The second market correction of 2018 quickly took the S&P 500 down a whopping 20%. That mass exodus sure looks like it's trying to warn us a recession is imminent.
Yet, there is little in current economic or earnings data that would lead any experts, or economists, to believe a recession is on the way.
So two important questions jump out right now. First, what's eating the market so badly? Second, is this "false positive" recession call setting up some great opportunities for 2019?
This article will describe the 4 market fears that have driven stock prices down and why they may be overdone, handing astute investors the keys to some great January bargains.
1) Growth Peak
It's not news to most investors that the last two years saw some spectacular earnings growth, with the first 3 quarters of 2018 averaging over 25% year-over-year EPS advances.
While some observers will claim that much of this was inflated by easy-money stock buy-backs and the corporate tax cut, we also know that real economic growth -- rising demand and sales for the products and services of thousands of companies around the world -- provided fantastic opportunities for stock pickers to play off of.
And US GDP also hit some heights we had not seen since the 2016 trough with readings above 3.5% in Q2 and Q3. But the concern of many institutional investors like Ray Dalio of Bridgewater, the world's largest hedge fund, has been that this growth just peaked in 2018 after the tax-cut "sugar high" and that it's all downhill from here.
While true that bull markets do not die of old age, Dalio and others point out that economic expansions often end abruptly when government policies shift and get in the way. This leads us to our next two headwinds.
2) Trade Angst
The world's two largest economies, the US and China, are locked in an economic confrontation that was inevitable and probably necessary. After decades of a symbiotic relationship that built up China's trade surplus and monetary reserves, while feeding the American consumer's appetite for cheaply made goods -- and siphoning US intellectual property -- it has come time to correct some imbalances and unfair practices.
The trouble is that global economic supply chains across dozens of industries in every sector are inextricably linked. Tearing those trade webs apart with arbitrary tariffs has been hurtful to businesses of all sizes. While Ford may be able to handle a $1 billion hit to their bottom line, many smaller businesses can't handle a comparable fraction of sales or profit declines.
Throughout the trade negotiations, two elements have become clear: (1) uncertainty about any final deals now weighs on company plans and outlooks, and (2) the "trade war" between the economic giants, with vastly different cultures, will not end anytime soon. It will persist and evolve over decades.
But there is a silver lining here. Stay with me for my conclusion.
3) Fed Hawks
After the new Federal Reserve Chairman Jerome "Jay" Powell spooked markets in early October with how he believed interest rates were "a long way" from neutral, investors started to get panicky. Considering the growth peak and trade angst described above, hearing that the new Fed leadership was an inflation and "bubble hawk" was not welcome.
Besides that, many investors considered that maybe he was right. Maybe with unemployment stuck under 4%, and a massive debt pile up from easy money for too long, it was indeed time to rein in Fed fuel. By definition, economic cycles don't go straight up forever and if the Fed could engineer a softer landing, it had better get started now.
But the majority of market players not only didn't believe this logic, they were actually terrified by it. You started to hear big name money managers and strategists like Stan Druckenmiller and Ed Yardeni tell Powell that he was wrong and should immediately signal to the markets that rate hikes and balance sheet asset sales would cease.
In short, the market threw a tantrum and played a dangerous game of chicken with the Fed to force the world's most powerful central bank to pay attention and keep the punch bowl flowing. I don't know if Powell & Co. will give the cry babies what they want -- a dovish turn -- but I think this over-reaction has set up a big opportunity now.
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4) Credit Tremors
None of the preceding negative news narratives bother me as much as this one. Many economists insist that a recession doesn't happen unless a shock occurs in financial markets first, i.e., stocks, bonds, credit, lending, etc.
So far, we've seen high-yield spreads "blow out," or get more expensive, at least relative to the extreme complacency and ease of the past 5 years or so. And on Dec 19, after the Fed "autopilot" message, we heard Scott Minerd of Guggenheim ($225B+ AUM) worry about a trillion dollars’ worth of Investment Grade credit slipping off the last wrung of IG (BBB-) to BB, or junk status.
This is what can happen in tsunami fashion if companies that have relied for too long on easy money to finance operations and debt suddenly have to pay much higher borrowing costs. The ratings agency models take note and downgrade the borrowers' ability to service that debt -- and then their lifelines of credit get even more expensive.
We almost saw this in 2015-16 when dozens of Energy sector firms were driven to the brink of insolvency by sub-$40 crude oil. The difference then, and what ultimately saved the sector's smallest players -- and the economy/financial markets -- was that interest rate rises under the Yellen Fed were determined to remain very "low and slow" after just one hike in 2015.
And the Fed continued its monthly QE asset purchases of $80 billion. But now, we have the opposite conditions, with a steadily tight Fed and $50 billion being liquidated from the balance sheet on autopilot. The onus remains on the Fed to engineer something, be it a crash landing or a new leg of the economic expansion.
The Silver Lining
I have described four dark clouds for stocks that just handed us a 20% correction very quickly. So quick, that from Dec 14 to 24 -- just 7 trading sessions -- the S&P dropped 11%!
And herein lies your opportunity: When markets correct 20% with low odds of a looming recession, it has always been a great long-term buying gift. Just think, weren't you wishing all summer that the market would pull back a bit to give you a decent lower-risk entry into your favorite stocks and sectors?
Well here it is. Most investors are still just too scared to recognize it. But since we just examined the causes and fears surrounding the correction, we can more confidently proceed to put money to work, knowing what the risks are and carefully calculating the upside vs. the downside.
For instance, even if Wall Street's investment banks are still too optimistic about earnings growth of 9% in 2019 and those estimates get cut in half to only $165 EPS for the S&P 500, that puts the market's forward P/E at just 15X. This is where fund managers are eager to reallocate to stocks.
January will be full of great buying opportunities, especially as we get fresh economic data about December and Q4 and we head into the "main event," the FOMC meeting at month's end. I'm building a shopping list right now across all sectors, but two in particular that I believe are due for a sharp rebound: Technology and especially Biotechnology.
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Kevin, Senior Stock Strategist at Zacks, is a leading expert in biotech and medical stocks. He provides commentary and recommendations for Zacks' investment portfolio, Healthcare Innovators.
¹ The results for the trades listed above are not (or may not be) representative of the performance of all selections made by Zacks Investment Research's newsletter editors.