Looking Towards 2019: Recession or Soft Patch? Inflection Point

Though the year is not over (9.5 trading days remaining for US equity markets), I have been thinking and preparing for 2019 since mid November. I called it a year then, and went on a three week hike (mixed with some business). I feel very refreshed and relaxed, after what was a very difficult year for me (evidently, I am not alone). I have not written a post publicly since April/May (in hindsight, both posts reflected the right idea).

Current Take and Immediate-Term Outlook

Measures of sentiment are poor yet us equities grind lower 

According to various measures of sentiment (no need to point out the ‘usual suspects’), sentiment is bad. I believe that some of these measures of sentiment are already at or below levels where US equity markets have tended to bounce or even bottom, at least within the last 5 years. Yet markets continue to grind (grind, and not flush) lower, though the indices remain at levels higher than the lows from earlier this year. This suggests two things: (1) the last 5 years’ of price action is not sufficient to understand current price action (and therefore, price action with a much larger ‘N’ than n=5, must be studied) and  (2) US equity markets have not bottomed.

Equities grind lower yet there is a notable absence of fear, panic, or capitulation

What has been notable about the price action in US equity markets in recent months is the lack of visible fear, panic, or capitulation. Rather, I sense unhappiness, frustration,… even weariness. There have been countless commentators, strategists, etc. anticipating bottoms in the last two months, but no fear/panic. In fact, all 10 strategists surveyed by Barron’s in recent days expect the S&P 500 to rise next year: https://t.co/pI3tyzL9aQ These qualitative observations also lead me to the belief that US equity markets have not bottomed.

The above observations lead me to believe that the best thing that could happen for those desiring a 2019 rally: a flush/capitulation, occurring before year end (in the absence of major historical, 9/11-like event). The worst thing that could happen is that we bounce into year end.

2019 Full-Year Outlook: Soft Patch or Recession? Inflection point 

One might say that the US equity market price action in 2018 - particularly in Q1 and Q4 - has served the purpose of curing very high embedded economic/profit growth and market expectations starting in 2017 and continuing into 2018, rather than pricing in recession.  The corrective price action has also helped US equity markets to “catch up” with the rest of the world’s equity markets (all down between 15%-25%, with China markets as one of the worst performers), though our equity markets still remain way ahead of rest of the world’s equity markets. US equities have been the only game in town.

More evidence points to soft patch versus recession, as of now

“Soft patch” or “deceleration” seem to be the most accurate words to describe the present and expected state of the US economy/corporate profits in the current and coming quarters, based on current and available information. That is, evidence points to the US economy and corporate earnings continuing to expand next year, albeit at a lower rate of change. A soft patch is not a recession, though it is an inflection point.

Soft patch as inflection point: precursor to recession or resumption of more aggressive expansion

Just because most evidence points to soft patch rather than recession, does not mean caution is not warranted. We are at an inflection point (a point where the previous growth trend may resume, after this pause, else we enter into recession). I personally don’t believe that it will take much to tip us over into either direction. An exogenous positive/negative event might be sufficient to move the needle. Here are some exogenous factors outside of the business cycle, that may tip us over.

What might tip us over in either direction: considerations for 2019

• China - I believe US investors are severely underestimating the importance of the Huawei CFO arrest from earlier this month, and possible resulting negative 2nd order effects. On the other hand, a recovery in the China macroeconomic picture and/or a Shanghai Accord 2.0 (thought some have cast doubt on China’s ability to ‘save the world’ this time around) would be positive.
• Europe - A major and likely cause of volatility in Europe is set to occur next year. It may end up being nothing more than a tapebomb. And no, Brexit is not what I’m referring to.
• USA - Impeachment or similar would be a major tapebomb. On the other hand, the absence of impeachment, coupled with sound policy enactment would be positive. Two more rotational considerations: There are two fund flow factors that will add downside pressure to Tech, private + public.