This post was originally posted here. The writer is a veteran community member and blogger on InvestingNote, with username known as el15, with 200+ followers.
After hitting an intra-day high of 2,941 on 21 Sep 2018, S&P500 has tumbled 17.9% or 525 points to close 2,416 on 21 Dec 2018. In fact, S&P500 has just logged the worst monthly performance in Dec since 1931! Dow has also fallen 3,535 points from the intraday high of 25,980 on 3 Dec 2018 and 4,507 points from the intraday high of 26,952 on 3 Oct 2018. What is happening? Is Armageddon coming?
Most things have not changed since 21 Sep, except for…
In Sep, when S&P500 hit 2,940, the usual concerns were also there, namely trade tensions; U.S. 10Y treasury yields above 3%; Brexit; concerns on Europe; peak in earnings growth in U.S. market; slowing global growth etc. Since then, nothing much has changed except that
a) Part of the yield curve has inverted
On 3 Dec 2018, the yield curve for U.S. 3Y note and U.S. 5Y note inverted. According to the chief economist of North America at The Conference Board, he wrote in an article posted on MarketWatch 10 Dec 2018 that from the time that the above yield curve inverts, a recession typically starts from nine to 69 months, with an average of 27 months (i.e. more than 2 years).
For the more closely watched indicator i.e. the spread between the 10-year note and the 2-year note, it is still positive and not inverted. Although the spread between the 10-year note and the 2-year note has been narrowing / flattening, some strategists have noted that a flat curve can last for years and the economy can still be strong. According to an article by BMO Capital Markets in June 2018, BMO found that the S&P 500 has appreciated an average 12.3% when the yield curve was flattening vis-à-vis a 7.9% gain amid a steepening yield curve for all periods since 1980. In addition, BMO found that the S&P 500 can still rise an average 14.3% during the later stages of flattening cycles (from 50 bps to 0 bps).
b) U.S. and China have agreed on a trade truce for 90 days
U.S. and China have agreed on a “cease fire of sorts” on trade for 90 days. Notwithstanding the arrest of Huawei’s CFO in Canada and other negative headline news, it seems that China and U.S are still making some progress on the trade front post the dinner between President Trump and President Xi (i.e. it seems relatively better now than in Sep on the trade front)
c) U.S. 10Y treasury yields have dropped from >3% to 2.79%
U.S. 10Y treasury yields have dropped from >3% in Sep 2018 to 2.79% on 21 Dec 2018. This seems to be a net positive for stocks as this may reduce long term borrowing costs and increases the appeal of equities vis-à-vis bonds.
Has the bull market ended?
Nasdaq has slipped into a bear market with the 3% drop on last Fri. Most readers will be wondering whether the 9 or 10 year bull market has ended.
According to most strategists, the equity bull market typically ends when some of the conditions happen. For simplicity, I only list three conditions below (i.e. the list is not exhaustive).
a) Inverted yield curve
As per above, the yield curve is flattening but has not inverted yet. According to Blackstone, they do not believe that the yield curve is going to invert soon.
b) Negative earnings growth
It is common knowledge that 2018 likely marks the peak in earnings growth for U.S. corporates. However, it is noteworthy that a peak in earnings growth in 2018 does not necessarily mean a decline in earnings in 2019. For CY 2019, based on Factset, analysts estimate earnings growth of 8.3% and revenue growth of 5.5%.
Chart 1: Earnings and revenue growth in 2019