But I can't find any evidence that the healthcare, online retail sales, and cloud computing sectors are slowing. I think the correct way to look at recessions is to judge them on an industry by industry basis. We simply are not in an economy like the 1970's or 1980's when every sector moved up and down in unison. By that reckoning, we're in a commodities recession and in a healthcare expansion at the same time.
My base case is that we are headed for an economic slowdown that will feel like a recession for stock market investors. If companies are valued based on their future growth potential and the outlook looks weaker, stock prices will simply discount that, like they are doing now. Lots of factors are influencing investors' forecasts, such as the trade issues between the U.S. and China and tighter monetary policy in both the U.S. and Europe. Also, the waning effect of the tax cuts passed one year ago today is leaving investors asking of stocks "what have you done for me lately?" Does this mean I should advise everyone to sell every stock they have? Of course not. I could be wrong and the economy could perk back up. Stock buybacks could start to have a positive impact on stock prices. Mergers and acquisitions could provide lift to stocks. And the most important thing is that for a good many sectors and stocks, investors' negativity may have gotten overly intense. Not that it means overly intense negativity on stocks can't get even more intense!
When I survey the landscape, it is stunning to see how far so many stocks have fallen from 52 week highs that were set only two or three months ago. I think that's what has so many markets pros and retail investors' alike feeling gloomy - market cycles have gone from being evolutionary to revolutionary. With the advent of algorithmic trading, we're going to have to get used to seeing markets adjust to changing economic forecasts much more rapidly than in the past. Slowdowns are factored into stock prices so fast that by the time that happens, it'll already be time to invest for the recovery around the next corner.
No commentary could be complete without a few words about the FED. Four rate hikes this year and a  balance sheet that was reduced from 4.5 Trillion Dollars at its peak to about 3.9 Trillion Dollars, the lowest in over 4 years. My take on FED Chairman Powell's post-FOMC speech was that he is focused on reloading the FED's policy ammunition but will take into account data as it presents itself. In other words, he left himself a little wiggle room to be flexible going forward. Therefore, I believe the Street overreacted and continues to overreact to his speech. Today, New York FED President John Williams reiterated that the FED will take into consideration new data as it comes in, reinforcing that the FED will be flexible with its monetary decisions, even if it means changing the rate of speed in which it is shrinking its balance sheet.
Does this months' trading action mark a near term bottom for equities? I believe finding a bottom is a process, not an "exact, right moment". My reasonable thesis for this moment is that values for quality stocks are very compelling; that many stocks are in deeply oversold territory. But that doesn't mean you won't have to wait for capital appreciation. Shouldn't that be the point of this whole post?
It's an investors' market now and investing is humbling. When stocks reset, mean revert, return to trend, or whatever you want to call a bear market, it requires you to accept that the future will be better for the companies you're investing in. When cycles turn, it means that the conditions that got them to old highs no longer exist. But new conditions do come into play because corporate managers, policy makers, and investors always manage to create them, pushing stocks to new highs once again. And once again building a bigger ladder to climb the new, bigger wall of worry. 

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All the views expressed in this report/commentary accurately reflect our personal views about any and all of the subject securities or issuers and no part of our compensation was, is, or will be, directly or indirectly related to the specific recommendations or views we have expressed in this report. This material is not intended as an offer or solicitation for the purchase of sale of any security or other financial instrument. Securities, financial instruments, or strategies mentioned herein may not be suitable for all investors. Any opinions expressed herein are given in good faith, are subject to change without notice, and are only correct as of the stated date of their issue. Prices, values, or income from securities or investments mentioned in this report may fall against your interests, and you may get back less than the amount you invested. The information contained in this report does not constitute advice on the tax consequences of making any particular investment decision. You should consult with your tax adviser regarding your specific situation. Diversification is a method of managing risk and doesn't protect against loss in a down market. 

Mitchell O. Goldberg, AIF®, AAMS

President | Investment Professional

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