Winter is coming…
If you read the Game of Thrones books or watch the series, that phrase will be familiar.
It’s the motto of the Starks, rulers of the North on the fictional continent of Westeros.
Winter hits the lands of the North the hardest. As such, the motto “winter is coming” essentially boils down to “be prepared for the worst”.
We’re almost halfway December and winter isn’t just coming in the literal sense, meaning that the coldest season of the year is upon us. Winter is also coming for the stock markets.
The sun has shone on Wall Street for an exceptionally long period of time. The bull market in stocks has lasted for nearly a decade, but now the weather has taken a turn for the worse.
The past few months stocks have sold off around the world. The Dow Jones and S&P 500 have seen all of their 2018 gains erased and are now down for the year.
The Indian summer in the stock market has come to an end. Nothing but foul weather can be seen on the horizon.
The weather’s turning
Although the economy isn’t exactly a force of nature, its different cycles are just as inevitable as the changing of the seasons.
A period of growth has to turn into a recession at some point just like the leaves on trees can’t stay green all year long.
But unlike the seasons which change like clockwork every year, economic cycles aren’t as predictable.
The US economy has now gone almost a decade without a recession. That’s roughly twice as long as the time it usually takes for a slowdown to occur.
Even though the different cycles in economies don’t follow one another as routinely as the seasons, this exceptionally long period without a recession does imply we’re overdue one.
The stock market acts like a barometer of the economy. Generally speaking, if the economy is doing well the stock market is doing well.
A period of economic growth tends to benefit shares because it usually leads to bigger output, bigger profits, and bigger dividends to shareholders.
The opposite is true as well. If the economy looks headed for a recession, stock markets tend to fall in anticipation of lower output and lower profits.
In retrospect, the stock sell-off in February may have been a first warning that the market’s summer was coming to an end. Like showers marking the end of a period of hot weather.
After a bad spell, the stock market recovered and went on to reach new highs. We even saw the first companies with a trillion dollar market capitalisation.
But after 10 years of stock market gains, this recovery proved no more than the odd warm day in autumn, deluding us for a minute that winter was still far away.
The weather turned abruptly in October. A rout in technology stocks, just about the only sector that had performed strongly throughout the year, sparked a stock sell-off that put investors on red alert.
The Volatility Index, or VIX, is Wall Street’s fear gauge. It shows that investors have been expecting more volatility recently, which is considered a bad sign. They’re worried about market risk and no longer see sell-offs as a buying opportunity.
Speaking of bad signs, an inverted yield curve is another portent of doom.
Short-term bondholders are now being compensated more than long-term bondholders. When investors think the near future is scarier than the distant future, it usually means a recession isn’t far off.
“An inverted yield curve is a nearly perfect omen of lean days ahead,” writes Daily Reckoning editor Brian Maher.
“It suggests an economic winter is coming… when investors expect little growth.”
The bad weather hitting the stock market has been a long time coming.
It could have hit sooner if it hadn’t been for a string of events that kept stocks in the sunshine for a little while longer.
For the longest time, central banks propped up the markets by flooding it with a dazzling amount of money. When the market’s biggest sponsors said they’d put a stop to their liquidity injections, investors worried what would happen next.
But then President Donald Trump, who had equated a rising stock market to successful economic policy, came to the rescue. Thanks to his tax cuts, and the resulting boost to corporate profits, the market got another stroke of luck.
Companies found themselves with an unexpected financial windfall, which they splurged on stock buybacks. Once again stocks got pushed higher without it having anything to do with companies’ underlying fundamentals. It was a bonus rally.
And then there was the extraordinary performance of technology stocks. Just six stocks – Alphabet, Amazon, Apple, Facebook, Microsoft, and Netflix – accounted for the lion’s share of this year’s gains.
I’ve called them “Maradona stocks” before because they basically carried the team, lifting the stock market higher. These six tech “superstars” are now all in a bear market after tech stocks ran into stormy weather in October.
“Growth has lost its leadership,” is how Jim Paulsen, chief investment strategist at Leuthold Weeden, has put it.
All of these things pushed up stocks earlier this year and camouflaged that most stocks were already falling out of favour.
Now that the effects of the tax cut and buybacks are wearing off, these one-off stimuli can’t be repeated in order to stage another market rally. A rally in tech stocks also looks unlikely at the moment, which means the market has lost its three biggest drivers.
But that’s not all. Piercingly cold Northern winds are heading towards the markets.
Barry Ritholtz lists them in Bloomberg:
“Rising deficits have spooked bond markets; enthusiasm about the large corporate tax cuts passed in December 2017 has faded; the strong dollar is often cited as a headwind for corporate earnings; US stock valuations remain rich; China’s economy has slowed; Brexit is problematic, and the rest of Europe has more than a few messy problems. Any combination of these could be contributing to market volatility.”
Winter is coming for the stock market. Investors should prepare for the worst.