Zeller Kern’s Investment Monitor
The World's a Stage For Drama
June 12, 2018
By Steve Zeller
Things are getting pretty interesting as we move through June, 2018, with the G-7 talks occurring over the weekend, and now the historic Trump vs. Kim Jong Un peace summit in Singapore.
The conclusion of President Trump’s attendance at the G-7 resulted in likely escalation of tariffs and personal feuds with the Prime Minister of Canada. President Trump’s senior economic advisers ratcheted up the tension between the two leaders, by suggesting Justin Trudeau, Canada’s Prime Minister, betrayed the president by criticizing U.S. trade policy and threatening retaliatory tariffs, soon after the G-7 members came to an agreement on a joint policy statement and as President Trump left the summit, according to the Wall Street Journal. Worse, Chief of the White House Office of Trade and Manufacturing Policy, Peter Navarro, stated: “there’s a special place in hell for any foreign leader that engages in bad-faith diplomacy with Donald J. Trump and then tries to stab him in the back on the way out the door.” This is in addition to Trump’s statement “We’re like the piggy bank that everybody is robbing.” The concern is that this spiraling out of control and causing the U.S. economy to roll over.
Then of course, we have the takeover of the Italian government by anti-establishment/ anti-Eurozone parties in Italy and Sunday’s pro-populist parliamentary election in Slovenia, which are unique events that may be signaling a dramatic change across Europe. There’s also the UK parliament’s Brexit vote, and the ECB’s possible announcement that it is ending its QE.
Meanwhile, there is indication of a slowing economy in China and in Europe. Speaking of China, there was a report in the Washington Post, over the weekend, that the U.S. Navy and the FBI are investigating a massive cyber-attack by China that compromised a network of an unidentified Navy contractor that rendered the theft of 614 GB of submarine missile secrets.
But, all of this does make for a lot of excitement, drama, and maybe even some market volatility.
Meanwhile, the U.S. economy is cruising right along and is producing impressive employment numbers and healthy growth stats. This week, all kinds of economic data will be released, including business optimism on Tuesday, Producer Price Index on Wednesday, retail sales, initial jobless claims, and business inventories on Thursday, and industrial production and the Empire Manufacturing survey on Friday. As we have suggested previously, there is no doubt that we are in a period of growth, and the growth we have been waiting for, but has this growth peaked along with the bank lending, debt load, market speculation, and momentum? We can’t determine that just yet, and by some measurements, there doesn’t appear to be signs of a recession coming.
The Recession Alert Index, which is a counter index to the ECRI’s Weekly Leading Index Growth Indicator, posted a latest reading of 19.6, down from 21.1 the previous week. A recent article from Advisor Perspectives, by Jill Mislinski, provided an update of these indexes and a recap on how they are trending. This weekly index uses fifty different time series from these categories: Corporate Bond Composite, Treasury Bond Composite, Stock Market Composite, Labor Market Composite, and Credit Market Composite. The index has weakened slightly, which may raise a suspicion that the economy may be peaking.
Although, based on this data, as well as other data we follow and track, we don’t see any evidence of a recession on the horizon. So, we’re safe to say that, barring any sudden event, we don’t see one coming into the picture for number of months. May’s economic data does appear to have improved over April’s data, which is a positive. Consumer confidence remains strong, business confidence remains intact, jobs growth is at incredible point, to which more jobs available now exceeds the number of unemployed – You couldn’t ask for more than that.
May job growth came in at 223,000, and April’s job numbers were revised up from 159,000 to 164,000. The yield curve remains in a good zone with the spread between the 10-year and the 3 month rates has stayed in a steady state, which keeps us out of any danger zone. Although, the impact of future hikes in short term interest rates by the Fed may cause for concern down the road. However, one area that can cause a recession is an economic shock, which could conceivably occur through the drama of our trade wars. The usual cause of economic shock is the cost of money. But the trade wars and the geo-political risks forming in Europe may be potential spoilers for favorable economic conditions.
There is not any sign of concern for the economy at this point, but the question of whether we are peaking, and therefore, whether asset prices are peaking and introducing an increased level of risk is another question. As far as the stock market, valuations are extremely high historically speaking, in particular when measuring it according to the Shiller Price to Earnings Ratio, which looks at average earnings over the past 10 years. The levels of this measurement, is extremely high, with the current levels being close to the second highest reading on record, and exceeded only by the dot com bubble.
The other risk factor indicator is margin debt. Margin debt levels, as a percentage of market capitalization, ticked down slightly last month, but they do remain close to all-time highs. So this is a concern for us. But this does not indicate any probable immediate risk. A good way of interpreting immediate risk with margin debt is the annual change in debt as a percentage of market capitalization. That measurement has trended down slightly in recent months. But more recently, we are beginning to see a spike trend, we shall see.
Another factor is tracking the market relative to the 200-day and the 400-day moving averages. A flashing red light occurs when the market breaks below these averages. In the last few months, the market has flirted with these thresholds but now remains above these lines.
In the immediate short term, this is one of the most significant weeks we’ve had for a while with the meeting in Singapore with North Korea followed by the Fed raising interest rates. While the NASDAQ continues to lead the way higher, once again it is representing a major divergence in the indices. With all of the major indexes being led by 10% or less of the total stocks in the index, the markets are becoming quite narrow and focused once again. With the Fed meeting this week, there is a 95% probability that they will raise the rates once again. Typically, after the FOMC releases their statement, if there is a conference call, it’s usually because there is some sort of action they want to discuss with the press.
Furthermore, this week with the geopolitical events in Singapore with North Korea and the US sitting down at the negotiation table for denuclearization, there is likely to be plenty of noise from this as well. The tone is set for plenty of volatility this week as uncertainty appears to be the key word to pay attention to.
As far as where the market stands year-to-date, as of the market close on last Friday, the Dow Jones Industrial Average remains slightly positive at 3.50% (including the reinvestment of dividends). The S&P 500 Index is up 4.85%, year-to-date, while the NASDAQ, which represents the majority of tech stocks, is up 10.75%. The Russell 2000 Index, which represents small company stocks here in the U.S., is up 9.47%, which shot up to positive levels in the last few weeks.
In summary, market risks remain high, the current cyclical bull-market is in an extended period (late stages), while the overall economic environment remains favorable. However, geo-political risks, ala trade policies, the Brexit drama unfolding this week, and the likelihood of the Fed raising rates, are introducing potential factors for volatility within the market.
Zeller Kern Investment Committee