2019: Recession or Soft Patch? Considerations at the Inflection Point

Recap of 2018, since December 16th

“There are decades where nothing happens; and there are weeks where decades happen.” - Lenin

On Sunday afternoon December 16, 2018, I wrote Looking Towards 2019: Recession or Soft Patch? Inflection Point . Here is what subsequently happened in the following 9.5 trading days into year end:

• Sunday afternoon December 16, hours after my post, Stan Druckenmiller released an Op-Ed on the WSJ titled Fed Tightening? Not Now , followed by an extensive TV Interview with BBG TV just 2 days later arguing as much (coupled with other content), on December 18th, exactly one day before The Fed.
• On December 19th the Fed “tightened”.
• US equity markets (more or less) declined in a straight line into Christmas, followed by a slight bounce into year end. As a result of this price action, Q4 2018 and the month of December 2018 are now in the history books, among the worst quarters/months/Decembers in US equity market history. In fact, Since 1923, the month of December has never been the worst month of a calendar year…until now.

Current Take and Immediate-Term Outlook

Measures of sentiment have recovered, despite poor price action

Various measures of sentiment have recovered since I wrote Looking Towards 2019: Recession or Soft Patch? Inflection Point on December 16, 2018. This recovery in sentiment contrasts against the clear and severe deterioration in price action. Even with the bounce from 2,350 on the S&P 500, buying and/or holding stocks continues to feel like what shorting stocks feels like (the true gauge for a bear market, in my view). Price action feels very unstable (just take a look at the price action within the last 5-10 minutes of the 31st).

No capitulation: Buyers AND Sellers Want Higher Prices

Historic market price action tends to climax with some very clear markers. While sentiment was certainly lower when S&P 500 briefly touched 2,350 compared to the the days leading into that day, we have still yet to see the capitulation that tends to mark the end of historic moves. And the December move was historic.

Those who were bearish into December, have flipped bullish: they want higher prices to sell and/or short into. Bulls who were bearish in December want higher, to reinforce the possibility that a bottom is in. When both buyers and sellers want higher prices, what tends to happen?

the above observations - coupled with other observations - lead me to believe that: (1) the market continues to be defined by bear market price action (I don’t care for “official” definitions of bear markets) (2) the bottom is not in.

2019 Full-Year Considerations

If the US equity market price action in 2018 – particularly Q1 and Q4 – has served the purpose of curing very high market expectations rather than pricing in the risk of recession, markets would not be irrational to start pricing in the possibility of global recession, regardless of whether or not an actual recession is to take place this year. Markets overshoot to the upside and to the downside. Some reasons markets may overshoot to the downside (reasons beyond those mentioned in my previous post):

• China and Europe Softness - China and parts of Europe of showing signs of recessionary or near recessionary conditions, as their respective markets have been signaling. What is the transmission mechanism - if any - to the US economy? US Markets may shoot first, ask questions later.
• US Deceleration - Some additional signs (beyond rates, housing, and semiconductors) of faster and/or more severe deceleration than expected. For example: “Global trade has slowed in recent months and leading indicators point to ongoing deceleration in global trade near-term.” - Fedex, December 18, 2018.
• Wealth Effects in Reverse - Do asset prices (particularly, changes in asset prices) affect the real economy? Some believe that the wealth effect is stronger when asset prices decline, rather than when they rise. On a YoY , QoQ, Peak to trough basis, financial asset prices are meaningfully down, worldwide.
• Hedge fund blowups and Family Office Conversions - If US equity prices do not immediately recover in Q1, the risk of further redemptions and more blowups in hedge funds substantially increase (as many “hedge funds” are really nothing more than levered beta…this observation, by the way, applies doubly/triply so to private equity). At what point does the institutional investor LP see the truth that many “hedge” funds (and more so private equity firms) are nothing more than rent collectors? If a hedge fund with significant short exposure (though long biased) nevertheless underperforms the S&P 500 in 2018, AND over the last 2, 3, 4+ years, why bother? Why pay ANY management fees? Perhaps the industry requires a return to capital-guarantee and/or only performance fee-only models.
• Short sellers became short squeezers - Since 2017, many formerly short only professionals have become… short squeezers. This behavior was rewarded by the market, until recently months, yet I don’t think this behavior has “unwinded” just yet. Note that this phenomenon was in vogue in 1987, in the months preceding the now famous crash of ’87.
• DIS long pitch - a recent DIS long pitch (which boils down to multiples expansion), suggests to me that the corrective action in US equity prices is not complete yet.
• Historical comparisons and analogues must look past the last 10 years - Analysis that consisted of “this hasn’t happened in the last 3-5 years” got many market participants in trouble in December.