The ONE Signal That Should Make You Worry About A Major Correction…

As we begin to close the books on the first half of 2018 — and prepare for second-quarter earnings season — it’s prudent to take stock of where we are.

-The earnings multiple of the Standard & Poor 500 Index is 25.07, more than 10 points higher than its historical median of 14.69. Conservative investors might find this as dizzying as I do — it is rich valuation. The current bull market began in March 2009, which was 112 months ago. The average bull market lasts 97 months.

-In May, U.S. companies bought back an astonishing $174 billion worth of their own stock. While that might be good for investors, it also reveals a profound law of money: You only get to spend it once! Allocating that pile of cash to buybacks means those dollars aren’t being spent on the capital expenditures that fuel organic business growth. After all, one can’t build a new widget factory if one has blown her allowance on Widget Co. shares.

But remember Obermueller’s Law: No number has any meaning without the context of another number.

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Here, I think it’s prudent to point out that U.S. production is hardly running at full tilt: Capacity utilization is 77.9% overall. The index value is 107.3 versus the 2012 baseline of 100.0. So what we see is companies that are doing well but aren’t allocating significant sums to building their businesses, which seems to suggest they don’t see demand rising on its own, or that they see it falling.

-A couple weeks ago, the U.S. Federal Reserve increased interest rates, raising the target fed funds rate to 2.0% from 1.75%. The Fed signaled it will likely raise rates two more times this year. This increases borrowing costs, which is meant to constrain consumer debt spending. It also tends to take a little cash out of the market, as it pushes the margin rates that traders pay higher, too. This is likely to be felt in the housing market. Loans become more expensive; fewer people sign on the dotted line, and this decreased demand can push down prices, which have been on a tear of late.

-The domestic employment situation is strong: The joblessness rate recently ebbed to 3.8%, a nadir it has reached only twice before in the past 50 years. (It notched up to 4% on Friday, not because of layoffs, but rather on a rise in participation in the workforce. A good sign indeed…)

The Fed forecasts the employment situation will continue to tighten, which puts upward pressure on wages. Some argue that a 5% unemployment rate is “full” employment — that’s the normal slack created by people switching jobs. When the level is this low, it causes pressure on wages. It’s just basic supply and demand from ECON 101: As scarcity rises, so do wages. When people across the board have more money, they spend more money — but on the same things. So while people working is a Good Thing, uncontrolled wages tends to generate inflationary pressure.

-Consumers are feeling very good. The University of Michigan Consumer Sentiment Index was at 99.3 as of June, up substantially from its 10-year low of 55.3 in November 2008. What makes consumers feel flush? Rising employment, a rising market (that fuels 401(k) balances), and rising home prices. Gas is cheap; credit is plentiful.

-The world is, well, a mess. Japan posted negative economic growth, two consecutive quarters of which means recession. Chinese growth is slowing, and its benchmark Shanghai Composite Index has given up 14.9% of its value so far this year. The European Union is struggling: Italy is embroiled in a political crisis and its banking system is on the rocks, the ripple of which can spread to other nations as the Maastricht treaty that established the euro puts all euro countries on the hook in the event of a bailout. Germany’s growth is anemic. Britain is dealing with Brexit. Russia’s political situation and stability are questionable.

What Does All This Mean?

Well, I’ve already told you. You read it here first. Barron’s summed it up nicely (emphasis mine): “Hedge fund titans, prominent investors, and bank CEOs alike proclaim that robust growth and burgeoning inflation will prompt the Federal Reserve to raise interest rates to 3.5% within the next year, pushing the 10-year U.S. Treasury yield, now 2.9%, closer to 4%.”

As that happens, I expect the market to correct. Investors will exit stocks and move to bonds, a classic “flight to quality.” Investors would rather accept the lower rate of return from bonds than to risk the potential downside of a correction.

Additionally, I want you to pay close attention to earnings reports this season. Normally I take them in stride — one quarter does not a successful investment make. But earnings are expected to be strong, and that means Wall Street will be looking for any clue that 1) they aren’t, which will mean severe market punishment for an earnings miss, and 2) any comment that suggests a change in the outlook that points to a weakening economy. The recent aggressive trade policies promulgated by the White House are ruffling a lot of international feathers, and that adds another layer of complexity.

My thinking has not changed here. I recommend investors with significant market-facing assets, such as index funds, reallocate those dollars to the safe harbor of fixed income, notably investment grade corporate debt. This will become imperative as the rate on the 10-Year Treasury reaches 3.7% for three consecutive trading days. We’re not there yet — it’s about 2.9% — but we don’t want to get caught flat-footed. Best to devise a plan.

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