Tariff Impact Negligible: Bear Market Unlikely  

Sentiment Indicators

Surprisingly, the CNN Fear and Greed index was still stuck on extreme fear after the rally on Monday as it was at an 8 out of 100. The table below reviews some of the sentiment indicators and shows if each one is a bullish or bearish signal. The put to call ratios for 3 days and 10 days are bullish signals because they are high. This means more traders are seeking protection than looking for upside. It’s not a great time to buy puts and sell stocks after a correction. It’s interesting to see the financial media wondering when the next correction will happen after it happened; this was just like how the media wondered if a melt up was coming in January after it already happened.

As you can see, the VIX is above 20 which is a bullish signal. The VIX is clearly still too high considering the economic and corporate fundamentals. Even though the American Association of Individual Investors survey is neutral, it’s interesting to see how the bears have increased by about 7%. Individual investors have a terrible investing track record. The advisory services sentiment index is too optimistic and investment managers are a neutral signal. The crowd survey has switched from optimism to pessimism, mimicking the market’s performance. I doubt all of these indicators will tell you to buy stocks by the time the bottom hits; as you know, I think the bottom end of the range is the market’s floor.

Volatility Only In Stocks

As I mentioned, I think the volatility will fall over the next few weeks because the headlines about tariffs got out of hand. The chart below shows the 12 month historical implied 3 month S&P 500 volatility compared to the average 3 month volatility of interest rates, currencies, commodities, and credit. As you can see, the recent action has been focused mainly on stocks as other asset classes have seen a decline in volatility. The question is if stocks know something other investors don’t know. I think stocks are wrong in this case, but obviously, that’s not a rule to live by.  

Tariffs Still Small

The risk to the tariff situation is that bigger ones are levied which sparks a trade war with China. Unless that happens, the ones which were enacted thus far will have a negligible impact on the economy. As you can see from the chart below, the total 2018 impact will be $36.5 billion which is small compared to the $800 billion impact the easy fiscal policy will have. Most stock market corrections on built on fear of something that won’t occur. There is 1 correction of about 13% in an average year. The correction is coming at a convenient time because it is quelling the speculative fervor which developed in January. The more analysts who claim stocks have no upside until the end of the business cycle, the more optimistic I’ll be on stocks in the medium term. My expectation has always been for high single digit gains this year.

Historical Sharpe Ratio

Unlike the Shiller PE, which analysts have been expecting to mean revert, but hasn’t done so, the 12 month rolling Sharpe ratio has mean reverted this year. The risk adjusted return in 2017 was the best since the mid 1990s. A sharp drawdown with virtually flat returns is a preferable way to get back to normalcy than a bear market. This year has been similar to 2016. Even with the early volatility in 2016, stocks were up 9.54% that year.

Fed Is Moving In A Hawkish Direction

As you can see from the chart below, the Fed funds rate is now above the core PCE rate for the first time since April 2008. The core PCE is the Fed’s preferred inflation indicator. This chart is interesting because unlike when the Fed raised rates last, the core PCE hasn’t moved up prior to this rate hike cycle. The Fed isn’t reacting to increased inflation in 2018; it’s actually hoping inflation picks up to justify its prior hikes and guidance for future hikes. The Fed is closer to being ahead of the curve than behind it. I can’t say there has been a mistake yet because the yield curve hasn’t inverted. I pay little worry to a flattening curve because there has yet to be a cycle which stayed at a steep curve forever.

Fed’s Unemployment Rate Estimate

While the Fed has recently become more optimistic on GDP growth and unemployment declines in 2018, the Fed has been too bearish on unemployment in the past few years. The chart below shows actual results compared with the historical estimates. As you can see, there was only a significant change in the forecast in 2014. The Fed is now faced with a predicament because the unemployment rate is near prior cycle lows, so it can’t get too aggressive with its forecast. My point has been that the participation rate needs to improve before full employment can be hit.

The tweet below is a quote from John Williams, who is the current San Francisco Federal Reserve Bank President, in March 2015. Three years ago, he said the labor market was getting close to full employment. When he made that statement, I’m sure he didn’t expect such job growth and moribund wage growth in 2018. I’m expecting a full labor market in 2019, so he was 4 years off if I’m correct.

Conclusion

It’s amazing to see how small of an affect the tariffs will have on the economy because the market crashed 10% based on fears of them. You can argue tariffs were never the cause of the decline. It may have been technically driven or driven by the weak economic data combined with the more hawkish Fed. Just like how some headlines are noise, some near term market movement is noise. Every correction that doesn’t lead to a bear market is noise because it doesn’t signal a change in the market’s intermediate term trend.

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