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The next recession and equity markets …

While I think it likely that the US equity market has peaked for this cycle and thus I guess has technically begun a bear market, I doubt that the real thrust of the bear market will begin until economic growth begins to slide.

I have argued, largely based on my trusty growth cycle indicator that this will likely begin in the second half of 2018. If true that would mean a probable recession in 2019. This remains by base case scenario.

Happily, at least someone agrees with me. The good folks at Guggenheim Investments have recently reported on a new fancy recession timing model they have developed which points to a probable recession in Late 2019 or 2020.

Those interested can find the link here: https://www.guggenheiminvestments.com/perspectives/macroeconomic-research/forecasting-the-next-recession

The chart showing their estimates is shown below.

My own analysis suggests that the risk on the Guggenheim estimate is that the recession will come earlier than forecast, rather than later, but in principle I agree with them and it is nice to find someone who is thinking on the same plane.

If this scenario is broadly right, I expect the S&P will tend to enter a range-bound price action for the next 6 months or so because the S&P rarely suffers a sustained fall unless growth is genuinely weakening.

The prospect of a prolonged sideways move in the S&P would be an ideal environment for emerging market equities, offering something of a re-run of 2007. In fact, I think the price action is already mirroring that seen in the sharp market correction of July and August 2007.

I say this because the emerging market price correction, which began in late Jan, has demonstrated unusual equanimity. Confidence appears completely unshaken.

I see evidence of unbroken confidence in three events: (1) the market reaction to the evolving trade spat between the US and China; (2) the complete absence of any style rotation in the market; and (3) the resilience of market breadth.

The media promotes a view that news drives markets when, in fact, market psychology determines what news is important. Take, for example, the impact of the escalating trade dispute between the US and China. A trade war has long been touted as the major threat facing equity markets. When the risk of a trade war finally did erupt in February after the market correction had already started, what happened? Markets fell for two days. Since that time, the dispute has arguably worsened since then but most emerging markets have failed to make new lows.

Resilience in the face of bad news is a bullish market sign, not a bearish one.

Style rotation normally emerges as a clear sign that market psychology is shifting. Bull markets end when the market loses confidence in the stocks that have been leading the rally, or when the investment style that managers had been following, begins to underperform.

The table below compares the performance of the four equity investment major styles with that of the Hang Seng Composite Index over the past year, in the year to date, in the past four-weeks and in the past week. Performance data shown is for a basket of the top quintile of HSCI stocks in each of the styles.

The table demonstrates that both the momentum and the quality styles have been the strongest performing investment styles over the past year. In the period since the start of the year, and in the past four weeks, these two styles have continued to outperform both the market and the defensive income style.

The absence of style rotation reveals that there has been no change in investor psychology. Investors are taking less risk and hedge funds have lowered their net risk, but investors still like the same stocks they did before the correction began, suggesting that these stocks could fly again once the correction ends.

Market breadth is the final piece in the puzzle. Market breadth remains solid.

The next chart illustrates my Breadth Index for the HK market. Provided this index is positive, the market is generally bullish. Over the past 20 years, the HIS has returned 45% pa on an annualized basis when the Index has been in the Buy zone in the chart. I am surprised that the index has remained positive through the correction. After all, breadth went negative many times in the minor corrections of 2016 and 2017.

Positive breadth indicates that investors still like a wide range of companies. If it remains positive through a correction – as was the case for most of the correction of Jul-Aug 2007 — it generally indicates a powerful underlying bullish sentiment.

It is still too early to argue that the correction since Jan has ended. Indeed, it may yet find new lows. However, I am inclined to think that the resilience provides a clue that emerging markets could see significant upside once the present correction comes to an end.

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