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No bear market for stocks in 2019 because economy, earnings will keep expanding
By: MarketWatch | December 26, 2018

S&P 500 likely to retest its 2018 record during 2019 even as GDP, EPS growth slow

I will say flat out that I didn’t think December would be a down month, and yet it is shaping up to be the worst December since 1931, possibly ever when the month is over.

Needless to say, the economic environment today is very different than during the Great Depression, so parallels are difficult to draw, despite the similarity of the stock market’s performance. Based on the latest consensus estimates from FactSet, growth in earnings per share for the S&P 500 SPX, +1.21% is going to be 20.6% in 2018 with another 7.9% in 2019, along with 5.3% revenue growth.

I do not believe this financial panic is only about the expected slowdown in the economy and earnings.

It is true that the stock market is forward-looking and that both EPS and GDP growth are expected to slow in 2019. A good example of what happens in a slowdown of EPS and GDP growth is the 2014-2016 stock-market environment, where we had several quarters with negative EPS growth (see chart). The stock market went into a trading range but retested the highs of that trading range multiple times before it “broke out”.

While the Sept. 20 record close for the S&P may very well turn out to be the index’s ultimate high of this cycle, there is likely to be a retest of that level, meaning 2,930.75, or a gain of more than 20% from current levels. But I do not believe that the stock market is going straight down from here.

If the economy is still growing in the second half of 2019, this will become the longest economic expansion in the history of the United States. The previous record was March 1991-March 2001. I think the economy will continue to expand for all of 2019. This means that with a growing economy and growing earnings, this latest selloff is unlikely to be the start of a bear market.

Recessions do not start with unemployment at a 49-year low of 3.7% and the economy growing at around 3%. Before a recession can start, the economy needs to slow, and the unemployment rate needs to stop falling and begin turning higher because of the economic slowdown. That takes time. While a slowdown is likely to begin in 2019, the recession will most likely happen in 2020 or 2021 (see chart).

Can the stock market go down in a good economy?

Yes, a stock market can go down in a good economy, as it is has been doing recently. For a protracted bear market, we need to see a shrinkage in the S&P’s earnings per share. The more EPS shrinks, the more the index goes down. This happened in the recessions of 2001 and 2008.

The most extreme example of the stock market going down in a good economy would be 1987.

The 1987 market was the new Fed Chairman Alan Greenspan’s trial by fire, where he felt compelled to jump in with a few interest-rate cuts, the same way he cut interest rates after the market sold off 25% in August and September of 1998 at the tail end of the Asian Crisis and the Russian sovereign debt default (see chart). Regrettably, the fortitude displayed by this Time magazine cover, dubbed “The Committee To Save The World,” is hopelessly missing at this very moment.

I think the present volatility of the stock market is not due to the hiking of the fed funds rate alone, but also to the more disruptive overall quantitative tightening, which demonstrates itself via the rising Fed balance sheet runoff rate, which went from $20 billion in January to the present $50 billion/month rate (see chart).

Letting bonds mature (and not reinvesting the proceeds) also results in large repurchase agreement activity, which sucks excess reserves out of the financial system. Sucking electronic cash out of the financial system may be the simplest possible explanation as to why the stock market is doing what it is doing. (I urge you to carefully read the paper “The Federal Reserve’s Balance Sheet and Earnings: A Primer and Projections” by Fed economists Seth Carpenter, Jane Ihrig, Elizabeth Klee, Daniel Quinn, and Alexander Boote. There are other similar papers available from the Federal Reserve.)

In my experience, sharp selloffs in a good economy tend to reverse themselves as the economy keeps growing and so do earnings per share for major stock market indexes like the S&P 500. Some of those “good economy” sharp selloffs — as in 1987 and 1998 — required active government intervention in order to stabilize the market, while others took care of themselves. I do not believe that the 1987 and 1998 declines are real bear markets. They may have been down more than 20%, but there was no shrinkage in the S&P’s EPS.

Still, in the present uncharted territory of quantitative tightening, I would feel a lot better if Gary Cohn were the Fed chairman (he was considered for the job). He ran a large investment management organization (Goldman Sachs Asset Management) and had extensive experience as a trader before becoming an executive and a CEO-in-waiting. One certainly needs a lot of theoretical expertise to be a successful Fed chairman, like Ben Bernanke proved, but in the situation that we have now, practical experience would also count for a lot.

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