Will It Only Be a Correction or a Bear Market?

On Jan. 30, the Federal Reserve finally admitted it made a big mistake, but did the U.S. central bank take too long to realize it?

The Fed tightened monetary policy aggressively in 2017 and 2018. In September 2018, it ratcheted up the rhetoric, telling investors to expect a series of interest rate increases through 2019.

Changes in Fed policy affect the economy and markets with a lag. Just as the Fed was saying economic growth was sustain-able and the economy could handle higher interest rates, the economic data weakened and came in below expectations.

The effects of past tightening, the rhetoric and the weaker data led to the market slide in the last quarter of 2018.The Fed quickly changed course. Chairman Jerome Powell softened his rhetoric late in 2018, and the entire Fed Open Market Committee made the change official on Jan. 30. The Fed no longer is committed to regularly raising rates in 2019 and will wait for more economic data before deciding on its next move. Now, the Fed is back to its usual practice of following market expectations instead of leading the markets.

But did the Fed wait too long to pause, and when will it return to easy money?

I’ve said since the Fed began its quantitative easing in 2009 that the biggest risk to the markets and the economy is that the Fed might tighten too much for too long. Fed policy changes take six months to two years to work their way through the economy. So, we probably haven’t seen the full effects of last year’s tightening.

The interest-rate sensitive sectors of the economy already turned down.

Housing was very weak in 2018, though it might be stabilizing because of the recent decline in mortgage interest rates. The auto industry is looking at two years of declining sales, and auto manufacturers are closing plants. Business capital investment is weakening after showing strength in early 2018. Global growth also is declining. The economy is especially poor in Europe, and the continent has few tools avail-able to restart growth. China is registering slower growth than usual. Japan is at risk of tum-bling into another recession.

As a result, exports by U.S. companies have been lagging. Emerging economies are the rare global bright spot now, but they rely on growth in the rest of the world. The employment data in the United States still is strong, but the labor market lags the rest of the economy. Labor growth often is strong even after a recession has begun. In the meantime, there are signs of speculation and froth in U.S. stocks.

Stocks marched steadily higher after Fed Chairman Powell softened his rhetoric. But more U.S. companies now are lowering their earnings guidance for upcoming quarters than are raising guidance. Stock analysts, usually an optimistic bunch, have been trimming their earnings forecasts.

Yet, over the last three months, the average stock moved immediately after an earnings announcement has been the strongest in at least five years, according to Bespoke Investment Group. Even many companies that reported disappointing earnings numbers experienced stock-price increases. It could be that investors became too pessimistic in the fourth quarter of 2018 and are making up for it, but I think they fear missing out on the rally and are speculating. Expanding profit margins and higher earnings growth were keys to the U.S. stock rally since 2008. They’re the main reasons stock prices have increased much faster than economic growth.

Now, a lot of forces are arrayed to re-turn profit margins and earnings growth back to normal levels. If that happens, investors soon will reconsider the prices they’ll pay for stocks.