But most strategists acknowledge that such an occurrence isn’t a high-probability event. Much would depend on the cause of any disruption. Also, computers aren’t the only cause of selling cycles; bear markets, after all, long predate machine-driven trading. Quantitative investors argue that they have learned from past mistakes and are less likely to be leveraged or crowded into the same trades. Moreover, regulators and exchanges have instituted rules that could help arrest a bout of unchecked selling, with trading halts imposed when the S&P 500 falls 7%, 13%, and 20%. Maybe these precautions will work to stem a tidal wave of selling. One of these days—possibly soon, given stocks’ lofty valuation and the Fed’s plan to shrink its balance sheet—we’ll find out. In the meantime, we prefer to err on the side of caution! Our portfolios remain significantly underweight in stocks, overweight on preferred shares and cash and slightly underweight on bonds. Within the stock component, we have a clear bias towards ‘value’ names including energy, basic materials, telecom and media. We also have retained smaller positions in key large technology stocks for their continued growth and reasonable valuations, including Apple, Alphabet, Microsoft, CGI Group and Open Text.

More important for stock markets is the flow of economic and earnings data. In the end those are the variables that drive markets higher or lower. The analysis above just points out the risk of the ‘speed’ of these adjustments, particularly for a stock market that has not seen a correction in almost two years and a full downturn in over six years. While the third earnings numbers reported so far have beaten expectations, investors seem to have caught on to the predictable pattern of companies to ‘under-promise’ in terms of their projections and then ‘over-deliver’ on actual results. The bottom line is that U.S. earnings growth is headed to a 5% year-over-year growth number. While that’s not a bad number, it is down from the double-digit growth in the first half of the year and probably not enough to sustain stock valuations at record highs, particularly since the ‘sea of liquidity’ that has been used to elevate all financial assets, is being slowly drained as the U.S. Federal Reserve raises interest rates and sells bonds to reduce its US$4.5 trillion balance sheet.

In terms of where we are in the economic cycle, we continue to see us in the late stages of the recovery that began in 2009. The chart below shows the U.S. unemployment rate (blue line) over the last sixty years compared to NAIRU (which, for the technical types, is the Non-Accelerating Inflation Rate of Unemployment, and refers to a level of unemployment below which inflation rises).   The grey-shaded areas of the chart show periods of economic recession.

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