Five signs this market party might be winding down
In our last column, we gave you five reasons why the stock market party might continue for a while longer. Of course, “a while longer” is not the same as “forever.” Like any good party, there does come an appropriate time to leave. If you are young (and drunk) the time to leave a party is before the first fight breaks out. If you are older, and the host of the dinner party starts to vacuum, you have already overstayed your welcome. With that in mind, let’s look at five warning signs to watch for in the market to perhaps give you a clue about when the market party might be winding down.
INFLATION WITH SLOWER GROWTH
Right now, markets are partying because we have an ideal scenario: good economic growth but no inflation. Sure, no one is worried about inflation now, nor have they been for quite some time. But that alone does not mean it cannot happen. The worst-case scenario for stocks is higher inflation combined with slower, or no, growth. If inflation ticks up, the Fed might decide to be more aggressive on rate increases. This would be a sure sign to get out of the market for a period of time.
SURPRISE UPTICK IN UNEMPLOYMENT
When companies see a slowdown in orders, the first thing they do is stop hiring. Again, right now, this is hardly an issue. Unemployment levels are near decade lows. A surprise rise in unemployment, though, might signal an economic reversal, and investors would likely take this very seriously and begin seriously selling. It can send false signals, as it is reported regularly, but it is certainly one indicator we would watch very closely.
DECELERATING EARNINGS GROWTH
This can confuse investors. Companies might still be reporting higher earnings, but stocks might roll over. This is because investors are always wary when the rate of growth slows down. Similar to other indicators, earnings do not rotate 180 degrees from growth to slow down. First, earnings growth will decelerate. Whether this deceleration results in weaker earnings going forward hardly matters. Investors will see the earnings deceleration and reduce equity exposure as a precautionary measure.
LOAN LOSSES AT BANKS
This can sometimes be the canary in the coal mine. Bank earnings one day might be very strong, due to higher fees and investment gains, but corporate loan losses might tick up. Looking solely at earnings, one might think all is fine. But rising loan problems can be a big signal to a potential reversal in the economy. This, though, is a tricky indicator, because banks can have a degree of subjectivity here. Banks can take loan losses to also smooth out earnings, so higher loan provisions do not always signal problems in the economy. But they should certainly be watched, and the trend here is extremely important.
BOND MARKET
Being an equity guy, I hate to admit it, but the bond market is usually “smarter” than the stock market. Bond investors can’t stand losing money, as even a
0.25 per cent difference in fund performance from a benchmark index can be the difference between a large bonus and no bonus for a bond manager. Bond investors are closely tied in to companies’ financial picture: cash flow, earnings and asset protection. On the corporate side, lower bond prices (higher yields) can sometimes be a warning that corporations’ (en masse) financial health is not as good as it was before. With government bonds, lower prices can sometimes be an indicator that interest rates and/ or inflation is about to rise at faster rates. We would certainly pay close attention to the bond market if you are at all concerned about the stock market.
Like with our positive points two weeks ago, we are not predicting that any of this WILL happen. But — like at a party — knowing when to stop imbibing is key. You sure don’t want a stock market hangover, either.