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What next? Michel Pireu     | Business Day Tuesday, November 6, 2018
October might have left some investors feeling a little like Worthington Fowler’s speculator who, “One day is lifted to dizzy heights, the next, plunged into black depths. [Who] is hurried through dark labyrinths where a single misstep is destruction … where he tastes joys brief as a dream, and in an hour is abased to the earth where he drinks the full cup of humiliation and want, blacksmiths' sparks flickering before his eyes.”

In which case the problem may be, as Barry Ritholtz tells Bloomberg, that they’re probably looking at the day to day from the wrong angle. “We have a tendency to lose the ability to put any given week or month into the broader context,” says Ritholtz. “As an example, last year was a tremendous year with markets up over 20%, with little volatility. We never know when that’s going to end, but typically we do see some regression to the mean … As Hyman Minsky told us way back when, markets go through regular boom and bust cycles and stability tends to breed instability. We get a little more complacent, we get more speculative, we take advantage of attractive market conditions and then, of course, that leads to the eventual denouement that we saw last month. The other thing is there’s been a ton of great news and everybody keeps talking about that, but the markets figured it out way in advance. So the tax cuts, the deregulation, record-high earnings and pretty decent GDP are already reflected in prices. When you look at the stock market now – at relatively high valuation with all the good news built into it - the question may be: What’s driving markets into the future? And, what we’re looking at is an economy that’s doing OK but not likely to ramp-up much above this in any appreciable way, some slow-downs around the world. So, we’re moving off the emergency footing towards a more normalised footing, but that’s not the end of the world. It doesn’t mean a recession or that stocks are going to crash. What it means is that what was once a tail wind is no longer there and is at risk of eventually becoming a head wind.”

On a more bullish note, “October means bottoms for markets,” BMO Capital Markets Chief Investment Strategist, Brian Belski tells CNBC. “Traditionally, September’s the worst month. There’s only been 9 times in the history of the markets when we’ve seen double digit losses in October and that’s when we usually wash out. Seems to me everyone’s looking for this capitulation. We talk about ETF selling, we talk about the machines, but to us this is a pretty normal correction; Led by small caps, then the high beta and finally the tech stocks. Not only is this normal but we think it’s healthy. We don’t like it when people lose money, but we needed it to take some of the froth and complacency out of the markets. We think the next 3 to 6 months will be led by tech and financials and industrials on the bounce, followed in the next year by health care, financials, technology – the cornerstones of the US economy. We still think that earnings are understated, that companies remain defensive and are still so afraid of being wrong that they don’t want to be right and that this defensive mind-set, to under-promise and over-deliver, is clearly showing up in earnings. We think the next few years is all about US dominance in terms of economic growth and earnings growth.”

Oppenheimer Senior Investment Strategist, Brian Levitt agrees. “People were asking for a ten percent correction in markets, we’ve now seen financial conditions tighten with rising rates and a strong dollar, so this is normal. This does not look like the end of a cycle. The US economy will slow into 2019 but growth will be strong enough … and on we’ll go.”

Are fears of the Federal Reserve hiking into a trade war and potentially peak economic growth and peak earnings unfounded?

“I think the biggest risks right now,” says Levitt, “are what the Federal Reserve and the Dollar are going to do. However, the market is slowly bringing down expectations. If the Fed is really convinced they’re going to go [raise rates] four times in the next year then we will have more worries. But I think with inflation where it is the Fed has the room to back off. If the dollar stays stubbornly strong and accelerates from here because of trade wars that could spoil the economy … but a strong dollar and rising interest rates means that the economy is improving and earnings are improving, we’ve kind of forgotten that.”

Not everyone is as optimistic. Morgan Stanley’s Chief Equity Strategist, Michael Wilson, is predicting a much longer bear market. "There is growing evidence that it is morphing into a proper cyclical bear market in the context of a secular bull," says Wilson, "We think the evidence is building and the message from Mr. Market is clear: the consensus outlook for earnings growth is too rosy next year. Some corporate officials have cautioned that between higher borrowing costs and an uncertain tariff outlook, 2019 could prove a tough year for stocks. The markets seem to agree and have been quietly revolting all year with about half of all the stocks in the broad MSCI U.S. Equity Index at least 20 percent below their 52-week highs. We don't think the revolts will stop until central banks pause or at least signal they are concerned. With the Fed having to respond to still strong economic data and the desire to remain apolitical, we think it could take another 200 S&P points making 2,450 a reasonable downside target to consider." Another 10% down on last week’s close.

Then there’s the former budget director for the Reagan White House, David Stockman, Global Chief Investment Officer at Guggenheim Partners Scott Minerd, John Hussman of Hussman Investment Trust, and Ted Bauman’s team, predicting a market collapse of between 40% and 70%, depending on who you want to listen to.

In which case a lot more investors are likely to have blacksmiths' sparks flickering before their eyes.

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As William Hester at Hussman Strategic Advisors reminds us, any discussion of expected profits and how they relate to market performance should always begin with the caveat that earnings and stock prices are not joined at the hip. “There is virtually no historical correlation between changes in year-over-year earnings and stock prices,” says Hester. “The main problem is that the prospect for long-term returns hinges on whether the earnings and profit margins used to value stocks are normal and sustainable. Unless current profit margins can be sustained indefinitely, P/E multiples may turn out to be very unreliable measures of value. In addition, most meaningful profit recessions have been preceded by stock market declines. Lower prices led both of the earnings declines beginning in 1991 and 2001. While the earnings slowdown in 1998 was mild, it was also preceded by a drop of almost 20 percent in the market.”
 
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