Just Another Market Correction

KCS Wealth

August 22, 2019

Those of you who follow the financial markets are no doubt aware that August has not been kind to stocks: since July 30, the global All Country World Index (ACWI) of equities is down -6.0% through yesterday. Not a disaster, but no fun, either. The main reasons for the fall—according to the financial news media—are the same ones you heard about in May of this year, when the ACWI fell -5.9%. They are also the same ones that the pouting pundits fretted about in December of last year, when the ACWI cratered nearly -13% in just 3 weeks.

First, there’s the trade dispute with China, which keeps threatening to turn into an all-out trade (and currency) war. President Trump seems determined to keep ratcheting up the pressure on China (and on American consumers, farmers, tech companies, etc.), but he blinked on Monday when he delayed some of the threatened 10% tariffs until after the Christmas shopping season. We continue to predict that it will be the US, not China, who eventually capitulates, because Chinese leaders don’t have to worry about an election next year.

Then there’s the yield curve inversion, which we first heard about late last year (see our newsletter from early December 2018 for more on this). This week, however, a more meaningful segment of the yield curve “inverted,” with 10-year Treasury note yields falling below that of 2-year notes for the first time since 2007. This indicator has been a harbinger of recessions in the past, leading to the worry (voiced during nearly every correction) that a recession is just around the corner.

Not so fast! Even if the signal from the yield curve this week is accurate (and there are reasons to believe that it is not), the predicted recession is not likely to arrive for 15 to 24 months. And since stock prices don’t generally peak until 5 months before the economy starts to turn down, that suggests we have a good 10 to 19 months of stock market gains ahead of us, even if the yield curve signal is correct.

For some context, the 2-year/10-year Treasury note inversion has occurred 5 other times since 1975. One year later, the S&P 500 index was higher in all 5 cases (on average by +13.5%). Three years and 5 years later, the S&P 500 was higher 4 out of 5 times. Thus, yield curve inversions shouldn’t scare you.

Historically, stocks are higher 1 year after a 2/10-year Treasury yield curve inversion

As we said in the title, we think the current decline is just another run-of-the-mill stock market correction, which we see on average once a year. We think this is the second leg of a 2-legged correction that began in May. If it follows the usual playbook, this leg should bottom close to current prices, or perhaps 2% to 3% lower. Uncomfortable, but far from a recession-induced bear market. We do expect a recession and greater than 20% market decline in the future, but we believe that future remains a year or more away.

Yours truly,

The KCS Wealth Investment Management Team

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