This market commentary was originally published on Thursday November 7.
Although the financial media attributed today’s steep market decline to the “strong” growth in 3rd quarter GDP that supposedly makes earlier Fed tapering more likely, we doubt that this is the case. As numerous observers have already pointed out the underlying details of the GDP report were not only quite weak, but pointed to even less growth in the current quarter. Notably, the 10-year yield was down today, indicating that the bond market seemed unconcerned by the prospect of economic strength. In our view the decline was foreshadowed by the recent weak technical condition of the market including the “nothing can go wrong” attitude reflected in various current sentiment indicators. In addition, contrary to consensus opinion, market valuations are significantly higher than historical norms on a wide variety of measurements.
As widely reported, 3rd quarter GDP details continued the sluggish pace seen since the 2009 recession bottom. Although top-line growth of 2.8% exceeded forecasts of 2.0%, the entire overshoot was attributed to the largest increase in inventories since the 1st quarter of 2012. Consumer spending, accounting for 68% of GDP, rose by only 1.5%, the slowest rate in three years, while business spending on equipment was down for only the 2nd time since the start of the recovery.
Moreover, the signs for the current quarter are not good. With retailors reporting slow sales for the back-to-school and Halloween seasons, it is likely that the 3rd quarter inventory surge is involuntary and that stores were stuck with goods they couldn’t sell. This means that inventories will probably be cut back in the 4th quarter. Job gains were tepid in September, and indications so far for October appear bleak. Although spending on residential construction was up 14.6% in the 3rd quarter, housing has weakened considerably and will likely impact GDP in the current period. In addition, the 3rd quarter results did not reflect the 16-day government shutdown that will show up in current quarter data.
With a renewed fight over the federal budget and debt ceiling coming up early next year, we see little improvement in the economy in the 1st quarter as well. While this may delay Fed tapering, we think that pervasive weakness in the economy will lead to little or no earnings growth, and, perhaps, even to an important earnings decline. Recently, we have seen an increased flight to safety and a move away from risk. A lot of the momentum high-flyers have stumbled and the Dow has begun to outperform the Nasdaq by a wide margin. Wednesday’s market action was particularly notable with the Dow up 128 points at the same time that Nasdaq declined along with the Dow Transportation index.
All of this is being accompanied by a big shift in sentiment to the bullish side. Investors Intelligence shows bulls at 55% and bears at only 16%, an historically high disparity that has often presaged steep corrections or outright bear markets. In addition, the latest AAII Survey indicated retail investor equity allocations at 6-year highs, while net inflows to domestic equity mutual funds have recently been strong.
All in all, we believe that stocks show significant signs of an impending top, and for good reason. In late 1999 and early 2000 the widespread belief was that the dot-com boom would go on indefinitely. In 2007 almost everyone thought that the subprime mortgage market was too small to affect the economy. Now everyone seems to think that the Fed can hold up the stock market forever. In our view, the outcome will be similar to that of the prior two periods.