We wrote a piece for Forbes this past September called, “Is Billionaire Ray Dalio Right About the U.S. Economy?” The gist of the article was whether Bridgewater’s founder was correct in his assessment that the U.S. economy was in the proverbial “seventh inning.”
Suffice to say, we agreed with Dalio’s assessment.
Later that month, during our “Quarterly Macro Themes” call—before the October selloff began—our CEO Keith McCullough explicitly warned our subscribers to “adopt a defensive posture” and beware of Momentum, High Beta and Growth style factors. Mr. Market confirmed our concerns, falling hard shortly thereafter. The question now is whether the stock market is also in the late innings of a record run.
Here’s a quick look at what our top two themes were heading into Q4.
In our September Forbes article, we cited some of the 200 data points that we follow as examples of economic data that appeared to be peaking. These included small business optimism hitting an all-time high, manufacturing indices hitting cycle highs, and consumer confidence hitting its highest level since the internet bubble back in 1999.
Since publishing that article, those key data points (and many others) have slowed. The S&P 500 is down more than -8%, while the tech-laden Nasdaq is down closer to -11%. In the parlance of our firm, we were (and still are) predicting a Quad4 transition, which occurs when both growth and inflation slow.
The point of citing that article is not to provide a victory lap. Rather, we think it is important to consider the implications of this market correction and whether there is more to come.
In the chart below, we highlight Hedgeye’s view of economic growth compared to the consensus view. As the chart shows, for Q4 of 2018 we are expecting economic growth that is 51% lower on quarter-over-quarter basis than consensus and Q1 2019 growth that is 17% below expectations on the same basis.
On the positive side, our models aren’t predicting that the U.S. is entering a recession anytime soon. That said, we are set up to potentially miss GDP growth expectations meaningfully. In addition, we believe we are shifting into an economic reality that is slowing, and it is this change on the margin that matters most in our predictive analysis.
Stepping back from the macro environment, the other important factor important to consider is the trajectory of corporate earnings. Comparable to our top down view of the economy, we believe that corporate earnings have a tough comparable heading into 2019.
The primary reason is the corporate tax cuts implemented in 2018. Based on the (somewhat busy) chart below, actual corporate taxes paid in the U.S. were $297 billion and are projected to be $204 billion in 2018. Because of this tax cut, earnings growth in 2018 is up 23.6% in 2018 versus revenue up only 8.0%. This tailwind will not exist in 2019.
By any standard valuation model, slowing earnings growth should lead to lower valuations for equities. This, of course, is before we consider the impact of a slowing economy on the top line and flow through to earnings.
But what about the stock market you ask?
Volatility may well be the “river card” in terms of considering intermediate term market returns. Since we penned out missive back on September 18th, volatility across all asset classes has been rising, but most notably in equities. As of Friday’s close, the S&P 500 has moved greater than 1% for the 50th time this year (versus 8 times in 2017) and the Nasdaq had moved greater than 3% for the 3rd time in a month. Meanwhile, realized tech volatility is clocking in at the 99th-percentile on a 5Y basis.
The implication of heightened volatility is that risk as measured by potential prices moves, to both the downside and upside, in markets increases.
To the extent that you believe U.S. economic data will continue to slow into 2018, as we do, and that the Federal Reserve is not ready to become dovish, then the risk to equity markets remains to the downside despite the recent sell off—perhaps meaningfully so. Currently, one of our best ideas to short (or sell) in this environment is the ETF MTUM that tracks momentum stocks.
