Usually when we append a chart to one of our commentaries, the aim is to shed light on a particular trend. Sometimes, though, the trend in question is actually the lack of a trend, and such is the case this week. Behold the chart below and call up your metaphor of choice: a plate of spaghetti (that multicolored kind with beet, spinach, squid ink etc.), a few tangled skeins of knitting yarn, an attempt at abstract art by a hung-over wannabee Picasso.
Up, Down, All Around
What to make of that tangled web? Healthcare has performed rather well, for no particular reason. Energy has fared poorly of late, despite oil prices near their best levels of the year, just off $80. Otherwise it’s up one day, down the next. Information technology, which has been the main driver of the market’s performance for the better part of the last 18 months, is actually trailing the benchmark index in the most recent three month period.
It’s as if Ms. Market wakes up every morning and flips a coin – heads for risk-on, tails for risk-off. There’s no discernable leadership theme. Remember the “value rotation that wasn’t” about which we wrote earlier in the summer? The forensic evidence is there – note the sharp drawdown in the blue line (representing technology) around the 7/30 time period, which then bounced back up almost immediately. There was no value rotation then, nor in the immediate period after Labor Day when tech fell again while defensive favorites like consumer staples and utilities jumped.
Nowhere Else to Go
What happens in the S&P 500 is increasingly important, because there are few other refuges for risk-on portfolios. For much of this year we had a strong leadership trend in domestic small cap stocks. The Russell 2000 small cap index is still ahead of the S&P 500 year to date, but the outperformance trend ran out of steam a couple months back, as the chart below shows.
We do see something of an uptrend in non-US stocks over the past couple weeks, but there are reasons for not being too excited about an imminent mean reversion of any meaningful duration here. Most of the juice in the MSCI EAFE (gold) and Emerging Markets (purple) in this recent trend is coming from a weaker dollar versus other currencies. That in itself is counterintuitive. US interest rates have been rising, with the 10-year Treasury now comfortably over 3 percent and the 2-year steadily continuing its ascent ahead of an expected rate hike when the Federal Open Market Committee meets next week. Higher interest rates are normally a bullish signal for the home currency, attracting investment income from abroad. But no – the dollar has confounded rational investors by retreating while interest rates rise. We illustrate this in the chart below.
Going back to that first chart with the chaotic sector spaghetti, we can be thankful that the overall directional trend of US large cap stocks remains resolutely upwards. Who cares what’s ahead and what’s behind, as long as everything more or less moves in the same positive direction – right? And to be clear, the broader story remains largely the same. Good job numbers, good growth, strong corporate sales and earnings – the narrative, like The Dude Lebowski, abides. But at some point one wants to see that tangle of price trends turn into a clearer picture with a rational supporting narrative. Is it finally time for value investors to come into the sunshine? Could a value trend sustain the bull market for another cycle before it gives up the ghost? Or is this just a phase of directionlessness before the tech giants reassert themselves for yet another gravity-defying cycle of outperformance? Stay tuned. And happy autumnal equinox!
Round numbers and anniversaries…the little human foibles so beloved of our financial chattering class. This past week, of course, marked the 10-year anniversary of the great collapse of the House of Lehman. No surprise, then, that the print and digital channels were all atwitter (pun partially intended) with reminiscing and ruminating about the crash and all that has happened since. There is a plentiful supply of topics, to be sure. Channeling the Mike Myers’ “Coffee Talk” character on SNL: “Negative interest rates led us to the other side of the Looking Glass. Tawk amuhngst yuh-selves.”
Supercalifragilistic S&P 500
One fact of life to which we and everyone else who manages money are highly attuned is the remarkable outperformance of US equities relative to the rest of the world over this time period. For a while in the early years of the recovery geographic asset classes traded off market leadership in the usual way, rewarding traditional asset class diversification strategies. But sometime in 2012 that all changed. US stocks went on a tear and haven’t looked back. The chart below shows the trajectory of the S&P 500 against broad market indexes for developed Europe, Asia and emerging markets from 2009 to the present.
That’s a huge delta. The S&P 500 cumulatively returned about twice what the non-US indexes earned over this nine and a half year span of time. The difference is even more profound when you adjust for risk. All three non-US indexes exhibited higher volatility (i.e. risk) than the US benchmark. The standard deviation of returns for the MSCI EM index was more than 19 percent, just under 18 percent for developed Europe and 14 percent for developed Asia, while it was just 12.3 percent for the S&P 500. Twice the return for much less risk…sounds like one of those free lunches that are supposed to never exist, doesn’t it?
What Goes Up…Right?
And that, of course, is the big question. Since we are trained to believe that free lunches only exist at picnics hosted by the tooth fairy and the Easter bunny, we look at that chart and wonder when the law of gravity will reassert itself. Asset class price patterns over a long enough time horizon typically revert to mean. What goes up eventually comes down.
But asset prices are not bound by the same fixed laws as those governing physical objects in actual space-time. Economists and financial market theorists may suffer from all the “physics envy” they want – it won’t make asset prices any more rational or predictable. In fact, the “higher risk, higher return” mantra fails in the case of emerging markets versus US stocks over even longer periods, going back to when the former became a sufficiently liquid tradable asset to be a candidate for long-term diversified portfolios.
Mean reversion tends to work best when the primary evaluation criterion is the relative valuation metric between two assets. If Company ABC has a price to earnings (P/E) ratio of 30 and Company XYZ, a competitor in the same industry, has a price to earnings ratio of 10, then investors would at some point expect the price of XYZ to rise relative to ABC. But increasingly we see evidence that daily market trading is not dominated by stock-specific valuation considerations but rather by macro narratives. Continued demand for US equities is simply driven by a better “story” according to this narrative – strong corporate financial results and an economy that is growing faster than elsewhere in the developed world. The same thinking says that the US is a safer bet than elsewhere if the worst-case scenario for a trade war plays out. ETFs and other passive investment vehicles afford the opportunity to take these kinds of broad bets without paying any attention to whether, say, Unilever (a Dutch company) has a more attractive valuation profile than US-domiciled Procter & Gamble.
There are plenty of individual assets in many non-US markets that look attractive on the basis of relative valuations. We do not sense, however, that we are at a clear and compelling turning point justifying a significant re-weighting of asset class weights among diverse geographies.
Happy September! Now that the month is upon us, the kids back at school and the weekends filling up with tailgates or trail runs (or both, even better), it’s time to think about that possible rate hike a couple weeks away. Just kidding – we’re not thinking much about a September hike because we think that is well and truly baked into the cake already. We’re thinking more about that possible December hike, the year’s fourth, which is less fully priced into current asset markets but which we see as increasingly likely. Today’s job numbers add a resounding notch to our convictions.
Meet the New Data, Same As the Old Data
Sometimes it can seem like the world is changing in unimaginable ways every day. However, one just has to study macroeconomic trends over the past four-odd years to be reassured that, economically speaking at least, not much ever seems to change at all. We often use the chart below in client discussions to drive this point home: in terms of jobs, prices, sentiment and overall growth – the big headline data points – the story more or less remains the same.
In brief: monthly payroll gains have averaged 215,000 in 2018, including today’s release showing job creation of 201K in August (and also factoring in a downward revision to July’s numbers). Real GDP growth is above-trend, consumer confidence has not been higher for literally the entire millennium, and consumer prices are above the Fed’s 2 percent target for both core and headline readings. This composite view suggests a fundamentally stronger economy than the one we had in between the two recessions of the previous decade. What is inconsistent with this picture of strength is a Fed funds rate staying much longer at 2 percent. It was 2 percent at the end of 2004, on its way to a peak of 5.25 percent by the time that growth cycle peaked. With the caveat that nothing in life is ever certain, including economic data releases, the picture shown in the above chart tells us to plan on that fourth rate hike ringing out the old year come December.
As the US rate scenario settles into conventional wisdom, there is plenty of upside room for the dollar (a rising rate environment, all else being equal, is a bullish indicator for the national currency). While the greenback has traded strongly against the euro and other major developed market currencies this year, at $1.15 to €1.00 it is far from its late 2016 peak when it tested euro parity.
Where the dollar’s strength can do much more harm, though, is in emerging markets. Many of those currencies are at decades-long, if not all-time, lows versus the dollar already. The dollar is up 22 percent against the Brazilian real this year, and 12.6 percent versus the Indian rupee. If you hold emerging markets equities in your portfolio you are feeling this pain – when your equity price returns are translated from the local currency back into dollars you are directly exposed to those currency losses. For example, the MSCI Emerging Market index reached an all-time high in local currency terms back in February of this year. But in US dollar terms – shown in the chart below – the index has never recovered its pre-financial crisis peak reached in November 2007.
We’ve communicated our sentiments about emerging markets frequently on these pages – while important as an asset class given the size of these economies (and the wealth therein), emerging markets have underperformed domestic US stocks on both an absolute and risk adjusted basis over a very long time horizon. They enjoyed a sustained period of outperformance during the mid ‘00s in conjunction with the commodities supercycle – and again for about a year following the reversal of the ill-considered “Trump trade” fever after the 2016 election. During that latter growth spurt we elected to sit tight with our underweight position rather than try any fancy tactical footwork. We stand by that decision today.
We have yet to arrive at our conclusions for positioning in 2019, in EM or any other asset class. But from where we sit today the most convincing picture of the global landscape points to a continuation in the US up-cycle, with the attendant implications of a stronger dollar and further downside potential in other markets, particularly emerging ones. That does not necessarily imply blue skies ahead for US assets – there are some complicating factors at home as well, which will be themes for forthcoming commentaries. But we see little out there today arguing for a bigger move into emerging markets.
Is anyone else not quite ready for back to school season? Every year it seems that the calendar races by that much faster – which of course just means that we’re getting older and grayer. Anyway! Labor Day weekend is here and thus begins the critically important fall season for asset markets. Much of the time the going is great these last four months of the year, particularly if things look promising for retailers heading into Black Friday and the holiday season. But in October, the stock market reminds us of that old nursery rhyme about the little girl who had a little curl – “when she was good she was very, very good, but when she was bad she was horrid!”
Indeed. 1929, 1987, 2008 – investors need no reminding of just how horrid some of these fall seasons have been. From where we sit today, things don’t look particularly ominous. Which is not to say that we may not have some twists and turns ahead, but no one particular X-factor looms large. Here is a brief run-down of some of the events ahead that we’ll be keeping an eye on to make sure our prognosis stays intact.
The Never-ending Back Story
US stocks this year had a somewhat wilder ride than they did in 2017, but the back story really has not changed all that much. The two key propellers behind this slow and steady boat are (a) continued GDP growth with relatively modest inflation, and (b) strong corporate earnings and sales. Businesses are confident, consumers are spending at a decent pace, and all that trade war rhetoric seems to be on a back burner for now – at least the trade negotiators are fumbling along incoherently without actually choosing the worst possible outcomes. Now, at some point the music will stop – no expansion lasts forever. And the next downturn will have its own special set of problems, not least of which will be how much ammunition the Fed has on hand to fight back. But that is likely a problem for another day.
September and December…
“Wake me up when September ends” goes the Green Day song. By the time September ends we will know if the Fed funds rate is higher than it was at the beginning of the month. The likelihood is that it will be – a third 2018 rate hike is pretty well baked into current market yields for short term Treasuries. That leaves December, the final FOMC meeting that will include the whole carnival of press conference and dot-plots. Recent FOMC press releases have conveyed a generally more upbeat assessment of market conditions (see “never-ending back story” above). We sense the Powell Fed wants us to understand that a fourth rate hike is very much a possibility (and not subject to undue pressure from certain Executive Branch politicians with incurable Twitter habits).
But December is still a long way off. If little has changed in the economic story and holiday shoppers appear to be rocking their Santa hats all over the malls and cyberstores, then we should expect a rate hike (and also expect that it would not much faze markets). But, anything can happen between now and then.
…And Don’t Forget November
Oh, yes, and one of those “anythings,” of course, happens to be a midterm election likely to draw much more interest than these midterm decision days usually do. How much event risk might there be in the midterms – either because Democrats win big and the specter of impeachment rises front and center, or because the Republicans hang on to Congress and Trump announces the evisceration of the Mueller probe and the Justice Department on November 6 evening amid all the victory and concession speeches? Not much, in our opinion. Markets have been almost unrelentingly placid in the face of all the political squalls and brushfires of the past 19 months. There seems little reason to think this one will be any different.
Don’t Cry for Argentina – Or Ankara
We’ve had our eye on the various emerging markets woes that have been a drag on this asset class this year, including the meltdown of the Turkish lira a few weeks ago. This week it’s Argentina’s turn to fail at winning the battle against a freefalling currency. The monetary authorities there have pushed interest rates up to 60 percent to fight the peso’s plunge (remember those hundred year Argentine bonds that were in vogue a couple years ago? Ouch) and the reformist government of Mauricio Macri is fighting to retain credibility. Meanwhile, Argentina’s neighbor to the north, Brazil, has presidential elections this fall where the leading candidate is in jail and the second-place contender in the polls is a far-right populist with a flair for controversy. The good citizens of Brazil, like Queen Victoria, are not amused.
These random disruptions in developing markets could continue to stay mostly in isolation – witness that the S&P 500’s total return for the year to date is over 9 percent while the MSCI emerging markets index has moved in and out of bear market territory. Again – we don’t see event risk clouds of a dark enough hue to suggest a more systemic pullback across a broader swath of asset classes. But it’s the fall, and tricks & treats come with the territory.
This past Wednesday, apparently, was one of those red-letter special days in US stock market history. The current bull market, which began in 2009, became the longest on record, based on the daily closing price of the S&P 500. So said the chattering heads, not just on CNBC but on your friendly local news channel. Hooray! Or should we worry, perhaps, that the good times are coming to an end?
The right answer to that question and all others about the bull market’s record longevity is to ignore it, because technically it didn’t happen. Nope, this is not the longest bull market on record, not by a long shot. Now, some may quibble when we present the facts, arguing that we are splitting hairs. Well, sorry, but ours is supposed to be a precise business where performance measurements are concerned. And facts, surprisingly enough in this day and age, are still facts.
So, to be precise, the bull market that reached its peak on March 24, 2000 (the one we supposedly beat on Wednesday) did not in fact begin on October 11, 1990. That was a span of 3,452 days. The basis for “longest bull market ever” claims made this week is that 3,453 days elapsed from March 9, 2009 (the low point of the last bear market) to August 22, 2018. However! Based on the technical definition of bulls and bears, the bull that peaked in March 2000 actually began, not in 1990, but on December 4, 1987. That’s a total span of 4,494 days, or 1,041 days (about 2.8 years if you prefer) longer than our current bull market.
So why did the media spend so much energy this week talking about the “longest bull market?” Because (a) it’s more fun to talk about things grand and historical than about the daily grind of random market movements, and (b) on October 11, 1990 the S&P 500 closed down 19.9 percent from the previous record high set in July of that year, and, well, 19.9 percent is close enough to 20 percent, which is the commonly accepted technical threshold of a bear market.
Let the quibbling begin! 19.9 percent is close to 20 percent, certainly. But it never passed that threshold. More importantly, the stock market pullback of 1990 (which started with the recession of that year but had recovered before the recession was over) never spent a single day – not a single day! – in actual bear market territory. You can’t say that a bull market began the day after a bear market ended when that bear market never even began.
So, again sticking to the definition of a 20 percent pullback from the prior high, the last bear market before the dot-com crash of 2000 occurred after Black Monday in 1987. On December 4 of that year the S&P 500 had retreated 33.5 percent from the prior record high reached in August. That wasn’t a super-long bear, lasting less than a couple months from the breaching of 20 percent, but it was certainly impactful.
The Music of the Market
Here’s the more important reason why we’re not just splitting hairs over the 19.9 versus 20 percent, though. If you look at the way markets trend over a long enough period of time you notice a certain pattern – a tune, if you will, the music of the market. Every bull market experiences periodic pullbacks. These happen for a variety of reasons, some of which may seem frivolous and some of which may seem more serious at the time. Traders in the market are highly attuned to how far these pullbacks draw down from the previous bull market high. A 5 percent pullback is deemed significant. The 10 percent threshold has its own special name – correction. And the 20 percent level, as we noted above, is the event horizon for a bear market.
What tends to happen during the more severe bull market corrections is that they get ever so close to the 20 percent threshold without actually going over it. This happened in October 1990, as we showed above. It also happened in August 1998 with a 19.3 percent pullback (this coincided with the Russian debt default and subsequent meltdown of hedge fund LTCM). More recently, it happened in 2011 with a 19.4 percent pullback in the S&P 500 while the Eurozone crisis and US debt ceiling debacle played out simultaneously.
It’s not accidental that these pullbacks flirt with bear markets but refrain from going all the way. It’s how short term trading programs, which make up the lion’s share of day to day liquidity, are set up to work. A correction or bear market threshold is considered to be a technical support level. If prices approach, but don’t breach the support level it means that the net consensus of the market supports the status quo; in other words, that conditions continue to justify a bull market. These pullback-recovery movements happen frequently. Real bear markets are much rarer, and more durable when they do happen.
The chart below provides a good illustration of this “music” – it shows the price trend of the S&P 500 from 1987 to the present (lognormal scale to provide consistency in magnitude of returns over time).
This chart is instructive for another reason. To paraphrase Tolstoy, every pullback has its own dysfunctional story. What causes a pullback to become a full-on bear market? It’s not always a recession – witness 1990, when we had an economic downturn but only a limited market pullback. It’s not always a financial crisis – we had one of those in 1998 and again in 2011 but in both cases economic growth stayed positive. In 1987 financial markets came close to shutting down, but again the economy was still resilient and the drawdown, while intense, turned out to be brief. By contrast, in 2000-02 and again in 2007-09 we got a double-dose of financial crisis and recession in roughly the same time frame (the grey bands in the above chart signify recession periods). Both the magnitude and the duration of these drawdowns, of course, were more severe.
In any event, with all apologies to financial market pundits everywhere, there was nothing particularly historical about this week. Perhaps our good fortune will last another 1,039 (and counting) days and we will have a real, actual “longest bull” to celebrate. Or maybe not. Expect more pullbacks along the way in either case. Remember that most pullbacks do not end up in a real bear market, and also remember that while we humans have a need to read meaning into calendar events, markets themselves do not.