The world of finance has its own particular lexicon, handed down from generation to generation of Wall Street and City folk. “Dead cat bounce” is one of the more colorful, if dolorous, examples of the patois of equity traders. It refers to a relief rally after a sharp pullback that fails to propel itself far enough to reclaim the high ground set by the last bull market peak. In the case of the pullback that began last October, we have already seen three unfortunate kitties bounce lamely off intermittent selling pauses. The chart below illustrates the topography of this pullback (which, as you will recall, stretched to a magnitude of minus 19.8 percent at its Christmas Eve trough).
The Wall of Round Numbers
As we write this commentary on Friday morning the S&P 500 is dithering somewhat around the price level of 2,600. That’s not surprising in that 2,600 is exactly 100 points above 2,500, which is the last place the index wavered for a few days before resuming its upward ascent. As we have said many times, there is nothing magical about these round numbers…except that the trading patterns of the computer models that dominate every day’s volume of trades confer importance on them. Given where general short-term sentiment appears to be – genuine relief that the pullback in December stopped short of a bear market, some soothing words from the Fed, and optics (if not a whole lot more) from US-China talks on easing trade tensions – we would be not at all surprised to see that 2,600 threshold breached in the coming days if not today. To prove that this Schrödinger’s cat is of the live variety, though, there are 200 more points to get back to those intermittent relief rally highs, and another 100 of climbing after that to reach the Hillary Step within sight of that 9/20 Everest peak. That could involve many days and multiple returns to lower base camps before a new bull confirmation can be presumed with confidence.
Back In the Real World…
While those whimsical round numbers do matter in the context of short-term market moves, the only determinant of long-term value for any common stock is that company’s financial condition, specifically the magnitude and timing of its future cash flows. Here we may have reason to be somewhat optimistic in the weeks ahead. Earnings season gets underway next week, and attention will focus not only on how well companies performed in the fourth quarter relative to expectations, but also how they guide performance for the twelve months ahead. From a valuation standpoint, there is good news to be had from paying attention to these metrics. The chart below shows both the price-to-sales (P/S) and price-to-earnings (P/E) ratios for the S&P 500 for the last five years. Both ratios are expressed on a next twelve months (NTM) basis, meaning the consensus forecast for the year ahead at each point on the graph.
Thanks to a combination of strong sales and earnings growth in 2018 and the magnitude of the stock market pullback, valuation levels currently look quite attractive relative to the past five years. The price-to-sales ratio (green graph) is right around its five year average. The P/E ratio (blue graph) is well below its five year average of 16.5 times, but that is somewhat misleading. Earnings here are after-tax, so they reflect the massive windfall to corporate bottom lines created by the tax cuts of December 2017. That windfall will fade now that one year has passed since the tax cuts were enacted, and earnings growth will moderate accordingly. Whatever way you look at it, however, current stock price valuations are not excessively dear. The current outlook for Q1 2019 sales growth is around 5.6 percent according to market research firm FactSet, and earnings are projected to register a bit more than 10 percent growth. If that kind of cadence can be sustained through Q2 and beyond, it should provide at least something of a tailwind to stocks.
The Unknowns Abide
Of course there is no certainty that sales and earnings will continue their robust growth clip, as that will depend in turn on evolving global demand trends, ten years into an economic growth cycle. As we noted last week, IMF forecasts for growth in 2019 have moderated, with potential trouble spots including China and the EU. Regardless of whatever happy talk comes out of the current round of trade talks there are plenty of unresolved issues there. And plenty of other X-factors lurk in the soup of any given day’s data feed. We continue to believe that market trends this year will be challenged by higher than usual levels of volatility. All that being said, though, continued strength in corporate sales and earnings will matter a great deal, starting with the first batch of releases next week.
In May 2018 the US economy achieved a milestone of sorts, outlasting the growth cycle of 1961 to 1969 to become the second-longest expansion in the country’s history. In 2019 an even more auspicious accomplishment is in sight. If the economy does not experience a recession between January and July of this year it will become the longest-ever expansion, supplanting the decade of growth enjoyed between 1991 and 2001. From where we sit today, the odds appear rather strongly in favor of July arriving without a recession along the way. Indeed, for a recession to officially begin as early as July we would need to be experiencing nearly uninterrupted negative GDP growth between now and then – a possibility that would appear remote to the point of being negligible. Barring the catastrophically unexpected, this recovery looks set to claim the gold medal for longevity, if for nothing else.
What Have You Done For Me Lately?
Not that we should expect investment markets to be toasting the newly-minted longest-ever recovery with Champagne and noisemakers, though. Markets are forward-looking by nature, and they are already looking well past July in anticipation of when this economic cycle does turn. In some corners of the developed world outside the US, initial signs of the turn are already at hand. Five developed-market economies – Germany, Japan, Italy, Switzerland and Sweden – saw negative GDP growth in the third quarter of 2018. The IMF has lowered its outlook on global growth in 2019. At 3.7 percent the outlook is still relatively rosy, but the effects of slowing international trade, including the potential impact of a trade war yet to be actualized, give cause for concern. As the effects of fiscal stimulus in the US wear off, the persistent absence of meaningful growth in productivity – the one viable source of long-term growth – will come back into focus.
As the World Turns
There is a growing dissonance between markets and the economy based on deeper issues than headline macro data and other short-term sentiment drivers. There is a case to make that the world is in the early stages of a transition not unlike the unraveling of the Bretton Woods framework that guided the global economy’s first quarter century after the end of the Second World War. By the late 1960s the US was losing its grip as the great stabilizing force of the world economy. The waning of US preeminence was underscored when then-president Nixon took the US off the gold exchange standard in August 1971. What ensued for the next decade was a period of great uncertainty, including four recessions of varying degrees of intensity with persistently high unemployment accompanied by soaring inflation. Equities fell in and out of bear market territory, finishing this miserable stretch more or less where they began it – in nominal terms, that is. On an inflation-adjusted purchasing power basis, an investor in a basket of S&P 500 stocks was much worse off at the end of this cycle than he or she was at the beginning.
Eventually the fog of uncertainty lifted and the era of what former Fed chair Ben Bernanke termed the “Great Moderation” began. Neoliberal politics and relatively unfettered global capitalism – known as the “Washington Consensus” – flourished as the dominant model for the next quarter century. That model got its comeuppance with the 2008 market crash and deep recession. The institutions emblematic of the Washington Consensus have become increasingly strained. As in the early 1970s, there is a sense that what worked once is no longer working. And, likewise, a growing uncertainty about what comes next.
We believe heightened volatility will be the principal characteristic of asset markets in 2019. Volatility cuts both ways – up and down – meaning that predictions about market directional trends will be subject to high amounts of variability. Developments to which markets typically pay little heed – including political dysfunction and foreign policy crises – potentially will come under greater scrutiny. Outside the US, China and the EU may be sources of increased instability. Risk spreads are positioned to widen between benchmark government credit and various tiers of corporate, mortgage-backed and other debt types. The corporate debt market could be particularly tricky, and we will be paying close attention to trends in lower-investment grade paper. Central banks will be following these developments closely and may turn more dovish than expected in efforts to mitigate the impact on global markets. What central banks do – and do not do – will in turn influence investor sentiment back and forth between risk-on and risk-off. Currency and commodity markets will likely find themselves in the cross-winds of these sentiment shifts – again, volatile swings have the potential to impede the formation of durable directional trends.
Reasons (Maybe) to Smile
A prediction for heightened volatility does not necessarily translate into a doom-and-gloom outlook. For starters, we do not see compelling evidence of imminent financial risks on par with those that catalyzed the massive market sell-offs in 2000-02 (absurd asset valuations) or 2007-09 (overleveraged and intertwined credit markets). Valuations, in fact, are relatively attractive: the S&P 500 price-to-sales (P/S) ratio is currently below its 5-year average on both a twelve trailing months and forecasted basis. With the consensus forecast for FY 2019 sales still in the mid-high single digits, there are buying opportunities aplenty for investors willing to look past the short-term fury of the past two months.
Inflation – or rather its absence – could be another positive influence in the months ahead. The Core Personal Consumption Expenditures (PCE) index, which is the Fed’s preferred inflation gauge, has remained fairly closely tethered to the central bank’s two percent target in recent months, with little upward pressure thus far from continued tightness in the labor market. As long as inflation remains in check, the Fed will have flexibility to pause its monetary policy tightening in response to other potential developments, without increasing the risk of overheating the economy.
Finally, one wild-card boost to sentiment (though relatively limited in terms of real economic impact) could come between now and March if UK Prime Minister Theresa May’s government manages to either succeed in bringing about a second referendum on Brexit (i.e. with the potential to avoid Brexit altogether) or at least push the March deadline for Article 50 down the road. As things stand right now the only viable options on the table are a deal loved by precisely nobody, or a hard crash out of the EU with potentially dire economic and social consequences for Britain. Popular support for a second referendum has grown markedly, offering at least some hope that Britons may wake up, breathe a sigh of relief and say “it was all just a bad dream.”
The Big Unknown, Even Bigger
Any such positive X-factors as may emerge will, however, have to contend with plenty of negative possibilities. In our view the biggest of these resides at 1600 Pennsylvania Avenue. We say this with no regard whatsoever for ideological reasons or personal preferences, but simply as an assessment of the current power dynamics in Washington and sufficient existing evidence of a willing recklessness on the part of this administration with scant regard for consequences. Global trade, geopolitics and the independence of the Federal Reserve are examples of where and how what happens in Washington could matter to markets far more than is typically the case. Markets are used to political dysfunction as long as it stays within the sausage-making policy factory inside the Beltway. That assumption worked in 2017, but it has steadily unraveled since.
In conclusion: while the direction of risk assets in 2019 could plausibly end the year in either positive or negative territory, we believe the going will be bumpier than usual. If we truly are in the early stages of a tectonic shift in the socio-economic environment similar to what happened in the late 1960s, then there will potentially be an increased tendency to interpret new information through a glass-half-empty rather than half-full perspective. There will be opportunities, but it will be harder to capitalize on emergent trends in the presence of higher volatility – and this could well be equally true for equity, credit and alternative asset classes. In this environment we believe a more defensive position is warranted than one year ago, and that careful diversification among both riskier and low-risk portfolio segments can help buffer the impact of multiple cross-winds.
If you are a regular reader of our weekly column you may recall a somewhat nitpicky piece we penned back in August called “What Record Bull?” where we took issue with the much-trumpeted theme in the financial press that week about the apparent new longest-ever bull market. It wasn’t, as we took pains to point out. During the recession of 1990 the S&P 500 came ever so close to that 20 percent bear market threshold, surrendering 19.9 percent from its previous high. But it didn’t cross over the threshold, leaving the bull market that began in December 1987 fully intact until the dot-com implosion of 2000.
Market Corrections Don’t Repeat, But They Do Rhyme
And so, the events of this week. On December 24 US stocks had their worst Christmas Eve ever, to cap of the worst (to then) December since the dark days of 1931, in the middle of the Great Depression. At the end of that trading day the S&P 500 was down 19.8 percent. Just like 1990 – and a handful of other occasions, as we will illustrate in the chart below – the broad-based US large cap index approached, but did not cross, the threshold into bear territory. “Just shy of 20 percent,” be that 19.8 or 19.9 or 19.7, seems to be a regular visitor to market correction events.
Sometimes this just-shy-of-bear phenomenon happens during a recession, as in 1990. Sometimes it happens when the economy is holding up but other factors muddy the waters, as in 1998 (Russian debt default and LTCM collapse), 2011 (Eurozone crisis) and now 2018 (political uncertainty, trade war and whatever else). And there are, of course, the exceptions, arguably the most striking being the one day in October, 1987 when the market lost 22 percent in the course of one trading day. The two bear markets of 2000-02 and 2007-09 witnessed both recessions and specific financial crises, as we pointed out in a column several weeks ago.
The Importance of Silly Numbers
These thresholds – 10 percent for a correction, 20 percent for a bear market – are not meaningful in and of themselves. An investor’s mood is unlikely to improve much if you tell her that her stock portfolio is down ONLY 19.9 percent rather than 20.1 percent. As silly as these arbitrary definitions are, though, they do matter. They matter because the preponderance of trading volume out there on any given day is wired to trade off them. Think about what happened on December 26, the next trading day after Black Christmas Eve. Twice during the morning session the market tested the 19.8 percent support level, and then it surged in an insane rally to close the day up more than four percent.
A rational person might ask, what happened in the world to suddenly make the projected future cash flows of S&P 500 companies that much less, or that much more, valuable in such a short period of time. The answer is: absolutely nothing. These movements are all noise, no signal. More than three quarters of the total trading volume on any given day is driven by algorithms programmed to react to specific trigger events. It doesn’t “mean” anything that sellers put the brakes on as prices converge on that minus 20 percent support threshold. That’s just a particularly prominent trigger, and it was busy at work on both 12/24 and 12/26.
Spin the Wheel
Trying to game the system in these short term bouts of spasmodic price lurches might be fun for people who enjoy rolling the dice. But since the likely payoff is more or less the same as rolling actual dice on an actual craps table – why not just head out to Las Vegas and do exactly that, with a nice meal and fun entertainment afterwards? A prudent long term investment strategy, on the other hand, blocks out the noise to the extent possible and focuses on the factors that matter for each investor’s particular goals around growth and risk mitigation.
We wish our clients and friends a very happy New Year, with joy and good health in the year ahead.
The month of December opened with the continuation of a relief rally that started just after Thanksgiving. The S&P 500 had dipped into correction territory but was clawing its way back up. The index closed on December 3 just 4.8 percent shy of the last record high set on September 20.
And that was as good as it would get. In the 12 trading days since then, the benchmark large cap index has registered only three up days, and those could charitably be described as anemic at best. As the opening bell rings in the last trading day of this tumultuous week, the S&P 500 sits more than 15 percent below that September 20 close. The Russell 2000 index of small cap stocks is in a bear market, down 24 percent from its early September peak. The Nasdaq Composite of erstwhile high-flying technology powerhouses is also on the cusp of that 20 percent bear threshold.
The suddenness and magnitude of the turnaround, in the absence of any obvious turn for the worse in economic and corporate financial data, has caught many hedge funds and other sophisticated investment vehicles, particularly those driven by quantitative trend methodologies, flat-footed. The natural question on investors’ minds is: how much worse can it get?
Making Sense of the Senseless
The intensity of this month’s drawdown in equities seems to derive from the confluence of three strands of worry: the prospects for a global economic slowdown, the apparent end of the “Fed put,” and the eye-popping level of dysfunction in Washington, illuminated most recently by the looming likelihood of a government shutdown and the departure of the widely respected Secretary of Defense James Mattis. Let’s take these in turn, summing up with our argument for taking a deep breath and staying disciplined.
There’s a tried and true old saw among market wags that economists have predicted nine of the last five recessions. To be fair to practitioners of the dismal science, recessions are fiendishly difficult to predict in advance. That being said, there continues to be very little in the monthly macro releases to suggest that growth in the US will turn negative any time soon. But the “harmonious convergence” story of 2017—with the US, EU, developed Asia Pacific and emerging markets all moving up together – has faded. The trade war sits over the globe, Damocles sword-like. China, the EU and Brexit-addled Britain all have their own particular problems. With the current recovery cycle being long in the tooth as it is, expectations are building that is as good as it will get. The same story plays out in corporate earnings: the go-go days of 25 percent earnings growth will end when the tax cuts lap one year in January. Earnings are still expected to grow in high single digits in 2019 , but the end of the sugar high brings a glass half empty mentality.
Greenspan’s Punchbowl Is No More
To put it mildly, the market was not at all pleased with Jerome Powell’s Fed this week. Wednesday was the conclusion of the December FOMC meeting. Ahead of the customary 2pm press release and subsequent press conference, investors seemed primed for at least a little good old-fashioned happy talk. After all, it wasn’t all that long ago that a stock market pullback of a lesser magnitude than the current one would elicit comforting reassurances from the Fed’s dove wing. But that was then. That was when the Fed’s stimulus program depended on shaking investors out of low-risk assets into equities and other higher risk asset classes. True – expectations for 2019 dropped from three rate cuts to two, and true also that the language was somewhat more measured about global growth prospects. But rate hikes are still on the table, and so is the winding down of the Fed’s balance sheet. Think of the “Fed put” as an opioid, and the market as a morphine addict. In the long run, weaning off that artificial stimulus will be beneficial. But those first few days (i.e., now) are rough sledding.
Whoville On the Potomac
And that brings us to Washington, which appears to be vying hard for the title of “world’s most dysfunctional political capital.” For most of the past two years the market has largely ignored the political gyrations that have consumed those inside the increasingly weird Beltway snow globe. Now, the prospect of a government shutdown, which seems likely to happen at midnight tonight, by itself is not something that normally spooks the market. The resignation of a major cabinet official – even when that official happens to be arguably the most respected personage in the present administration – is likewise something that normally gets more eyeballs from readers of the Washington Post than those of Bloomberg News. And the prospect of complete policy gridlock once Democrats retake the majority in the House next month is something that almost never freaks investors out (if no policy is getting made in DC then we can sleep well at night, go the usual thought bubbles over Mr. Market’s head).
This time, though, there are concerns – reasonable ones, sadly – that the dysfunction has the potential to become genuinely destructive in the weeks and months ahead. Anyone who has closely followed all the goings-on in the executive branch for the past two years can quite easily construct a plausible worst-case scenario that looks – well, really worst-case. There is at least a taste of that sentiment getting priced into the market right now.
What Tomorrow Brings
If one is convinced that the most likely scenario to play out is the worst-case one, then the rational thing to do is to reduce all exposure to risk assets and willingly accept zero percent real returns as the trade-off for sleeping well at night. If one sees a higher likelihood for something other than the worst case to emerge, then a stronger case could be made that the current market is quite oversold.
Always remember this: the price of any company’s stock is nothing more and nothing less than a collective estimate as to the net present value of all the future cash flows that company can generate. Of all the things out there that have the potential to impact those cash flows – recession, trade war, actual war – what magnitude will that impact likely be? On any given day, the collective wisdom may be wildly off the mark – either unrealistically pessimistic or too giddy in optimism – but over time share prices should converge to a realistic assessment of value.
We have plenty of concerns about the year ahead, and we will be discussing these in detail in our forthcoming annual outlook. These concerns will very much factor into our specific asset allocation decisions, and they anticipate a continuation of market volatility. But conditions like the present call for discipline and for perspective beyond the short-term sentiments buffeting daily market swings. Breathe in, breathe out, repeat.
The Lunar New Year in 2019 falls on February 5, a bit shy of two months from now. According to a New York Times article today, managers in some factories in China – where Lunar New Year is one of the big holiday events of the year – are letting their employees off for the holidays starting this week. Imagine if your boss came into the office one sunny October morning and said “Merry Christmas all, and I’ll see you in January!” Pretty weird. Such, apparently, is the extent to which the cadence of growth in the world’s second largest economy is slowing.
Tales From the Not-Yet-Trade War Front
A rather dour investor sentiment has been traveling across time zones from east to west this morning, cutting a swath of negative figures through the major equity indexes of Asia and Europe before showing up for another down day on Wall Street. The culprit appears to be another set of macro data releases from China coming in way below the already modest expectations of analysts. We show two of them below – retail sales and industrial production – along with the current state of things in China’s equity and currency markets.
Both these figures are notable in that they represent multiyear lows: in the case of retail sales, a 15-year low. Robust double-digit growth in sales has been the norm even through the 2008 financial crisis, but today’s read is just 8.1 percent year-on-year growth. The other point worth making is that these numbers have relatively little to do with the trade war. China’s exports have not turned down notably even after the implementation of successive waves of tariffs by the US. The problem appears to be domestic sentiment – households are turning down the volume on their spending habits and businesses are cutting production shifts accordingly (hence those extended “holiday breaks” noted above).
Old Habits Die Hard
We’ve been writing about the “China rebalancing project” seemingly forever. For literally the entirely of this decade to date, Beijing has loudly proclaimed its intention to move the economy beyond the old formula of massive spending on state-run infrastructure and development projects, towards a more consumer-oriented society closer to Western economies in terms of consumer spending as a percentage of GDP. By some measures it has succeeded – while official published figures from China are not necessarily reliable, consumption has grown as a GDP contributor over the past ten years. But the old fallback growth formula of debt-funded infrastructure has not abated. Indeed, fixed-asset investment, led by housing and infrastructure, hit a five-month high in the most recent data release. With debt levels already sky-high, though, there is a serious question about how many more times policymakers can go back to their old quick fixes for further growth.
Abroad and At Home
China’s slowing domestic economy is a major reason for the weakness in global energy and industrial commodities prices that has persisted over the past several months. That, in turn, seems to be having a positive impact on consumer spending here at home. With gas prices down a couple percent over the past month, US retail sales for the same period jumped by 0.9 percent month-over-month, exceeding analyst expectations (this refers to the so-called “control group” basket of retail goods and services that excludes volatile categories like automobiles, building materials and food services). November was a particularly bright month for big-ticket items like furniture and electronic goods.
US companies will be hoping that trend keeps up domestically. The average S&P 500 company earns around half of its total revenues from markets outside the US, notably China and the EU (which is having its own particular growth problems). Flagging demand in those markets will be a drag on the pace of sales and earnings growth, which in turn will put pressure on stock price valuations, which in turn could feed into prevailing negative sentiment towards risk assets generally, which in turn can spill over into spending plans by households and businesses, which eventually has the potential to lead to recession.
Protectionist and nationalist rhetoric may fill the political airwaves around the world, but it is still a globally interlinked economy, where the fates of consumers and business managers in China, the US, Europe and elsewhere are joined at the hip.