Posts published in September 2015
So here we are, somewhere along the path of the latest double digit reversal in large cap US stocks. Whether this is a technical correction – a bump in a still-bullish road – or the early stages of a long winter of discontent remains to be seen. In our opinion, though, the evidence appears to favor the former interpretation. While the script changes from pullback to pullback, there are some similarities in how they play out. Consider the following chart, which illustrates the current environment in the context of peak-trough-recovery trends for three previous corrections.
Selling Waves and Relief Rallies
We focus on these three prior instances – in 1998, 2010 and 2011-12 respectively – because they represent corrections that did not lead to subsequent bear markets. Let us examine some key metrics. The dominant feature of each pullback is a series of volatile selling waves and relief rallies in between the previous high point and the eventual recovery of that high point. The volatility can seemingly come out of nowhere, which is what makes the initial selling waves so difficult to foresee. The CBOE VIX index, widely used as a so-called market “fear gauge”, was relatively benign in the month leading up to each of these four reversals and then shot up literally overnight with the first selling wave. Consider the most recent case. In the thirty days leading up to the first massive selling wave one month ago, the average VIX close was a tame 13.4. A week later the index was over 40, and it has averaged 26 from then through yesterday’s close. Based on historical averages, a VIX level over 20 generally indicates an environment of elevated risk.
While much of the media focus during a pullback is on those days of extreme selling – for example the first several days of August in 2011 or that recent miserable sequence from August 21 -25 this year – investors would be better served to pay more attention to the directional pattern of subsequent selling days and relief rallies. The turning points of these successive micro-trends can be an important signal: if each successive trough of a selling wave is shallower than the previous one – and if each subsequent relief rally peak is higher than the last – it can potentially signal that the worst of the selling is over. However, the road to recovery can be a bumpy one. In a double digit reversal the normal relationship between a price index and its key technical indicators is inverted. Support levels become resistance levels. While many dismiss technical indicators as silly, past reversals show that they matter.
Consider the relationship between the S&P 500 price index and its 200 day moving average (the blue dotted line) in the above chart. Now, clearly there is nothing magic about this line – it is simply a rolling average of the index’s close for the last 200 days and therefore entirely arbitrary. But short term trading programs use metrics like the 200 day average as triggers for their buy and sell decisions. Note how, in each of the 1998, 2010 and 2011 corrections, the relief rallies approach but fail to breach the 200 day average on one or more occasions, then falling to another bout of selling. Perception becomes reality: the moving average has meaning simply because the trading algorithms confer meaning upon it. Bear in mind that more than half of the exchange volume on any given day is generated by computerized program trading, which helps explain the stickiness of these technical indicators.
Technical Context: Where We Are Today
Looking at the current pullback in this technical context, the good news is that the series of selling waves following the 8/25 trough have trended shallower. We have had a couple selling waves of more than one percent since the most recent relief rally peaked on 9/16, but the bottoms remain elevated from the previous selling waves that occurred just after Labor Day. The directional relief rally / selling wave trend is positive.
Against that good news we would offer two points of caution. First, the magnitude of the peak to trough even to date is 12.4 percent, considerably less than the maximum declines of the other three corrections shown. Second, the index has not yet tested its key technical resistance levels. In fact, the current pattern bears an uncanny resemblance to the Septembers of both 1998 and 2011: a decisive relief rally trend following a concentrated period of extreme selling. In September 2011 the index ran into headwinds at the 200 day moving average, and the subsequent selling wave set a new event low before finally recovering and achieving escape velocity at the end of the month. We may not yet be fully out of the woods this time around.
Technical analysis aside, though, one should never forget the decisive role external events play in these pullbacks. In August 1998 the Russian government defaulted on its debt, and a major financial institution (hedge fund Long Term Capital Management) went bust. In summer 2011 the wheels seemed to be coming off the single currency Eurozone, while the US Congress almost brought about a default on US Treasuries with its brinksmanship over the debt ceiling. By contrast, the variable most obviously at play in the current environment is China’s wobbly economy, punctuated this summer by its domestic stock market crash and subsequent currency devaluation. A slowing Chinese economy, while important, is not necessarily an event of the same magnitude as a government default or currency union breakup. The US, meanwhile, does not appear to be headed towards recession, and odds are still good that the Fed will get on with its rate program before the end of the year.
In other words – just because recent corrections have ended closer to 20 percent down than 10 percent down does not necessarily mean that we still have another five percent or more to lose in this one. Events and context do matter. We study the technical aspects of historical corrections because it helps give perspective when a new one occurs. But we always remind ourselves that each double digit reversal is miserable in its own unique way. And also, inevitably, that this too will pass.
The Fed did the right thing yesterday. Below trend inflation, modest wage growth, tepid productivity and sub-80 percent capacity utilization all point to a US economy that, while growing, is far from running hot. The urgency for an immediate rate hike simply was not there. Given the elevated threats evident elsewhere in the world, why risk it? That was the clear message in the communiqué which accompanied yesterday’s FOMC decision to leave rates where they are and live to fight another day. By explicitly calling out “recent global economic and financial developments” Yellen & Co. articulated the reality that what happens elsewhere in the world can have a direct impact on US prices and jobs, the twin components of the Fed’s mandate.
Data-Driven vs. Time-Driven
But the decision to stand pat at zero lower bound carries its own set of risks, first and foremost of which may be the Fed’s own credibility. The lead-up to the September meeting was particularly confusing. On the eve of the announcement the professional community was – at least according to the received wisdom – about evenly split as to whether or not there would be a rate hike. Fed funds futures markets seemed to be pricing in no action, but the 2 year Treasury was yielding over 80 basis points, a 52 week high, reflecting at least some degree of rate hike expectations (the 2 year promptly retreated back below 0.70 percent following the announcement). Observers were having trouble reconciling two somewhat conflicting positions: the “data-driven” mantra invoked by nearly all FOMC members in their various public comments, and the time stamp of “later this year” suggested by Chairwoman Yellen in previous comments, back before the Shanghai Composite began its nosedive this summer.
That earlier time stamp comment was what gave the September meeting such a frisson of breathlessness, being one of only two remaining FOMC meetings this year to be followed by a press conference (the next meeting, in October, will not include a press conference where Yellen could articulate the reasoning behind any action taken and thus is deemed a less likely venue for such action). In the wake of yesterday’s decision, we now know that data trumps the calendar, and we know that the data set extends well beyond US borders. What remains unknown is how those “global economic and financial developments” will specifically factor into the calculus going forward. Is the Fed now central banker to the world? Yes, to the extent that international growth rates and currency bourses affect US jobs and prices, and therefore domestic monetary policy. What actual global developments need to take place for the Fed to be confident about moving forward? That remains to be seen. The waiting game is, if anything, foggier today than it was leading into the September meeting. That has the potential to further roil already jittery asset markets as we head into the final quarter of the year.
Behind the angst about when rates will start rising is a deeper concern about growth. For all the unconventional firepower central banks around the world have thrown at the problem, the fact remains that global growth is well below trend. Europe is still struggling to maintain positive growth, China’s actual – as opposed to published – growth rate is a deepening mystery and many key emerging markets are in outright contraction. In this environment the burden of global growth engine has fallen on the US. The problem is that our own growth is below trend and will likely remain so without a more robust pace of activity elsewhere in the world. Consider the following chart, showing real year-on-year US GDP growth for the past forty years, going back to 1975:
Average baseline trend growth today is lower than at any time in the past forty years. Now, resumed growth elsewhere in the world could help reverse this trend. Many of the largest companies that make up the S&P 500 derive more than half their total revenues from markets outside the US. As those markets grow, so do our own fortunes. This is why those “global developments” are important enough for the Fed to explicitly call them out. If the current growth malaise is cyclical – and if keeping rates historically low helps us work through the cycle without falling back into recession – then one could reasonably expect trend growth to turn back up.
Of course, there is no certainty that the current lack of growth in the world is cyclical. There is no shortage of opinion out there that “winter is coming”, to use the popular Game of Thrones vernacular. This view holds that the downturn in world output is structural, not cyclical, and likely to be with us for some indefinite time to come. The Fed’s credibility likely hangs in the balance as to which of these views will ultimately prove to be correct. Given what we know today, though – and much as we would like to see conditions normal enough to move away from zero lower bound – holding off on rates in light of elevated economic risks was in our opinion the right thing to do.
Emerging market (EM) equities have long enjoyed a position as a core strategic asset class for diversified long term investment portfolios. Using the traditional tools of modern portfolio theory (MPT), investment advisors place EM assets in the high growth / high risk portion of the allocation pie: delivering outsize gains in the long run but not without some significant bumps along the way.
A look back at the last quarter century of emerging markets, however, calls this approach into question. Consider the chart below, showing the risk/return characteristics of the MSCI Emerging Markets index versus those of the S&P 500 from 1990 to the present.
Over this time period the S&P 500, a key benchmark for large cap US equities, delivered annual average total returns of 9.2 percent, while emerging markets as measured by the MSCI index produced average annual total returns of just 7.9 percent. Moreover, the outperformance of US equities came with lower risk: 21.7 percent standard deviation versus 26.0 percent for emerging markets. Now, there have been periods within this twenty five year window when EM stocks have done quite well. Given the overall performance though – and particularly within the context of today’s global economy – investors would be well served to think carefully about future allocations. Should emerging markets be considered a default asset class, or are they better as a periodic tactical option?
Good Times, Bad Times
Emerging markets did not escape the seismic market disruptions of the past quarter century, tumbling lower in the downdraft of the tech bubble collapse in the early 2000s and then freefalling during the 2008-09 market crash. But, while they felt the pain when developed markets fell, they didn’t always share in the gains when the US and other markets rallied. The following chart shows the price performance trends for US and EM equities over this time period, illustrating clearly where key trend divergences have occurred.
The first major trend divergence occurred during the spate of currency and debt crises that began when the Thai baht’s devaluation in 1997 triggered a landslide of Asian currency retreats, and continued with the Russian debt default in 1998. Unfortunately for EMs, these problems happened while the world economy was booming and US markets in particular were enjoying the fruits of the Internet’s ascendance. The S&P 500’s 19 percent pullback in August 1998, at the peak of Russia’s woes and the related collapse of hedge fund Long Term Capital Management, paled in comparison to the 65 percent-plus freefall the MSCI EM index suffered from October ’97 to November ’98.
Of course, the misery of the late 1990s receded in the rearview mirror as the stunning rise of China as a global economic power led the EM asset class to vastly outperform just about everything else in the middle of the 2000s. As with the dot-com collapse, though, EMs found themselves suffering from problems that originated elsewhere as markets headed south in 2008. The subprime loan crisis that begat the Great Recession was a home-grown American problem, yet the peak-to-trough drawdown was far more severe for emerging markets than for US equities. This again illustrates an uncomfortable risk asymmetry. Emerging markets are vulnerable to the flu when developed markets catch cold. But the severe illnesses which periodically befall EMs require little more than a couple Advil to restore US equities to health.
Growth: Gone Today…
Many emerging markets took bold steps after their late ‘90s crises to reform their economies and financial systems, notably by building up significant foreign exchange reserves and shifting the mix of their debt burden to include more local currency financings. These improvements notwithstanding, the EM model is challenged today by the elusiveness of the key ingredient at the heart of that model: growth. The tag line of “growth engine” does not fit well when Brazil and Russia are experiencing sharp reversals, South Africa and Turkey are likewise struggling to find a path back to prosperity, and China’s troubles send shock waves into the capital markets on a near daily basis. The uninspired performance of EM equities from 2010 to the present, as seen in the above chart, is particularly concerning given its coincidence with an era of unprecedentedly low interest rates. Growth markets should be catnip for cheap money – unless, of course, the growth isn’t there.
Today’s seemingly intractable problems notwithstanding, there are good reasons to not dismiss emerging markets out of hand as a strategic asset class. These countries are for the most part significantly wealthier than they were back in 1990. Although their political and legal systems are a mixed bag, in most cases the systems have produced a better living standard for the citizens of these countries, with investments in infrastructure, housing and domestic enterprises offering even more appealing opportunities for their future generations. It is generally unwise to underestimate the human will to prosper and make a better life for one’s children. A world economy characterized by young, strong growth markets and older, slowing but still rich developed markets certainly cannot be ruled out as a viable scenario. In such an environment emerging markets should plausibly regain momentum.
And that, in our opinion, is how you should answer the question about emerging markets as a strategic asset class: it depends on how you see the world. If you believe that growth will return to the world economy and that EMs will be the engine of that growth, it would be unwise to leave exposure to these markets out of a long term investment strategy. If on the other hand you believe that winter is coming and likely to stay put for a long time, then perhaps it would be wiser to consider other sources of high risk / high return performance. Our views tend towards the former, and we will continue to advise our clients to not abandon EM equities as a core asset class.
The ninth month of the calendar year is not off to a promising start for risk asset markets, as world stock indexes continue to swoon for no apparent reason. While Wall Street struggles, though, things on Main Street do not seem bad at all. The four charts below present a snapshot of a reasonably healthy US economy: steady payroll growth, decent GDP, strong consumer confidence and benign inflation. All else being equal, one would argue that the pace of recovery could take a small hike in interest rates in stride. All else never is equal, though, and the Big Question remains stubbornly unanswered, two weeks before the answer is due.
Unpacking the Numbers
Today’s job report is one of the last significant data points the FOMC will have in hand when they start their conclave on Wednesday, September 16 (awkwardly, the next CPI release comes out on the morning of the 16th, right as things are getting underway at the Eccles Building). The headline number of 173,000 new jobs is below trend, but upward revisions to June and July offset the disappointment a bit. Plus, August is a notoriously unreliable month, with frequent subsequent revisions up. Wage gains were slightly better than expected. At 2.2 percent year-on-year, wages are a bit ahead of core inflation (ex food and energy) and substantially better than the headline CPI number (which is the correct measure for comparison, since those food and energy items are a big part of household budgets). This release comes in the wake of the upwardly-revised 3.7% GDP growth and the highest post-recession reading on consumer confidence.
This picture seems to resemble the “Goldilocks” metaphor so fondly invoked by the financial chattering class: neither too hot nor too cold, but just right. Too hot means we need to take dramatic action on rates to prevent rampant inflation. Too cold means groping for some kind of stimulus measures (QE4, anyone?) to get people spending and businesses investing. “Just right” should allow the Fed to get rates off the floor where they have languished since the dark days of 2008-09. And there is a reason for doing so that goes beyond the current headline numbers. Eventually, this growth cycle will run its course and the threat of recession will loom. The Fed does not want to be approaching the next economic slowdown with no room for reducing rates – that would be unprecedented and most likely not at all fun to watch. When Chairwoman Yellen expresses her conviction that raising rates is the right thing to do, it is for this reason more than it is the notion that the current economy lives or dies on the basis of a Fed funds rate 0.25 percent higher than where it is today.
Data-Driven or VIX-Driven?
The problem, of course, is that Yellen and her colleagues can’t simply pretend that asset markets don’t exist, and that their irrational tendencies don’t matter. The current volatility, along with the ongoing parade of high-profile warnings against a rate hike from the likes of IMF head Christine Lagarde and ex-Treasury Secretary Larry Summers, puts the Fed in a corner. Simply put, it will be hard for them to pull off even a very modest increase in September without roiling further the already jittery markets.
So they are likely to wait. But raising rates is necessary. We will be far more comfortable if the Fed funds rate manages to get back above three percent before this economic recovery runs its course. The bears may have the floor this month, but we hope that Goldilocks will find her voice come December.