WILL THE TAIL WAG THE DOG?

The traditional money management approach assumes that the stock market discounts the future economy--the stock market is the dependent variable and the economic outlook is the independent variable.

However, since the Great Recession,  the opposite may have occurred.  The Federal Reserve, with its quantitative easing, or its zero interest rate policy (ZIRP),  has sought to inflate asset prices.  Higher asset prices would result in a " wealth effect", which, the Fed believed,  would stimulate consumption, and would kick start the economy into escape velocity, when the economy could  resume growth at historical rates without ZIRP.  In other words, the stock market would determine the economy, rather than  vice versa.

The Federal Reserve has been successful in inflating assets.  After all, the stock market, as measured by the Standard and Poor's 500 Index (the Index), has risen from 666 at the bottom in 2009 to over 2100 in six years.   I have argued that the Index is now vastly overvalued.

 However, the economy has so far failed to respond as expected.  Growth has been sub-par since 2009.   Only recently has the economy shown signs of a pickup in real growth.  There has been talk of the Fed's soon  raising the federal funds rate for the first time in many years. Unfortunately,  events in China may thwart this virtuous cycle.

I have  discussed that China is trying to morph  from an export-driven economy into one relying more on internal consumption.  That transition has proven to be difficult.  The macroeconomic stats coming out of China have always been suspect, so it is difficult to know what reality is there.  However, recent government measures to shore up the Chinese stock markets lead me to believe that economic growth there has slowed even more than recently expected.

The ramifications of a much slower growth in the Chinese economy are significant.  For example, raw material prices, largely dependent on Chinese consumption, have dropped precipitously recently, resulting in severe drops in the currencies and  stock markets of the raw material supplying countries.

If stock markets around the world continue to slide, then the key question is "Will the resultant NEGATIVE wealth effect cause a recession in the U.S.?"  In other words, "Will the tail wag the dog?" If a recession occurs, then a bear market would surely ensue.

As you know, I have a very significant percentage of my financial assets in cash. My next decision is at what Index level would I increase my equity exposure?   The answer is 1600.   (The Index closed Friday at 1971, down from the bull market high of 2130.)

Why that price? 1) It represents a regression to the mean valuation of the Index over the last fifty years; 2) It is slightly above the bull market highs of 2000 and 2007, which now should be viewed as support levels; and 3) It is roughly a three-eighths retracement  of the bull market from the 2009 low. That is an important Fibonacci number.  Because many traders believe in such numbers,  I pay attention to them.