The 7-Year Forecast is Signaling an Early Fall Correction

The economic and stock market forecast (which runs until September 6, 2021) that God gave me appears to be signaling a stock market correction in late September / early October 2016. If you have not read my explanation of that forecast, please do so before proceeding with this Letter (link above). 

My original assessment was that my second dream was sequential to the first, primarily because connecting the two ends the second dream exactly at the end of the current 7-year, sabbatical cycle (September 6, 2021). If this is the case, the U.S. stock market, as measured by the Standard & Poors 500 Index (S&P 500), will end the current Hebrew economic year right about where it started. This is a price level of about 1975 for the S&P 500, which is about 200 points (or 9%) below where it is trading at the time of this writing. 

                                                            Source: St. Louis Fed

                                                            Source: St. Louis Fed

Since the beginning of the year, I have been telling my clients that I expected the stock market to reach a price level about 12% higher than where it was on January 1, 2016. Let's call it 2260 on the S&P 500. All this year I have been leaning toward the S&P 500 reaching this level before mid-September, however, time is running out. If this does happen, I expect we will be looking at a mini-crash (e.g., 10% to 20%) in early Fall (no pun intended). Otherwise, I expect a steady decline over the next month or so, before a strong 4th quarter rally takes us to a new all-time high. 

Increasingly Overvalued Stocks But Level Price Indices

When I first released my 7-year forecast, I mentioned the fact that the period from October 2015 to September 2017 would be characterized by the price level of the S&P 500 remaining relatively flat, but with stocks becoming increasingly overvalued. This was because the two doe (no antlers representing flat annual returns) representing these years were on the other side of the creek and thus too far away for me to shoot at with my bow (i.e., too overvalued for me to purchase). I have witnessed this in my own portfolio management as stock holdings have been wittled down to a select few companies that are still undervalued.

The following chart shows how corporate profits peaked during the 3rd quarter of 2014—the quarter when the previous 7-year sabbatical cycle ended

                                                             Source: St. Louis Fed

                                                             Source: St. Louis Fed

This peak in corporate earnings during the 3rd quarter of 2014 coincided with an acceleration higher of the historical 12-month price-to-earnings multiple (P/E) of the S&P 500. The following chart reveals this:

                                                              Source: multpl.com

                                                              Source: multpl.com

The environment we are in now is one in which the broader stock market is generally trending flat on an annual basis, but shares are becoming increasingly overvalued. Index investors are taking on more risk but not being compensated for it. They are now paying a price for the S&P 500 which is theoretically equal to about 25 years worth of earnings. The market is being setup for a major correction between October 2017 and September 2019.

Keep in Eye on Oil

If I had to predict the cause of an early fall correction it would be significantly lower oil prices leading to a final round of devastation for U.S. shale producers and subsequent pain in the high yield bond market.

There is a narrative being thrown around that certain U.S. producers can be profitable in the $30 to $40 per barrel range and this is far from true. I generally subscribe to the view, articulated well by the likes of Art Berman, that the price of oil generally needs to be above $60 per barrel for these companies to earn a profit. They have been surviving because the oil & gas service providers have been losing money. During Baker Hughes' last quarterly earnings call, CEO Margin Craighead said the following which confirms this:

"So, that aside, as far as North America, I don't subscribe to the whole full commentary that I think, gets thrown around a lot by your community. And I think that the customers are going to need something that's coming and vectoring in on around $60 or high $50s just because certain costs on our side are going to go up."

Having listened to the Baker Hughes call, I can tell you first-hand that the tone of how Craighead said this was even more telling. It was definitely an "aha" moment for me. Craighead essentially revealed that U.S. shale producers will not survive with prices below the high $50s because the service companies will ultimately have to be profitable too. In other words, U.S. shale oil producers are on a temporary lifeline at current prices.

I expect we are going to soon be looking at a major buying opportunity for quality oil companies. My favorite, which the Lord spoke to me about 9 years ago, is generating free cash flow (FCF) this year at an average price of only $41 per barrel (brent crude). Not only is it generating FCF, but it is generating almost $5 per barrel in FCF (11% FCF margin per barrel). 

 

Joshua S. Hall, ChFC