Friday, August 18, 2017

Two Good Legs . . . only

I've been expecting a significant market correction since Spring and used a tripod to explain it.  One leg supporting the market is economic data, which has been reliably good.  That data has not been great -- just good enough to be sustainable over a long period.  We have examined the numerous economic cycles but concluded they are irrelevant in this economic environment, where normal market forces have been suspended by the Fed.

The second leg is stock market data.  Stock valuations or PE ratios are high but not historically high.  Trading volumes have been relatively modest, which suggests the market is vulnerable to a downdraft, but that is not predictive.  Sure, the S&P 500 is approaching its 50-day-moving average, but that usually just indicates a buying opportunity.  While some attribute the market's record performance since the election to being simply a "Trump Bump," I note that corporate earnings have been increasing strongly since Q3 of last year.  Corporate profits remain strong, although comparisons will start to suffer with Q3 earnings of this year.  There is also an obscure technical indicator called the Hindenburg Omen, indicating a market crash, but it has little obvious logic and a bad reputation for predicting crashes that never happened.  More than anything, I worry about a Minsky Moment, when the debt balloon bursts, and the only protection from that is to sell quickly once it starts.

The third leg is geopolitical information.  The turmoil in the White House has spooked the stock market for sure but not as badly as I expected.  The market was unnerved by the loss of support from CEOs but not badly.  If cabinet members start resigning, the stock market will be very unhappy.  We have studied the market impact from impeachment and found no consistent pattern.  The stock market will applaud when certainty is restored.  If the President resigned this weekend, for example, and the Vice President took over, the legislative agenda would be unchanged and, more importantly, no longer unrealistic.  That's probably good for a 500-point jump in the Dow.

An important component of geopolitical information is international.  Don't forget the lesson of  South Korea during the 1990s, when its economy suddenly shifted gears from booming to staggering, because it was blindsided by currency problems in Thailand.  We too can be blindsided from abroad.  The good news is that the rest of world is experiencing solid economic growth and are not likely to push their problems into our economy.  Of course, it is unclear how badly affected our economy would be impacted by a nuclear skirmish with North Korea, but it would be temporary.

I think the combined weight of the White House woes and the possible conflict on the Korean peninsula is all the weight that the geopolitical leg can handle.  As that leg weakens, the stock market weakens.