As I write early Friday afternoon, markets have turned south after news that China trade officials have cut short their U.S. visit. Not a good sign for the ongoing trade war.
Plus, it was only over a week ago that an ABC News/Washington Post poll showed that 60% of respondents believe the United States will go into recession in 2020. And according to a recent survey by the National Association for Business Economics, three out of four economists believe we’ll drop into a recession by 2021 — and half of them believe it will happen by the end of next year.
While that’s cause for concern — and action — it’s no reason to panic. Recessions and the market downturns that often accompany them are regular occurrences. And as we’ve discussed here in the Digest, many signals point toward additional gains for the market in the near-term.
But it’s our job is to give all you the necessary information to grow, and protect, your money. On that note, it’s important to understand that bear markets and recessions can come on fast, taking many investors by surprise.
Things can seem okay — the news says unemployment is down and that GDP has slowed some … but still rising. Earnings are generally okay. The stock market is near record highs.
But then it hits …
Today, we share with you the first in a two-part series of essays on this possibility. In them, InvestorPlace global investment strategist, Eric Fry, shows you how and why markets can suffer an abrupt, unexpected downturn.
So, let’s enjoy this rising market today, but not be blind to what could surprise so many investors tomorrow.
The $31 Trillion U.S. Stock Market Just Sprung a Leak
By Eric Fry, Fry’s Investment Report
Every flood begins with a trickle.
And every bear market begins with warning signs that most financial experts ignore.
Today, for example, investment capital is trickling out of small-cap stocks, even though many large-cap stocks are still climbing to all-time highs. If this trickle from the small-cap sector becomes a flood, most investors may quickly find themselves underwater.
Not every trickle leads to a flood, of course. But a trickle that springs from the foundation of an intensely pressurized structure — such as a financial market — deserves attention.
On the morning of March 12, 1928, the chief engineer of the Los Angeles Bureau of Water Works and Supply inspected a fresh leak near the base of the St. Francis Dam, about 40 miles northwest of the city’s downtown. After examining the leak, the engineer, William Mulholland, determined it to be “normal” for a dam of its size. He assured the dam keeper that the leak posed no risk to the structural integrity of the St. Francis.
Twelve hours later the dam failed catastrophically, and 12 billion gallons of water roared down the Santa Clara River Valley 54 miles to the Pacific Ocean. At least 500 people died in the floodwaters — the greatest loss of life in any California disaster, other than the 1906 San Francisco earthquake.
The “normal” leak that Mulholland observed became catastrophically abnormal because of a feeble foundation. Although the dam itself was up to snuff, the rock formations beneath it were not.
St. Francis Dam, Credit: U.S. Geological Survey
According to a California state commission that investigated the failure of the St. Francis, “The west end [of the dam] was founded upon a reddish conglomerate which, even when dry, was of decidedly inferior strength and which, when wet, became so soft that most of it lost almost all rock characteristics.”
The same view, post-collapse. Credit: U.S. Geological Survey
One might say that the St. Francis had feet of clay — and one could say the very same thing about today’s U.S. stock market.
At a glance, this immense $31 trillion market seems as robust as it is colossal. It is, after all, the largest and most liquid financial market on the planet. But on closer inspection, this market may be resting on a feeble foundation.
The small-cap sector, for example, has sprung a leak. The S&P SmallCap 600 index topped out one year ago and has slipped 15% since then, even though the S&P 500 has continued moving higher and making new all-time highs.
The failure of small-cap stocks to advance in unison with their large-cap counterparts is not always a bad sign, but it is never a good one. Technical analysts describe this phenomenon as a “bearish divergence” that often portends overall stock market weakness.
Another sort of bearish divergence is also signaling trouble ahead: The “new highs” list has been contracting for nearly two years. The “new highs” list tracks the weekly tally of stocks on U.S. exchanges that are hitting new 52-week highs.
Generally speaking, a “healthy” stock market produces a rising number of new highs as it marches higher, whereas an unhealthy stock market produces a contracting number of new highs.
Technical analysts refer to the latter phenomenon as “narrow participation” … and it is never a positive sign.
New highs are a bit like restaurant patrons; more is better than fewer. A restaurant that’s packed to the rafters with diners is more likely to flourish than an empty one. And even though the empty restaurant might open its doors tomorrow, every day is a struggle. Before too long, its few remaining customers will find an OUT OF BUSINESS sign hanging in the front window.
The contracting new highs list and the capital flight from the small-cap sector are not the only troubling signs for the stock market. A few other ominous omens include:
• An inverted yield curve. That’s when short-term bonds are yielding more than long-term bonds. This rare configuration, which received a lot of attention in late August after the curve inverted to its worst level since 2007, often signals a coming recession.
• A poorly performing transportation sector. According to Dow theory — and more than 135 years of market history — a weak transportation sector often portends a broad market downtrend. Several months before the great bear market of 1973-’74, for example, the Dow Jones Transportation Average topped out and started heading lower. The transports had already tumbled 30% before the major averages started their declines. Similarly, prior to the bear market of 2000-’01, the transports topped out and headed lower. Once again, the transports had fallen nearly 30% before the major average started their declines. Today, the Transportation Average is showing a similar weakening trend. After topping out one year ago, it is down 10% from that high.
• A reviving precious metals sector. As the ultimate anti-stock asset, precious metals often strengthen when stock prices stumble. It is somewhat concerning, therefore, that the price of gold has soared more than 25% during the last 12 months, while the S&P 500 has achieved a return of roughly zero.
Moving away from the financial markets to the real economy, warning signs are also proliferating. Let’s take a look at just one of them, the Institute for Supply Management (ISM) Manufacturing Index, which measures manufacturing activity in the U.S.
Readings from this index topped out one year ago and have been falling sharply ever since. The ISM Manufacturing Index has tumbled 19% year-over-year. Drops of this speed and magnitude tend to precede or coincide with steep stock market selloffs, as occurred in 2000 and 2008.
And yet, even when warning signs like these accumulate, investors tend to dismiss them as harmless, “normal” features of a healthy financial market. Most of us never see a bear market coming until it has already launched its initial attack on our portfolios. In fact, professional investors are often just as blind to risk as novice investors.
The list of infamously misguided forecasts is a long, storied one.
In the second part of this essay, I’ll share some of those forecasts.
And I’ll show you some of the tactics Fry’s Investment Report members are using to stay in front of — and even profit from – any coming financial storm.
See you then.
Meanwhile, you can learn how to join us at the Investment Report by clicking here.