Don't fear the bear

• The three main issues behind the December setback remain essentially unresolved.
• From a technical perspective, the market could face several resistance walls over the coming week(s). If such walls are not crossed, we might soon test the December lows .
• In the absence of valuation excesses, and barring any major global crisis, we expect the next bear market to be contained in terms of magnitude, versus the current levels.

Since hitting bottom during the week before Christmas, the market has staged a nice rally of 13% or so. As usual, opinions are divided as to whether this rally is a short-term bear market trap, or a continuation of the bull market.

Benjamin Graham said: "In the short run, the market is a voting machine, but in the long run, it is a weighing scale". So for now, investors and analysts are voting, and we will soon find out who wins the vote.

The market has its way of defying all expectations and proving people wrong. However, if we were to take a rational, objective look at things, we would be tempted to reiterate our view of late, that the issues that led to the recent market setback remain unresolved. The three main issues are late cycle concerns, tighter liquidity and trade war rhetoric. In our update of January 12, we covered the three points at length.

In terms of fundamentals, not much has changed since January 12 or since the recent setback was triggered. By way of update, recent news has only corroborated the common view that the current boom cycle is aging. China, which accounts for the bulk of global economic growth, is slowing down. Europe, the other global economic fortress, is also fluttering. Last week, Mario Draghi sounded the alarm bells in terms of the challenges facing European economies, including geopolitical factors and trade protectionism. While Draghi stopped short of predicting a recession, fresh economic data does point to slowing growth. According to Bloomberg, German manufacturing has shrunk and Purchasing Managers Indexes are pointing to worsening performance.

For now, the US economy continues to hold the fort, but as we know, economic growth in the US will slow down from nearly 3% in 2018 to 2.5% in 2019. While this is still quite healthy, and the numbers do not yet preclude the possibility of an extended growth scenario, tighter liquidity, fading fiscal stimulus and the inevitability of a cyclical downturn will eventually take their toll.

Obviously, when the threat of a major recession becomes real, the Fed will have to stop selling bonds. If the economic picture worsens, one should not even discount the possibility of another round of quantitative easing, depending on how bad things get. This debate remains unsettled. Meantime however, bond sales in the open market continue to drain liquidity from investors' hands.

As for the trade war with China, it's been a succession of good and bad news. Despite the recent optimism, we are still to come close to a final agreement.

The bottom line is, even though the market may rally further in the short-term, the foundations remain weak. For the time being, investors seem to rejoice when good news spread, which is a good sign. The upcoming string of corporate earnings announcements could be what the market needs to overcome the resistance levels. Otherwise, if the market starts ignoring good news and starts looking for excuses to drop, that means we would have entered another period of bearishness.

From a technical perspective, equity markets are facing several resistance levels which will be tested in the coming week(s). If such levels are crossed, the rally would continue feeding itself until one or two pieces of bad news is released. If the market hits a resistance wall in the coming days, chances are the rally will fizzle and the December lows will be tested.

All things considered, short-term movements should be of secondary iumportance, and one should always be focused on the bigger picture. On that, we are big believers in cycles. Yes, we could very well be in the final stages of the boom cycle, but in terms of valuation, we do not see the major excesses that are typical of a severe bear market. In other words, unless preceded by another excessive rally, we expect the next bear market to be contained in magnitude.

Regardless, some investing rules are good for life, and one of them is Benjamin Gragham's famous rule that one should never bet the farm on any outcome, no matter how confident you are. Graham believed that your equity allocation should always vary between 25% anmd 75% of the total portfolio, depending on where we are in the cyle and how bearish or bullish you are. Given the near consensus that we are currently approaching the end of the cycle, we would be inclined to favour an allocation that is moderately tilted towards bearishness. Once the cycle is over, you can start rebuilding your equity accumulation towards the other end of the pendulum. In any event, what the exact equity allocation should be is something that depends on each investor's individual profile in terms of risk tolerance and specific financial circumstances, which is something to be discussed with your advisor.

There are two major risk factors to our scenario of moderate pessimism. The first risk is inflation. At this point, everybody is hoping that, as the cycle ages and economies slow down, central banks will come back to the rescue. This is very plausible, unless inflation sticks out its ugly head. High inflation would tie central banks hands and would prevent them from opening the money taps. For now, fortunately, there is no indication of a high inflation risk. Chances are, if the economy slows down and unemployment starts creeping up again, inflation will be contained. Still, this is somewthing to watch because inflation could become the wild card that jeoperdizes our best expectations.

The second factor is mounting corporate and sovereign debt across the globe. Debt levels are everywhere reaching, or have reached, unsustainable levels. Until recently, hungry borrowers had beed fed by accomodating central banks and excess reserves from surplus countries like China and OPEC exporters. Now that central banks are tightening and trade surpluses are vanishing, who will feed the debt monster? That's another dynamic to watch. The hope is that central banks will be able to strike a proper balance, by maintaing the right amount of liquidity to prevent a market collapse, without triggering inflation. This is a fine line to walk and only time will tell.

January 28, 2019

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