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In my June blog, The View – Bunny Slope or Matterhorn Slope?,  I discussed the market consensus that any downside risk was most likely a Bunny Slope, rather than a major Matterhorn-like market downturn. Has anything changed since then? We haven’t seen any dramatic change in the market. Has there been any change in the underlying narrative of Fed and Congressional actions solving all economic problems and protecting investors against all serious risks?

Despite an increasing amount of worry, stocks just keep grinding upward. Have we achieved nirvana at last? If you’ve listened to me for any length of time, I’m sure you know I don’t think that’s true. At some point returns should at least normalize, which means stock valuations and prices being more in line with historical averages – whether over the past 100 years or the past 25 years. I’m going to avoid talking about the basic math, but how do people expect to get a 15% stock market return year after year when the economy is growing at 3% a year? Earnings growth? P/E expansion? History tells us it never lasts, and no, this time, eventually will not be different. But no one knows when “eventually” will arrive. What should we do?

There are a lot of fully invested bears out there – people who fully acknowledge the basic long-term issues, but as a practical matter, they see that the market keeps going up, so they stay invested. Thus far, that’s been right, but someday that will change.

Give Me Chastity and Temperance – But Not Yet. – St. Augustine

Is it time for the market to sober up? I think that’s a tough game to play. I can cite worries and problems, but aren’t they always around? For that matter, isn’t the market supposed to climb a wall of worry?

So, is there a way to know for sure when a decline is coming? Wouldn’t that be easy!  I will admit that we successfully got out of the way of the major declines in 2000 and 2008. How did we do it? You’d think I should know, since I was there and pulling all the levers at the time.

I’d say those two experiences were fairly different from each other. In 2000, the broad economy was bottoming out and on its way to improving. In 2008, the market was out of gas and set for a fall. Was there anything in common? The thing that strikes me is that, in both cases, in the runup to both major downturns, we got a significant boost in stimulus. In 2000, we’d had the Y2K concerns, which the Fed had soothed with ample liquidity. 2008 was complicated, but simply put I’d say it was an extension of more, continuing stimulus-encouraged leverage and risk-taking stemming from 2000, and the risk-taking was most obvious in banks. In both cases I’d say what we saw was an overwhelming burst of stimulus that eventually ran out of gas.

I’ll admit that’s a super simplification, but does it make you at least a little nervous about what’s been going on lately? Just between you and me, there’s been some amount of stimulus lately, and it may be fading.

Most of the time, the end of the world doesn’t happen. – Howard Marks

Again, though, nothing much keeps happening. We go down to the 50DMA, then we bounce. Rinse and repeat. How would we get a big decline? At this point, first we’d have to go down to the 50DMA yet again. On the S&P 500, that would represent about a 3% decline. Maybe that Bunny Slope would furrow some brows, but not that big a deal.

It would get more exciting if we went down to the 200DMA, something we haven’t touched since last November. Again, though, that’s only down about 10%. That’s a correction, and I’m sure it would hurt some people, particularly considering that some names could go down much more, but passive indexers would still be up a bit on the year.

Could we go down even more? John Hussman, for example, is of the opinion that the market could quickly go down 30% in the next downturn. Ridiculous? Well, what happened last year? Was that just due to the unique circumstances of Covid? I’d suggest the hedging action of the now-huge options market aided the sharp frenzy, and that risk ‘feature’ hasn’t gone away.

Where’s the Beef? – Clara Peller

Again, that’s nice and all, but who really cares? The Prophets of Doom have rent their garments for years about issues, with not much more than a brief plunge into and off a trampoline last year to show for it. The jury has spoken, and the verdict is that we have sufficient stimulus to banish all Matterhorn declines. Buy the forking dip. The End.

But what if that’s just the madness of crowds talking? Looking at history, stimulus tends to work fine as long as more is coming. Once that ends, reality can be a harsh mistress.

I’ll point out again that we’re starting to come off a massive stimulus, and even if we get the new round of stimulus, it will be smaller and probably not arrive until the fourth quarter. There’s also the debt ceiling that markets have largely ignored but that Republicans have vowed to fight over. Investors may want to believe that new stimulus will show up after the next 10% market decline, but given the budgetary acrimony and inflation concerns, I wouldn’t be too sure. I particularly wouldn’t be complacent about the recent pattern of ever larger stimulus continuing.

I hold that it’s hard to nail these market moves in advance, but you can see that more preconditions of risk actually mattering are in place. The VVIX, the volatility of volatility, is showing signs of stress compared to VIX and SPY, which is concerning given how important volatility is for investors in modern markets.  M2 money supply growth is less than GDP growth, which is creating liquidity worries. According to Bank of America, we seem to have hit peak GDP growth, corporate profit margins, and investor sentiment last quarter.

Further, consumer confidence just plunged to levels lower than during the lockdowns, similar to what happened in 2000 and 2008 according to Lawrence McDonald. Retail sales this week are expected to show a slowdown, according to Bank of America. The Jackson Hole meeting towards the end of the month may advance a timetable for a taper, probably in the fourth quarter. A lot of Covid-era stimulus is rolling off, so the free money train is running out of steam.

What, Me Worry? – Alfred E Neuman

Can I say we’re facing a big decline? Not at all, but ask me again tomorrow. I think I can say we’re in a fairly dangerous setup. It’s particularly worrisome that the market doesn’t seem at all concerned. Like the calm before a forest fire, it’s from that sort of initial perceived stability that instability can spring up. Eventually there will be a real problem. Could that start soon, even really soon? Maybe. Could we see a sharp decline like John Hussman talks about? I’d think probably not, but I also think it’s a lot more possible than most are willing to believe. Then again, maybe the Delta variant moderates and people get back to the dance floor. That’s what makes a market.

So, is the big one coming? Sure. But is it coming soon? That, I can’t say. I do think we have enough warning signs that it’s worth pulling in the horns a bit, being prepared. Safer, low volatility stocks have been trending fairly well lately. Maybe it’s time to hop on that trend, at least until the skies clear a bit. All those high beta stocks that did so well for so long are starting to look broadly more dangerous. Maybe that’s a dip you want to hold off on forking buying, at least for a bit. Bottom line – let’s continue to do our job, but –

Let’s Be Careful Out There. – Sgt. Phil Esterhaus