Bear or Bull Market: What’s the Beef? (January 11)

Update 322 — Bear or Bull: What’s the Beef?
What Market Volatility Means for Real Economy

Markets are notoriously difficult to read, let alone predict.  And market performance correlates to growth and other macroeconomic factors in an opaque way.  But the increasingly erratic capital markets are arresting attention and arousing concerns.

Which of these real economic concerns are well-founded, which merely alarmist?   Do they shed light or shade on the question, how imminent is the next recession? We boldly go into the murky distant future and the murkier near-term as well.  

Good weekends all,




State of the Economy

In macroeconomic terms, the U.S. economy is chugging along at a steady clip. Unemployment is at 3.9 percent, below what economists consider “natural unemployment” (or full employment). The economy added 312,000 jobs in December. Inflation is holding steadily near the Fed’s target rate of two percent. Wages are finally rising above the rate of inflation. In October 2018, wages had increased 3.1 percent from a year earlier — the fastest rate of increase since 2009.

Source: Labor Department

Although GDP growth is expected to slow, per Fed projections, the labor market is forecast to stay strong. The Fed predicts that unemployment will drop to 3.5 percent this year and stay at that level into 2020.

Revenge of the VIX

Despite these solid macroeconomic indicators, the U.S. stock market has been experiencing increased volatility, as indices such as the Dow Jones Industrial Average (Dow) and the S&P 500 entered bear market territory.

The increase in volatility is reflected in the Chicago Board of Exchange Volatility Index (VIX) — the “fear gauge” of the U.S. equities markets. The VIX tracks market expectations of volatility over the next 30-days, producing a numerical value that reflects investor sentiment and market risk in the short-term.

Source: Wall Street Journal

After a long period of stability and growth in the U.S. equities market following the Great Recession, the VIX came back with a vengeance and rose 130 percent last year — its largest climb since its inception in 1993. In fact, U.S. equities were even more volatile than emerging market stocks in 2018, a very rare occurrence as concerns over growth and trade sent the markets into a frenzied sell-off to finish out the year. January has seen the fear index come down from its highs, with the VIX down to around the 20 mark.

The bull market that preceded this recent correction was the longest in history, with the Dow quadrupling and the S&P 500 soaring over 320 percent since 2009. The recent rise in volatility and the end of the nearly decade long bull run has alarmed some, but what is the cause of this correction, and how does it relate to the real economy, if at all?

A Bear-y Sentiment

While the VIX has wild gyrations, the real economy seems to be just fine.  What are investors concerned about and are there any systemic risks that justify a bear thesis?

  • The Inverted Yield Curve: An inverted yield curve indicates an interest rate environment where long-term debt instruments have a lower yield than short-term debt instruments because investors are bidding for longer-term bonds. That is, investors are pessimistic about the near-term economy. On December 3, 2018, the yield curve inverted for the first time since 2007. Though an inverted yield curve has preceded each of the last seven recessions and economists agree that there is a 24-month recession horizon when a yield curve inverts, it is only a symptom of a stressed economy.

    Before the 2008 financial crisis, the yield curve inverted in late 2005, in 2006, and in 2007. By the time the Fed responded by lowering rates in September 2007, it was too late. An inverted yield curve coupled with the downturn and volatility of the late 2018 stock market is concerning. Though not necessarily a cause of increased volatility, perception of risk in the short-term can become a self-fulfilling prophecy.
  • A TCJA sugar rush: The Tax Cuts and Jobs Act of 2017 lifted corporate earnings for the first three quarters of 2018, leading to soaring confidence from Wall Street that many dubbed the “Trump Bump.” By the last quarter of 2018, though, the faith of economists and investors alike in Trump’s economy seemed to be shaken. The TCJA was the kind of sugar rush that burned bright and fast, and 2018 ended with the worst December the stock market has seen since the Great Depression.
  • Shaky leveraged-loans market:  Leveraged loans are high-risk loans extended to borrowers who already hold considerable debt or a have a weak credit history. Money has been pouring out of leveraged loan investment vehicles for a record six weeks.  Deregulatory moves since Trump took office have made these kinds of investments even riskier, and warnings about relaxing the standards on the leveraged-loan market by Former Fed Chair Yellen look more prescient. The leveraged finance market could be nearing a crisis, which would affect 16 percent of all U.S. companies and 12 percent of companies worldwide sustained by debt.
  • Geopolitical risk: Some experts are citing the trade dispute with China as one of the biggest risks to the economy. The dispute that started when Trump came to office is over the notion that China is taking advantage of the U.S. in trade. While markets have focused on trade talks, the effect on the real economy with the trade dispute and the president’s actions resulted in a concerted effort from Democrats and Republicans to prop up the farm sector through stimulus through the Ag bill.
  • Herds of algos: Algorithmic trading, also known as program trading or black-box trading, uses advanced mathematical models to make trading decisions at a speed and frequency that is impossible for a human trader. The machines, responsible for 80 percent of trades in the US equities markets, are raising concerns as their impact becomes more visible. In 2018, machines were responsible for a record number of market sell-offs as the rise of algorithmic trading amplifies volatility, causing much wider bands than before.

Dual Mandate for Duel Economies

Despite the pessimism and instability in the U.S. stock market since the last quarter of 2018, “real economy” indicators have remained favorable. The stock market and the real economy work on separate tracks with tangential correlatives. Most stock market corrections do not result in recessions, but corrections and sell-offs have coincided with a slowdown in the real economy — again, most notably the Great Recession in 2007/08. The prevailing consensus among economists and equity analysts is that stock market volatility is largely independent of the real economy, but volatility can be symptomatic of underlying issues in the real economy.

In a situation like the present, where the unemployment rate is actually below what the Fed considers its long-term sustainable rate (four percent) and inflation is already hovering around two percent, the role of the Fed seeks growth at sustainable levels that do not overheat the economy. Under current conditions, the Fed would have to raise the unemployment rate slightly to achieve a long-term sustainable rate.  

The Fed must also ensure that asset prices do not rise to an unsustainable level as they did in the housing market before the 2008 recession. Fed Chair Powell indicated initially that he intended to raise rates incrementally, but he has suggested recently that he remains flexible and might even consider eliminating one rate cut this year.

Tail Wagging the Dog?

The recent volatility in the stock market does not seem to jibe with current conditions in the real economy. The ubiquity of algorithmic trading seems to be a prime reason for some of the recent dramatic swings in the equities market, but there are clear systemic risks to the real economy that are cause for concern. The recent inversion of the yield curve and activity in the bond market also show a de-risking that implies a storm in the real economy may be approaching.  Price-earnings ratios are relatively low, suggesting value for investors, but corporate debt is high and money has flooded out of high-yield corporate bonds since 2018. High levels of leveraged corporate debt may be insulated in stock market valuations figures for now, but it may not be long before defaults of small- and mid-sized businesses incapable of consolidation begin to have an impact on unemployment and inflation numbers.

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