This is not going to be a partisan rant about what’s wrong with our government.
When I talk with clients about political issues, the only thing we can agree on is that our political system is in pretty bad shape right now. Washington, D.C. has become a dysfunctional, directionless mess. Depending on which tribe you identify with – left or right, liberal or conservative, Democrat or Republican – the odds are high that you are not happy about what you are seeing. And you undoubtedly place the blame for our ills on the other tribe.
Trump supporters are rightfully angry about where America is headed, and they believe that Trump will actually make America great again. Never-Trumpers are rightfully concerned that he doesn’t have the knowledge or temperament to get the job done. And the drama that has engulfed this administration isn’t helping. It has only distracted from the real job of every president – governing and leading.
Let’s put all of that aside and focus on what the stock market is telling us about where America is heading. If you can have an open mind about what the market is telling us, you may be able to recognize some important clues about what might be coming next.
Geopolitics
North Korea
What’s happening with our discussions with the North Korean leadership is cause for hope and optimism. The market likes that. By the way, when I refer to “the market” I mean the collective opinion of all market participants. The market doesn’t have a mind of its own. (Thank you, Captain Obvious.) The North Korea talks are having a positive impact on investor sentiment. It wasn’t that long ago we were concerned about rising tension and increasingly hostile rhetoric from both Trump and Kim. That kind of brinkmanship causes uncertainty, and we all know that the market abhors uncertainty.
Today, however, the tone of the rhetoric has changed significantly. And the market has taken notice, climbing back from a very soft 3 months and sitting within 5% of its all-time high water mark. Wouldn’t it be great if the North Korea situation was the only thing that the market cared about? It isn’t. The market pays attention to much more than the possibility of a denuclearized North Korea, as remote as that outcome may be.
Iran
The other elephant in the geopolitical room is Iran, and the Middle East in general. There the news isn’t so optimistic. For starters, Iran and Israel have now begun firing missiles at each other in Syria, which poses the threat of a proxy war turning into a real war between the two countries. This would further destabilize an already dire situation in the region, and the market doesn’t like that. Which brings me back to the question I posed in the title of this article. War: What is it good for?
As of this writing, apparently the increasing threat of a real war between Iran and Israel is being overshadowed by the optimism about a possible breakthrough with North Korea. Has the market made the correct assessment about geopolitical conditions? Who knows. What I do know is that the market is notoriously fickle, because humans are notoriously fickle. The Middle East situation could quickly escalate and bring other actors into the fight. The North Korea situation could go south in a hurry, especially if Kim reverts to form and turns out to just be playing for concessions, like his predecessors have been doing for decades.
Other market drivers
Now that we’ve covered geopolitics, what else is driving the market these days. Here’s a short list.
Positives
- Corporate earnings are strong.
- Inflation is below the Fed’s target.
- Interest rates are still low, but nudging higher.
- Employment is in full swing.
Negatives
- Budget deficits are growing rapidly.
- Government debt is ballooning relentlessly.
- Consumer debt is approaching levels last seen just before the last recession.
- Wages are not rising fast enough to cause an increase in consumer spending.
Is there a Bear Market coming?
According to my Bayesian probability model, the risk of a bear market arriving within the next 12 months is 21%. It’s up to you to decide what to do with that. My model is very accurate, but it’s not perfect. No model is perfect. What’s notable about my model is the lack of geopolitical considerations as a meaningful factor. Big events like North Korea, or the Iran Nuclear deal, make for great headlines and create much hand-wringing by the punditry, but they don’t have a lasting impact on stock prices.
When war is in the air, the market tends to react negatively at first, but quickly recovers as soon as missiles start to fly. Why is that? I’m not sure, but it may have something to do with our World War II experience. That was the scariest, bloodiest, and most destructive war since the fall of Rome to the Visigoths. But the lesson we Americans learned was that this country always rises to a challenge, and after the war we became the dominant force in the world, in geopolitics, economic strength, and policy influence.
Maybe that’s why the market thinks War is a good thing. At the very least, it’s good for defense contractors and spy agencies. We live in uncertain times, and maybe the market takes perverse comfort in the certainty of war, rather then the uncertainty of the threat of war.
Is a New Recession coming?
Of all the things that impact the direction of the stock market, economic recessions take the top spot – hands down. That’s why the folks at the Federal Reserve try so hard, usually in vain, to control the business cycle and prevent the next recession from happening. The holy grail for Fed types is to engineer a “soft landing” when the economy starts to roll over. They haven’t quite figured out how to do this, but give them a chance. They’ve only been trying since 1913.
My other tool for clients is a recession-forecasting model. Here again, there is no geopolitical component. The economy is what eggheads call a “complex adaptive system.” That’s a system that has many moving parts, and the interactions between all these moving parts is constantly changing. It’s complex because of the vast numbers of inputs, and it’s adaptive because it’s like a machine-learning mechanism, constantly reviewing and tweaking outcomes based on changing conditions on the ground.
Today my recession model places the probability of a new recession within the next 12 months at 14%. Once again, it’s up to you to decide what to do with that.
The point is that the market is driven by investor sentiment, plus fundamental factors like earnings, plus the condition of the business cycle. Geopolitics don’t really enter into the equation. So the answer to the question of War: What is it Good For? is… nothing. The market reacts on a short-term basis because investors are emotional. But once the conflict is defined, and the battle lines have been drawn, the market goes back to what it’s designed to do. Anticipating the growth of the economy and the future stream of dividends and earnings.