Will The Stock Market Take Another Dive?

It’s one thing to be wrong at the top of your voice, but it’s something else when it turns into a joke!

In early February when the stock market dived, it produced what’s called a ‘breakaway gap’, which I likened to a marriage breakdown.

Remember the story about John and Jenny? John was caught snogging Jenny’s best friend and then she found out it was more than ‘just a kiss’. And before he knew it, John was on the front lawn picking up the last of his chopped-up socks and undies with the sprinklers going full throttle.

The question back then was, ‘was the market correction a separation or a full-blown divorce’?

I called a divorce and expected the US market to drop 25-30% from its recent all-time high. The fundamentals all lined up as well. Namely, Trump’s tax cuts (read, inflation), US tariffs and the threat of a trade war, plus an imminent interest rate hike.

But John and Jenny kissed and made-up and the market proved me wrong. It turned around and went up another 10% in the space of nine months and produced another all-time high.

And that’s when the jokes rolled in. (Most of them were quite funny, and most of them can’t be repeated in public either!)

But life moves on, the seasons change, and here we are again. Another market correction.

Will the Markets Fall Further?
Over the past two nights, the Dow Jones has dropped more than 1,300 points (approx. 5%), so the question beckons…will the markets fall further?

Yes, I believe they will. I still expect the Dow Jones to drop 25-30% over the next twelve months and the Australian market to drop at least 20% from where it is now.

Note – even though I’ve calculated a correction of 25-30% in the US, remember the same market has also shot up approximately 45% in the past two years as well. Therefore, any correction won’t mean the world has come to an end, it’ll just feel like it.

Importantly, the Australian market is not over-priced at the moment, but, it will catch a cold as soon as Wall St sneezes.

However, markets rarely correct in one fell swoop, they generally ‘rollover’ and cascade down over a period of 9-12 months.

There are four reasons why I expect the markets to drop.
1. Interest rates are definitely on the way up in the US.
2. The US stock market is back to all-time highs and its overvalued.
3. Bull markets generally last for a period of nine years, we are now in the tenth year.
4. Possible trade wars with China.

The two most important points above are 1 and 2.

As recently as October 3, Fed Chairman Jerome Powell, said US interest rates are ‘a long way’ from neutral, meaning more interest rate hikes are imminent. He has hinted an increase of 25 basis points every 3 months for the next 9 months.

Now consider this…

A hiking cycle of 25 basis points every 3 months would be half the speed of the slowest hiking cycle ever conducted by the Fed. [1]

Eye watering isn’t it!

However, I doubt we will see a trade war, but the fear of one will just add to the panic. It’s the actual tariffs which will cause problems via inflationary pressures (especially in the US), not the wars themselves.

The Conundrum
There is an unusual paradox at play in the US which continues to confuse people.

The US economy has had a strong resurgence and will keep getting stronger, for a while. However, the economy’s strength will become the stock market’s weakness.

Here’s why.

Since Trump’s election to office, unemployment has dropped to a forty-three year low to the extent that, there is now a severe shortage of skilled labour in some parts of the U.S. i.e the economy is growing again.

However more jobs mean higher wages because businesses compete with each other to attract workers, and this eventually pushes up the prices of goods and services. Aka, inflation!

But inflation is not a dirty word, it’s just another name for growth.

And therein lies the problem. If the economy grows too quickly (inflation), it needs to be tempered by increasing interest rates.

Therefore, the US will become a victim of its own success. Meaning, too much growth will force up interest rates and cause the stock market to correct.

(BTW… given the Australian banks borrow 35% of their funds off-shore, you can expect interest rates to go up here as well).

The Problem
Too many US stocks are over priced at a time when interest rates are extremely low and, on the way up. That spells correction.

And that’s no joke.

Have a great weekend!

Adam

Source: [1] Brett Gillespie – ‘Hunter or Hunted’ (p.13), Ellerston Capital, September 18, 2018