Despite Big 2019 Rally, Top Wall Street Strategist Sees Potential Danger Ahead

Investing

Published: February 26, 2019 7:30 am

Last Updated: January 11, 2020 10:52 am

After a dreadful fourth quarter of 2018, with the stock market dropping a stunning 20% between early October and Christmas Eve, investors have been treated to close to a 12% gain on the S&P 500 in 2019. While the rally has been good for soothing investors’ frayed nerves, the bottom line is that despite the January and February strength, there could be some serious trouble ahead for equities.

Barry Bannister, the superb equity strategist at Stifel, has always kept a very balanced view on the markets. When his indicators look good, he has been bullish and positive. However, when those metrics start to fade, he tends to become more cautious.

In a recent macro and portfolio strategy commentary piece, Bannister noted this:

We spot trouble in the U.S. economy and equity market, and are increasingly concerned that the equity dislocation of 9/20/18 (S&P 500 peak was 2,930) to 12/24/18 (S&P 500 bottom was 2,351) was not “all of it.” The S&P 500 hit our 2,750 S&P 500 target and has slightly surpassed it, but now we and the market disagree (more than usual) on major macro fundamentals. We believe “the market” has concluded four things have already occurred, without any need for further price disruption (we agree that all four will occur over time, we just expect them to cause further disruption before becoming fully established).

He noted these four items, and they may indeed be a harbinger of some difficult times ahead.

1) The market is acting as if the Fed has completely capitulated to the market’s desire for easy money, with no further policy resistance and no equity or economic weakness yet to come from past (we think excessive) tightening.

2) The market seems to expect a grand “trade deal” soon that marks a NAFTA2-like quiet end to President Trump’s trade actions, even though major deals bring unexpected changes, and also U.S./Europe (autos) conflict awaits.

3) The market seems to have concluded that the global slowdown will be met with sufficient policy stimulus (one big “put”) and economic weakness will end soon, having had very little blow-back on the U.S. economy.

4) The market is toying with a Growth to Value reflation rotation, having rallied several reflation sectors, despite the history of such rotations (from Growth to Value) being fraught with risk and market weakness in the first two years.

Bannister feels the Federal Reserve raised rates too much during the tightening cycle and may be forced to actually cut rates twice over the next six to 12 months in response to potential recession-inducing data. He also sees the potential for the unemployment rate to rise from the current near 4% level back to 5%, a data point that is sure to get the Fed’s attention.

In addition, equities could be in trouble, with stretched valuations and the potential for declining earnings. This was also noted in the report:

Stocks face the combined headwind of a rising Equity Risk Premium and falling earnings-per-share growth, such that there is no benefit from lower Treasury yields. We see the 10 year yield falling to 2.25%, producing 2-10 inversion before the Fed cuts rates. In addition, S&P 500 2019 EPS consensus continues to decline unabated, and the earnings “valley” may be deeper and wider than expected.

The bottom line for investors is that over the next 12 to 18 months, there could be some dislocations. That said, the Stifel overall outlook for the next 10 years is one of solid, but lower average returns than we have seen over the past decade.

With the potential for a yield curve inversion and a recession down the road, analysts also believe that it could spark a resurgence in defensive, bond proxy type securities, which include utilities, consumer staples, telecoms and health care. We noted Monday that 75% of economists are predicting a recession by 2021.

We have followed Bannister’s work for years here at 24/7 Wall St. He has proven to be a prudent and consistent market strategist who is a realist when it comes to applying current and forward data projections to stock market potential performance. Flat out, now he feels price-to-earnings multiples are extended, earnings are dropping and the S&P 500 at current levels is overpriced.

With that in mind, it makes sense for investors to reviews portfolios now into the market strength and perhaps begin to lower equity exposure to build some dry powder for what could be a rocky rest of 2019. In addition, a slow rotation to more defensive areas could be a good idea starting in the second quarter.