Zeller Kern’s Investment Monitor

Is the Bull Market Over?

February 27, 2018

By Steve Zeller

An interesting ride in the equity markets for the first two months of 2018, with the Dow Jones Industrial Average (DJIA)  plunging more than 2,500 points in the matter of 7 trading days. The Dow Jones Industrial average ran up a year-to-date return of approximately 4% by January 26th, and then proceeded to plunge all the way down to 23,599 by February 9th, producing a year-to-date return on that date, of approximately -5%. As of the market close on Friday February 23rd, the Dow Jones Industrial Average has recovered, somewhat, closing Friday, up 2.74%, and the S&P 500 is up 3.05%, year-to-date.

But whether or not the market continues higher, or rolls over into a correctional phase of this bull market cycle, that is now almost 10 years in length, is anyone’s guess. Most bull market cycles last 5 to 7 years. Even though there are plenty of things in place to keep us optimistic about the economy and future corporate earnings, the market from a vantage point of a 10-year chart, looks somewhat troubling.

The S&P 500 Index 10-year Chart                                         

Click to enlarge (Source: Bigcharts.com)

It can be argued, that from an Elliott Wave standpoint, that the final top in this bull market cycle has just occurred - That is, if the wave count is correct. Elliott Wave technical analysis is based on the assumption that bull market cycles consist of 5 waves within the process: Wave one is up, wave two is down but never goes back down to where wave one started, wave three is a healthy leg up, wave four is down slightly or zig zags sideways, and wave five is up and ends by entering into a topping phase or ends abruptly. So, in an attempt to count the waves for you, we’ve provided a chart below that point out the possible wave patterns.                                     

The S&P 500 Index 10-year Chart


Click to enlarge (Source: Bigcharts.com)

We are not suggesting or declaring that “the top is in” and the bull market is over. The thing with Elliott Wave counting, is you don’t really have a confirmation of the wave count until things are of a certain sequence. But if January 26th was the top, it will have been a classic Elliott Wave count. We still are of the opinion that this isn’t the case and that this market still has some upside left in it – We’ll just have to see. As our readers know, we were bullish going into 2017, and we expected the bull market to last into the second quarter or third quarter of 2018. But, perhaps, this is all she wrote. We suspect we’ll know in short order, in other words, the market should either recover itself into new highs, or continue its way down over the next several trading sessions, weeks, or months.

Investors are consistently saying that there’s no way that the bull market can end, at this point, because there is too much good news out there and that we have an economy that is nowhere near a recessionary condition. This condition is true, however, bull markets don’t end with bad news, they end on great news. If you think about it, that makes sense, because at bull market tops, investor sentiment reaches record highs, margin debt reaches a high level, and stock valuations become very expensive – All of that existed in January. But that’s not to say that we can get into an even more extreme than where we were in January, and the market could recover and go even higher.

Click chart to enlarge

Again, we aren’t calling anything here, we are just discussing a few tools and concepts to help explain why things may be happening the way they are.

This now brings us to discuss the big buzz on the street, and that is inflation. Yes, there is a strong argument that many things are falling into place that could allow inflation to rear its ugly head. For one thing, we actually have an economy that is truly growing now, incomes are rising, corporate profits are notably strengthening, and GDP appears to be gaining steam. Add into the mix of a Fed that is behind the curve with raising interest rates, and you have money sloshing around at dirt cheap prices, meaning the rate of interest that you can borrow some of it, and you have a formula for demand driven inflation. We expect government bond yields to rise for a while longer, unless we get into sudden and serious trouble within the stock market and investors flee to a safe haven of government bonds, pushing yields back down. But over the longer term, we are speaking with somewhat of a level of confidence in stating that the 30-year bull market in bonds is likely over. Meaning, yields across the board will likely rise from here, over the longer term.

But as far as inflation versus deflation, as in which one will prevail over the short and intermediate term, is still uncertain. Yes, it appears that we have all of the previously discussed conditions in place to bring in a rise in inflation, but there are also other forces working against it. It also depends on what you look at to consider what prices are rising and which are falling.

The chart above is from a recent article from John Mauldin titled: “The State of Inflationary Confusion” where he discusses this very issue of inflation, deflation, and whether or not we are entering into a rising interest rate environment. Looking at the chart above, which is from the American Enterprise Institute, illustrates the challenge lower wage earners have. The goods and services that are rising the most are the ones consumers have little control over their consumption, such as hospital, medical care, prescription drugs, and college tuition costs. This hurts the lower income folks the most. On the other hand, you have a situation with items such as TVs, cell phones, software, and technology in general, showed disinflation or outright deflation in these areas.

And even though wages appear to be rising, currently, other forces are working against it including the continued “Amazonification” of the retail industry, and the replacement of human laborers by Artificial Intelligence or AI. As John Mauldin states, “I cannot tell which fate awaits us: the robot-driven apocalypse where we are all out of work, or the inevitable spike in wages that sends rates much higher and kills the market.

But the other force that is potentially greater than any of this to cause a disruption is the debt levels that exist in our country and throughout the world. Global debt ratios have been driven up as a result of “cheap” money created by the central bankers that has caused deflationary periods, such as 2008-2009 period, and an overall disinflationary condition over the years. Debt has risen so dramatically, that we can potentially have another 2008 episode or even greater. David Stockman recently wrote an article titled” “The Albatross of Debt: The Stock Market’s $67 Trillion Nightmare”.

This article sights the current public and private total debt load in the U.S. is now at $67 trillion. Yes, $67 trillion. To put it into perspective, In June of 1970, the total Federal debt was at $275 billion, and it took 188 years to get to that level. Even if you put into account inflation and compared it to what it would be today, it would only stand at $1.2 trillion. Wow, so currently, the reality is that we now actually stand at $21 trillion in Federal debt. Furthermore, in 1970, total public and private debt stood at $1.58 trillion, and amounted to 150% debt to GDP. That ratio persisted for the prior 100 years. To put that into perspective, if you inflated that number by the amount that GDP has expanded, and equated it in today’s terms, it would equal out to $19.6 trillion. However, today, we are now at $67 trillion.

Another fact that Stockman points out is in 1970, the Fed only had $55 billion in assets on its balance sheet. Today, the Fed’s balance sheet is north of $4.2 trillion. Even if we calculated money growth by Milton Friedman’s 3% money growth rule, the Fed’s $55 billion balance sheet would equate to $230 billion today, instead of where it’s at now - $4.2 trillion, or so.

In the meantime, investors can’t ignore the potential for substantial growth in GDP in 2018. Corporate earnings should continue to build and personal incomes should strengthen over the next year. That is good news, and it’s a reason that the negative action that we experienced earlier in the month of February was just a technical blip. Let’s hope so. It would be preferred to experience further upside in this Bull Run.

So, as the market continues to sort itself out, it’s only been 11 sessions since the drop of 2532 points were rendered on the DJIA, to which it has spent the time attempting to recover. That being said, the concerning aspect of all of it is that it happened so abruptly and plummeted in ways that haven’t been seen since the Lehman Brothers/AIG failure of 2008. Now we’re experiencing its recovery, however, the primary driver of the recovery is the technology sector, and as we near the end of the month, the markets have recovered about 61% of the loss as it rallied off of the lows. Yet many of the industry groups have not yet recovered by the same magnitude as were experienced in the primary indexes. We could see the broader market recover, but, the collapse earlier this month has taken its toll on the overall technical picture of the markets from a broader viewpoint.

Year to date, the broader indexes, as of the market close on Friday, February 23rd are up slightly for the year, for now. The Dow Jones Industrial Average is up 2.74% while the S&P 500 is up 3.05%. Technology is clearly the driving force as the NASDAQ has rebounded notably, and is up 6.29%, year-to-date. However, many of the other indexes are barely up, to even down, slightly. The bond market is a different story, and is negative across the board. The Morningstar U.S. Core Bond Index is down -2.18%, year-to-date, and the U.S. Long Core Bond Index is down -4.60%, year-to-date. The U.S. Corporate Core Bond Index is down -2.48%, and the U.S. Government Long Term Index is down -5.23%, according to Morningstar.com.

As this week unfolds there will be a substantial amount of economic news to be released. James Bullard will be speaking on Monday, followed by the release of New Home Sales and the Dallas Fed Manufacturing Survey.  On Tuesday being released are Durable Goods, Wholesale Inventories, FHFA House Index, Consumer Confidence, Richmond Manufacturing. On Wednesday, GDP will be released with expectations of a positive 2.5% number. On Thursday, Personal Income, PMI Manufacturing, Construction Spending, Jobless Claims, and on Friday Consumer Sentiment will be released.

Earnings will wind down this week with roughly 600 releases. There are some significant releases that could affect market sentiment but overall there will be a substantial amount of information this week that market participants will need to digest.

Best Wishes,

Zeller Kern Investment Committee