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Why Stocks Are At Record Highs, Why It Will Not Last – And What To Do Now

That stocks remain at a record high seems counter-intuitive. After all, with a seemingly-endless trade war raging on, portents of economic gloom flaring up worldwide, and an impeachment inquiry ongoing, one would think that confidence in the market, particularly the S&P 500 (SPY) (VOO) (IVV), and the Dividend Aristocrats (NOBL) would be ebbing - one would be wrong.

Contrariwise, many bulls are under the impression that the market will roar forever - they, too, are wrong.

There is one course of action in this set of circumstances that I believe is not wrong, but first, let's look at the issues that should be adversely impacting market confidence, and yet apparently are having next to no effect.

Factors In Play

The trade war between the U.S. and China (FXI), which has been raging for over a year now, is rooted in mutual suspicion: on the U.S. side, the suspicion that China is engaging in unfair trading and theft of intellectual property is not only idly rumored, but openly stated by the President of the United States of America. For China's part, the suspicion is that the West in general, and the U.S. in particular, is actively trying to put the brakes on its surge as a world power.

The resultant tariffs that each country has imposed on the other, which affect billions of dollars' worth of their respective goods, are having an adverse impact on business and has mired the world economy in uncertainty. It is further intensified by the populist politics which has also been contributing problems to other parts of the world that also exhibit signs of economic instability.

Hong Kong (EWH), the 'autonomous region' which has seen widespread political unrest over the legitimacy of its autonomy, is one such area, as these two factors have led officials to declare that the city's economy is expected to shrink by 1.3%. This would be the first annual decline that Hong Kong suffers since 2009, in the midst of the global Great Recession.

Hong Kong is not the only advanced economy facing issues. In Europe, Italy's debt burden remains the major concern of leaders and investors alike. With €1.5 trillion ($1.7 trillion) worth of debt on Italy's (EWI) books, and €425 billion worth of Italian debt - private and sovereign - on the books of Europe's main banks, a sell-off due to populist politics could leave these banks, and the European economy in general, facing severe headaches.


European BankItalian credit exposure (€)
Aareal Bank (OTC:AAALF)4.4 billion
Abanca (OTC:NCGOF)2.3 billion
Barclays (OTCPK:BCLYF)17.4 billion
BBVA (NYSE:BBVA)13.2 billion
BNP Paribas (OTCQX:BNPQY)143.2 billion
BPCE11.2 billion
Commerzbank (OTCPK:CRZBY)12.4 billion
Crédit Agricole (OTCPK:CRARY)97.2 billion
Deutsche Bank (NYSE:DB)29.6 billion
Deutsche Pfandbriefbank (OTC:PBBGF)2.1 billion
DEXIA (OTCPK:DXBGY)23.1 billion
NRW.Bank2.1 billion
RCI6.4 billion
Sabadell (OTCPK:BNDSF)6.0 billion
SFIL6.3 billion
Société Générale (OTCPK:SCGLY)21.2 billion
Volkswagen Bank5.3 billion
Other27.9 billion
TOTAL425 billion*

Italy is far from the only European country that faces economic challenges going forward. The United Kingdom (FXE), as a consequence of the self-imposed stupidity that is Brexit, is also suffering from the toxic combination of populist politics and adverse financial circumstances. The divisive political landscape, the looming general election, the prospect of being shut out of the EU market, the possible secession of Northern Ireland and Scotland, the firms which have exited Britain due to the uncertainty of the Brexit process - it is small wonder that investors look at the UK with a skeptical eye.

One could go on in this vein - the spiraling crisis in Venezuela, the weak prospects for South Africa, the continuation of short-term monetary fixes to the problem worldwide, the all-pervasive climate crisis - all of these issues are either going to have an impact, or are already impacting large economies which are based in manufacturing, including the U.S. economy. Yet the U.S. economy (UDN) (USDU) seems resistant nonetheless. Why?

The U.S. Economy Seems Resistant

The primary reason why the U.S. economy has held up better is because it is a consumer economy, and according to the University of Michigan, consumer sentiment is up from 95.5 in October to 95.7. This suggests consumers are optimistic about both their own financial position and the economic future.

More substantially, although there are signs of slower consumer spending, the Commerce Department recently reported that such spending did increase - albeit marginally - by 0.2% for September, in line with expectations. Furthermore, the U.S. job market remains a strong one - while hiring has slowed overall over the past year, an estimated 140,000 jobs were added in September, an increase from the 130,000 added in August. Consequently, Americans continue to buy consumer goods, and this more modest growth path is expected to continue.

Furthermore, the Federal Reserve has done its bit to encourage such growth to continue, cutting interest rates. These low interest rates, of course, serve to encourage borrowing and spending. And further cuts are anticipated, as per Gregory Daco, Oxford Economics' chief U.S. economist, who opined:

With wage growth no longer accelerating, and employment growth cooling, growth in consumer spending is expected to moderate as we enter 2020... We believe the Fed will be prompted to reassess and provide one additional rate cut in March 2020.

Of course, for investors, low interest rates serve to make stocks more attractive than bonds. Indeed, what we have is what has been called the TINA market - There INAlternative. If the other big economies outside of the U.S. are in worse shape, and the other asset classes are less attractive, then There Is No Alternative to U.S. stocks for investors seeking a decent return on their investments.

Appearances Are Deceptive

Markets may be hitting records, but stocks are not necessarily surging higher. Wall Street's bullishness can turn bearish quite rapidly. One should not be so arrogant as to assume American exceptionalism in the current environment - the factors outlined above will eventually have an impact on the U.S. economy too.

In June, the Institute for Supply Management released a report showing that production is at its lowest level since October 2016, and pinpointed the tariffs imposed due to the U.S.-China trade war as the reason for this decline. Midwestern farmers are also being adversely affected by the trade war, with the number of farmers filing for bankruptcy double that of those who filed in 2008 - during the Great Recession.

A broader view of the job market provides a more disquieting picture - the Bureau of Labor Statistics reported that between February 2017 (shortly after Donald Trump took office) and June 2019 the economy created an average of 194,000 jobs per month, lower than the 221,000 jobs per month average that were created between September 2014 and January 2017.

Worst of all is the national debt, which has now ballooned to $22 trillion, an amount that the junior Senator for Georgia, David Perdue, has said should have sounded "alarm bells." As Perdue told the Washington Post:

The single greatest threat to our national security is our national debt, and it's time Washington comes to grips with that reality... Ultimately, the debt impacts our ability to fund priorities, like providing our men and women in uniform with the resources they need to protect Americans. This debt crisis will only get worse, and if we don't act now, our country will lose the ability to do the right thing.

Questions over America's ability to do the right thing in the midst of an impeachment inquiry and a thoroughly poisonous political climate are flying thick and fast, but fewer voices among the public are raised regarding the economy despite the facts outlined above.

Many are complacent in the face of such facts because the current bull market is the longest in history, but the reason for its atypical length is its starting point - the second worst recession in history. The over-confidence in the current market seems oblivious to this starting point, but we may already be seeing the turn.

The Major Red Flag

In August, the yields on 10-year Treasury bonds (IEF) dipped below the 2-year Treasury bond yield (DTUS) (DTUL). This is the first time this has happened since 2007. What I wrote about this last month expresses my present view on the situation:

...the longer your money is lent to a government, the greater the return you expect owing to the higher risk of government default. The yield curve inversion, however, results in the 10-Year bond yielding less than 2-Year bonds. The consequence of this is that investors are offered lower returns for lending over a longer time-frame than a shorter time-frame would yield. It suggests that lower economic growth is expected long term, suggesting that a recession is coming.

Now, the yield curve inversion is not a cast-iron guarantee that a recession will occur - it may simply be an expression of investor nervousness. Bond prices have been affected by central banks over the past decade, and this may be having an impact on market behavior too. But I'd lean more towards the likelihood that recession is coming - when it comes is, of course, a question I cannot answer.

While I cannot say for certain when a recession is coming, there is a general consensus that it will come to pass. Indeed, the CFO Global Business Outlook survey carried out by Duke University reported that 70% of CFOs anticipate a recession will hit by the end of 2020.

What Is To Be Done?

So, what is to be done? I address myself to one specific type of investor here - the long-term value investor. That is, someone who is interested in buying quality stocks at bargain prices. Day traders and similar types can feel free to drift off now.

To the long-term value investors, I have this to say. At present, you should do one thing: store up as much cash as you possibly can.


At first glance, it seems counter-intuitive to devote yourself to storing up the one asset class that will deteriorate in value over time, but having a large amount of liquidity will enable you to forfeit the option of having to sell your current assets for less than they are worth when the recession comes.

Having a large cash surplus will position you to do the following. Once the market does hit the skids - and it will, it is not a case of if, but when - take advantage of the blue-chip stocks that will be on offer at bargain-basement prices.

Companies such as Microsoft (MSFT) and Johnson & Johnson (JNJ) are AAA-rated behemoths that will weather the coming storm successfully, but that will not stop their share prices going down along with the rest of the market. The opportunity to make a huge investment at a bargain price in both of these companies, and many others like them - such as the constituents of the Dividend Aristocrats index, or the overvalued choice constituents of the S&P 500, such as Alphabet (GOOG) (GOOGL), Amazon (AMZN) or Apple (AAPL) - will leave many such investors in a far better position over the long term.

The case of Microsoft is particularly telling - the only issue I have with the company is its valuation, as I explained in detail in my article last month. However, peruse the comments section, and you will find plenty of bulls who went out of their way to miss my point - "buy now or you will miss out" is the essence of the reaction of most of the commenters there.

Price is what you pay, value is what you get. In the event of a recession - a very likely event, and not just in my opinion - buying a stock that I believe to be overvalued now and that I anticipate will fall in price in the near future simply makes no sense.

What is true of Microsoft is true of many other excellent companies with sky-high valuations such as Automatic Data Processing (ADP), McDonald's (MCD), and Walmart (WMT). If you think such stocks are expensive now - as I do - and believed that they would be cheaper to buy one year hence, what would you do?

Would you buy now for fear of "missing out?"

Or would you wait, accumulating as much dry powder as possible until the recession hits, and take advantage of the cheaper entry point you will be offered at that time?

I doubt I have to spell out what I would do at this point. But just in case, I'll make it plain: I'll take the second option. And I believe I have made my case in this article for why I will do so.

Conclusion

In the present climate, it would be naive indeed to believe that all will continue to be rosy going forward. The U.S.-China trade war, the economic problems flaring up worldwide, the underlying problems with the U.S. economy, the bond yield curve inversion - all signs point to a recession, a conclusion that many experts have drawn. Despite this, the bulls continue to roar.

To the disciplined value investor, I advise prudence. Be greedy when others are fearful, and fearful when others are greedy. Right now, greed still trumps fear. Wait until the financial panic that is on the horizon cuts loose. Review the S&P 500 and the Dividend Aristocrats for those stocks that you would find beneficial as long-term holdings at the right price. Build up your cash reserves in the meantime, and position yourself to take advantage of the fear that is coming. That is what I plan to do, in any event.