The swift 10% correction in the S&P 500 index in October is a mild echo of the 25 – 35% bear markets emerging markets, led by the financial panics in China, Turkey, Argentina, Pakistan and the ASEAN markets.
Even in the US, the homebuilder index is down 25% and regional banks have lost a staggering 20% in 2018 to date. The volatility Index (VIX), Wall Street’s pendulum of greed and fear, has more than doubled from its complacent lows last summer. The spasm of risk aversion does not negate the secular bull market in US equities, unless the S&P 500 decisively falls below its 200-day moving average at 2750 and fails to regain this critical metric. The rise in US Treasury bond yields after the September FOMC rate hike, draconian US tariffs on China, angst about the US midterm elections, President Trump’s decision to revoke a nuclear treaty with the Kremlin and the sharp deterioration in Saudi-Western relations after the killing of Jamal Khashoggi have all taken their toll on a US stock market that was the consensus, safe haven darling of global investors only a month ago. The U-turn in market psychology has led to the worst episode of risk aversion in US equities since early 2016, when a botched Chinese mini-devaluation led to global contagion in Wall Street, Europe, Japan and the emerging markets.
Earnings disappointments a la Amazon and Google pose the greatest threat to the US stock market in 2019. While Trump’s tax cuts boosted earnings growth to 19% in 2018, it is realistic to expect a deceleration in earnings growth next year. With the recent acceleration in US economic growth even as consumer confidence is at 18-year highs while the unemployment rate is the lowest since the year Richard Nixon moved into the White House, the hipsters congregated at Woodstock and Neil Armstrong walked on the moon (1969!). It is thus rational for the Federal Reserve to project three interest rate hikes in 2019 in addition to a rate hike at the December 2018 FOMC. The overnight borrowing rate (Fed Funds) could well rise to 3% next year even as the Powell Fed shrinks its balance sheet by another $400 billion. This means the yield on the ten-year US Treasury note can rise to 3.6% – 3.8%. Add Brexit, Italian budget woes, China hard landing risk and King Dollar remains the dominant theme in Planet Forex in 2019.
It is unrealistic to expect valuation multiples to expand in 2019 as interest rates rise and earnings growth decelerates. Stratospheric technology stock multiples are obviously at risk. The crypto-currency bubble, reminiscent of Dutch tulipmania, has ended. Silicon Valley’s unicorns could be next as Uber, Airbnb, WeWork and their ilk have the potential to fall 50 – 70% from recent peaks. After all, $45 billion of SoftBank’s $100 billion Vision Fund is Saudi Arabian, a political and ethical dilemma for Silicon Valley. Healthcare and money center banks are my preferred sectors de jour in the S&P 500 index. In Europe, media, software and auto makers are bargains. It is premature to do a deep dive in emerging markets.