How I’m Looking At The Market (Short And Long-Term) Right Now…
The market’s price action has grown concerning to me over the past few days. I started to notice that momentum was waning last week. That became more apparent this week.
At the bottom of the chart is the stochastics indicator, a widely followed measure of momentum. This indicator is diverging from the price action. Momentum often leads price, which makes the downtrend in momentum a sign that the uptrend might end.
Slow Growth And Debt Are Going To Be A Problem
Adding to my concerns is the economic news. Last week, I noted that Wall Street analysts expect the economy to contract between 9% in second quarter GDP to as much as 50%. The median estimates are more than 30%. But they expect a rapid rebound in 2021.
As a reminder, economists at the International Monetary Fund expect the U.S. economy to contract by 5.9% this year and grow by 4.7% next year. On Friday, the Congressional Budget Office released its projections. The table below is from their analysis.
Unlike Wall Street and IMF economists, CBO analysts do not expect a rapid rebound in 2021. They believe unemployment will remain above 10% into 2021. During the Great Recession, unemployment peaked at 9.9%.
The weak economy partly explains the CBO’s expectations of a $3.7 trillion budget deficit in 2020. At that level, CBO projects the federal debt held by the public would be 101% of GDP by the end of fiscal year 2020 and would grow to 108% of GDP at the end of 2021, compared with 79% at the end of fiscal year 2019.
That is a problem for two reasons. One is the fact that CBO has historically underestimated the debt.
CBO analyzes their accuracy every year. A little more than six months ago it noted, “For deficits, the average absolute error in CBO’s budget-year projections was 1% of GDP…(In 2018, 1% of GDP was about $200 billion.) For debt, the average absolute error in CBO’s budget-year projections was 1.7% of GDP.”
This means the deficit and level of debt are likely to be even worse than the CBO expects.
Slower Growth, But More Trading Opportunities
The second problem is that important economic research shows that economic growth shrinks when the debt-to-GDP ratio tops 90%.
In “Growth in a Time of Debt,” renowned economists Carmen Reinhart and Kenneth Rogoff noted,
“We study economic growth and inflation at different levels of government and external debt. Our analysis is based on new data on forty-four countries spanning about two hundred years.
The dataset incorporates over 3,700 annual observations covering a wide range of political systems, institutions, exchange rate arrangements, and historic circumstances. Our main findings are: First, the relationship between government debt and real GDP growth is weak for debt/GDP ratios below a threshold of 90 percent of GDP.
Above 90 percent, median growth rates fall by one percent, and average growth falls considerably more. We find that the threshold for public debt is similar in advanced and emerging economies.”
The United States will be in the danger zone by the end of this year, but that doesn’t mean a crisis is imminent. It does mean growth is likely to be slow and that is consistent with the CBO forecast of a slow recovery.
Japan offers an example of a country that has high debt — currently at more than 237% of GDP. The debt-to-GDP ratio topped 90% in 1999. The chart below shows the how Japan’s benchmark stock market average — the Nikkei 225 — has performed since then.
There’s good news and bad news in that chart. The good news is that volatility is high, and that means it is a great market for trading. The bad news is that returns for long-term buy-and-hold investors have been fairly low.
According the work of Reinhart and Rogoff, two well-respected economists, the United States could be set to follow the path of Japan.
It’s All About Earnings (For Now)
That’s a long-run view. In the short run, I expect the trend to be revealed as earnings season plays out.
Earnings will determine the direction of the trend, and this is an especially important week for earnings.
Right now, the five largest stocks — Microsoft, Apple, Amazon, Facebook, and Alphabet (the parent company of Google) — account for 20.7% of stock market. (As a point of comparison, the top five stocks represented 18.5% of the stock market during the internet bubble in 1999.)
The earnings reports from these five companies will power the market’s next move. By this time next week, we should know if the market is moving higher or lower.
But if you’re already tired of waiting on the sidelines…
My colleague Nathan Slaughter just wrapped up an emergency briefing, unveiling what investors need to know to survive (and thrive) during the Covid-19 pandemic.
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He calls them “Predator” trades — and he’s developed a simple 6-part profit screen to detect these big trade events before they happen.