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President & CEO
Masood Vojdani began his career in the financial services industry in 1981. From the outset, he was driven by the vision of a firm that was different from the industry status quo. At the heart... Full Bio
So October just happened. With a couple relatively calmer days seeing out the year’s tenth month and seeing in the eleventh, it is a good time to take stock of what has, and what has not, happened in the story thus far. What hasn’t happened, as of today, is a technical correction in the broader market. The S&P 500 closed 9.9 percent below its 9/20 high this past Monday, just shy of a correction (recall that we have written in the past about the technical factors leading to these occasions when the market plays footsie with a correction or a bear market without actually going all-in).
The full story on this pullback has yet to be written. But we have lived through various flavors of October fright nights over the course of our careers in this industry. Each has its own story to tell – and from these stories we may gain some insight into how to think about the current version. History does not repeat, but it does rhyme from time to time. Here, then, are three Octobers of yore plus the one just passed. They are: Black Monday 1987, the Russian debt default and LTCM meltdown of 1998, and the Crash of 2008.
1987: Bang Goes the Market
On October 19 1987, Wall Street woke up to a market in full-scale panic mode. Prices had fallen throughout the previous week after an earlier rally fell short of reclaiming the record high set back in August. But the carnage on Black Monday was like nothing traders had seen before – and nobody had a convincing answer for why it was happening. By the end of the day the S&P 500 had fallen more than 21 percent, the largest percentage drop in its history (which thankfully remains unbroken today). Modest correction one day, full-on bear market the next. Not driven by any major piece of economic news, nor a major corporate bankruptcy, nor a catastrophic act of nature. What, then?
Black Monday happened largely due to a very new, very little understood investment strategy called portfolio insurance. The basic idea behind portfolio insurance was to protect downside by selling out of long stock positions when market conditions turn down. Selling begets more selling. On October 19 everyone wanted to sell, nobody wanted to buy, liquidity dried up and the market crashed. But the damage was over almost as soon as it began. Investors figured out in relatively short order that, indeed, the global economy wasn’t all that different from what it had been a month earlier. It took a bit less than two years to get back to the previous high of August 1987, but without much drama along the way.
1998: Russia Meddles In Our Tech Bubble
Everything was going along just fine – the economy was on fire, the Internet was well into stage one in its takeover of the human brain – but while America was rocking out to “…Baby One More Time” our erstwhile Cold War foe Russia was defaulting on its government debt. Which would have largely passed by unnoticed were it not for the massive exposure to Russian sovereign bonds among many of the world’s most sophisticated investment funds, including a super-smart group of pros called Long Term Capital Management. What we all learned from LTCM was that the interconnected global market has a dark side: a failure in one place can wreak havoc in a whole bunch of other, seemingly unconnected places (a lesson to come in handy a decade later). The S&P 500 flirted with a bear market though (stop us if you’ve heard this one before!) halting just at the cusp with a 19.3 percent peak to trough decline.
Again, though, the absence of any real, fundamental change in our economic circumstances, coupled with a quick and relatively efficient bail-out to contain the toxins released by LTCM, made this a relatively short-term event. By the end of the year the market had reclaimed its earlier record peak and was set to power its way through that giddy annus mirabilis of 1999.
2008: The Almost Depression
1987 and 1998 were instances where a major market pullback didn’t lead to worse outcomes – in both cases recessions were more than a couple years away (and neither the 1990 nor the 2001 recessions were particularly deep or durable). 2008 was a different category, of course. The entire financial system came close to shutting down, millions of Americans lost their jobs and – perhaps even more consequential for the long term – a deep sense of distrust in experts and institutions took root and strengthened. 2008 was not a “pullback” – it was a long, wrenching bear market.
Though it could have been worse. It took five and a half years for the S&P 500 to get back to the prior record high set in October 2007. By contrast, investors who saw the stock market crash in October 1929 (the mother of all scary Octobers) would not see their portfolios return to September 1929 levels until the mid-1950s.
There’s more to the 2008 story, though, than the spectacular failure of investment bank Lehman Brothers and the cataclysm that followed that fall. More than a year before the events of autumn 2008, there was already plenty of hard evidence that things were not well in the economy. Home foreclosures had started to trend upwards as far back as 2006. Monthly payroll gains stated to trend down in the middle of 2007, with particular weakness in areas like homebuilding and financial services. A sudden loss of liquidity in certain risk asset markets got investors’ attention in August 2007 – a small taste of the carnage to come.
When to Hold ‘Em, When to Fold ‘Em
So while the story of October 2018 continues to be written, what lessons can we apply from the lived experience of previous downturns? One approach we believe will serve investors well would be a healthy skepticism of the relationship between cause and effect. Any pullback of a meaningful enough size is likely to generate an army of Monday morning quarterbacks, fatuously explaining “why” it was so obvious that Event X would cause the market to reverse on Day Y (thanks for waiting until after Day Y to tell us!). Even highly sophisticated quantitative analyses, while arguably preferable to insufferable blow-dried touts spinning tales on CNBC, fail to deliver on the crystal ball front with their deep dives into correlation patterns. Those algorithms can tell you the likelihood of something happening based on tens of thousands of random hypothetical simulations. But they fall victim to the law of small numbers when applied to the sample size of one – one actual event on one actual day.
Because pullbacks and technical corrections happen much more often than actual bear markets, a good starting point is to make “not bear market” the default hypothesis, and then set up tests to see how easily the default hypothesis can be disproven. Understanding the macroeconomic environment, corporate earnings trends, sentiment among businesses and consumers and the like is important. So is a sense of history. For example, a currently popular thesis among some market pros is that a 3.7 percent yield for the 10-year Treasury will be a trigger point for rotating out of equities into fixed income. Why? A cursory look at past growth cycles seems to offer up little evidence that equities will encounter impassable headwinds once yields pass that threshold. And yet, we can’t dismiss the 3.7 percent crowd out of hand, because if there are enough of them, perception can become reality whether that reality makes logical sense or not.
The best way to survive market corrections is to always stay diversified, to resist the behavioral urge to sell after the worst has passed, to be alert to red flags but careful about acting on them. Unfortunately there is no failsafe formula for deciding when a correction looks set to metastasize into something much worse. Often, though, there will be enough data to build a case against the “not bear market” hypothesis, affording a window to build some protection before the worst happens (with no certainty, of course, that the worst will ever happen). It can be a frustrating exercise in practice – but it is also what makes markets so eternally fascinating.
Be careful what you wish for, because it might come true. A couple weeks ago, bond investors were wishing upon their stars for a retreat in yields from the 3.25 percent the 10-year Treasury had just breached. Well, retreat it did, falling below 3.1 percent in early Friday morning trading. But these falling yields were clearly of the risk-off variety, dragging down everything else with them. The S&P 500 is flirting in and out of correction territory (a peak to trough decline of 10 percent or more) and may well have settled there by the end of the day, while the Nasdaq has already gone full correction.
As we noted in our commentary a couple weeks ago, corrections aren’t particularly rare events. We also noted the Tolstoyan flavor of these events – each one has its own unique story of dysfunction to narrate. “Okay, fine, so what’s the sad story accompanying the current situation?” is thus quite naturally a question that has come up in conversations with our clients this week. The narrative for the glass-half-empty crowd has indeed started to gel, but it is yet by no means clear that this will be the narrative that dominates for the remainder of the quarter (we will remain on record here as believing that it will not).
What we still have is a battle between two narratives, each looking at the same set of facts and drawing different conclusions, as if they were so many Rorschach inkblots. Let’s look first at the case for negativity.
Europe and China and Rates, Oh My
Several strands of thought weave together the bears’ case. In last week’s commentary we had an extensive discussion about the malaise in Europe, first with the Italian budget standoff that has sent yield spreads on sovereign debt soaring, and second with the spread of political unrest from the continent’s periphery to its dead center. Germany will have another round of regional elections this weekend, this time in Hesse (the region that includes financial capital Frankfurt as well as a delightful-sounding tart apple wine called Ebbelwei). The establishment center-left party, the SPD, is expected to fare poorly as they did two weeks ago in Bavaria. A really bad drubbing for the SPD could lead to the party’s exit from being the junior partner in Angela Merkel’s national grand coalition. That in turn could ratchet up the growing uncertainty about Merkel herself at a time when steady leadership from the EU’s strongest member is of critical importance.
China forms the second strand of the pessimist case. The national currency, the renminbi, is at its lowest level in a decade and poised to break through a major technical resistance level at RMB 7 to the dollar. After China’s GDP growth numbers last week came in slightly below expectations (6.5 percent versus the 6.7 percent consensus) Beijing economic officials coordinated a set of emphatic verbal assurances to investors that renewed growth measures were in place. That was enough to give beleaguered Chinese stocks an upward jolt for one day, but the lack of any specificity in the officials’ assurances didn’t hold up for a rally of more extended duration, and shares resumed their downward trend.
With the rest of the world looking particularly unappetizing, attention then turns back to the domestic environment, specifically the prospects for continued monetary tightening by the Fed and concerns that the run of news for corporate financial performance – capped off by earnings growth expected to top 20 percent for 2018 – is about as good as it’s going to get. Higher rates will tamp down the currently rambunctious confidence among consumers and small businesses, while widening spreads will also spell trouble for the corporate debt market at a time when S&P 500 companies have record levels of debt on their books. Margins will be under pressure from upward creep in wages and input costs, and weaker economies around the globe will have a negative effect on overall demand for their products and services. Faltering leadership from high-profile tech and consumer discretionary shares is the canary in the coal mine, portending a more protracted period of market weakness.
It’s not a weak case, to be sure. But there is a strong argument on the other side as well, with opportunists scouring an expensive stock market for bargains made available in a 10 – 15 percent correction environment. This is the “song remains the same” crowd.
The Big Picture Hasn’t Changed
The glass-half-full argument always starts from the same point: the unrelenting sameness of US macroeconomic data month in and month out. The latest of these is fresh off the presses of the Bureau of Economic Analysis as of this morning: a Q3 real GDP growth reading of 3.5 percent, which translates to a 3.0 percent year-on-year trajectory. Same old, same old – healthy labor market with unemployment at decades-low levels, prices modestly but not dangerously above the Fed’s 2 percent target, zippy consumer spending and continued growth in business investment.
On the subject of corporate earnings, the optimists will point out that top-line sales expectations for 2019 are actually increasing. Yes – the tax cut sugar high will lapse once December comes and goes, so bottom-line earnings won’t repeat their 20 percent gains of ’18. But if sales continue to grow at a 6-7 percent clip it underscores the ongoing health in consumer demand, here as well as abroad. And yes – to that point about weakness in China, the adverse effects of the trade war have yet to show up in actual data. China’s exports grew at a 14 percent clip in September, and the $34.1 billion trade surplus it recorded with the US for the same month was an all-time record.
The Fed is likely to continue raising rates. The reason for that, as Fed officials themselves repeat time and again, is because the economy is growing well and (in their view) cans sustain growth while interest rates rise gradually to more normal levels. It’s worth remembering that yields on the 10-year Treasury averaged over 6 percent during the growth market of the mid-late 1990s, and around 4.5 percent during the mid-2000s. There is no particular reason (despite many reports to the contrary) that money managers “have to” rotate out of equities into bonds at some notional 10-year yield threshold (3.7 percent being the number bandied about in a recent Merrill Lynch / Bank of America survey).
To be sure, there are plenty of X-factors out there with the potential to add fuel to the present nervousness in risk asset markets. There are plenty of others that could accelerate a pronounced recovery of nerve heading into the peak retail season that begins next month.
It is also possible that we are seeing the first early hints of the next real downturn – much like those occasional days in August where there’s enough crispness in the air to suggest a seasonal change, even while knowing that autumn is still many weeks away. Just remember that while the timing of seasonal equinoxes is predictable, market transitions do not operate on any fixed calendar.
An up and down week on Wall Street may end on a slightly positive note, if the sentiment we are seeing on this Friday morning makes it through the afternoon. Don’t mistake this for some kind of definitive trend, though – what’s been happening this week is much more about technical buy and sell triggers that send much of the market’s intraday volume hither and yon. At one point earlier this week the S&P 500 actually closed below its 200-day moving average for the first time since early 2016. There’s nothing magical about moving averages, of course, except that lots and lots of trading strategies are programmed to react to them. Perception is reality in the world of short term trading.
In any event, while indexes bounce up and down in search of a driving theme to provide direction for the rest of the year (which we think has a better chance of being up but a not immaterial chance of being down) we want to dig into some of the X-factors contributing to the current frisson of unease. In this week’s commentary we feature the Italian debt market. Spreads between Italian benchmark bonds and German Bunds (the go-to safe haven for EU fixed income) are at their widest levels in four years.
Return of Eurozone Mal de Mer
The above chart shows that Italy-Bund spreads are a useful indicator of unrest in the Eurozone. After ECB chief Mario Draghi assured the world that the Eurozone would stay intact with his “whatever it takes” speech in 2012, the spread tightened from the wide gulf of the crisis years to a more typical risk premium that lasted for most of the past four years. That all changed with the national elections in March 2018, which ended with a populist government sworn in two months later, in May. The coalition government of the Five Star Movement (FSM) and the League, representing different flavors of anti-establishment populism, set out some ambitious plans to deliver on its campaign promises of stimulus measures for growth and jobs. Eventually, these plans found their way into a budget the country is required to submit to EU officials in Brussels, to ensure that the terms are in keeping with EU standards and constraints. Brussels, to put it mildly, was not amused.
EU economics officials routinely issue rebukes to member country policies which they see as deviating from rules – particularly the rules developed during the crisis years earlier this decade. But the language in this Thursday’s communique from Brussels to Italian finance minister Giovanni Tria was – well, practically Trumpian in its histrionic flavor. “Unprecedented in the history” of EU budget rules! – said the stern technocrats. One would think nothing of such a seismic nature had rocked the continent since Charlemagne crushed the Merovingians.
The odd thing is that Brussels’ main sticking point with the budget is its assumption of running a 2.4 percent fiscal deficit. While not inconsiderable, that is a lower fiscal deficit than those run by EU members France and Spain, and it is also lower than what the new Italian government initially planned after the coalition came together in May. The real underlying problem is that few observers believe a fiscal deficit of this size is sustainable for a country challenged by slow economic growth and a cost of debt that is already rising. The bond investors who have been selling off Italian bonds this week anticipate further downgrades to Italian debt from S&P and Moody’s later this month, and expect further headwinds to buffet the fragile condition of large Italian banks.
The bigger contextual picture, of course, goes beyond Italian sovereign debt to the overall health of the EU. There has been little in the way of good news from Europe this year. The Brexit negotiations are an ongoing fiasco painting nobody in a good light. On the eastern periphery Hungary and Poland can fairly be called ex-democracies as their authoritarian governments consolidate one party rule. Italy and Austria are ruled by populists. Establishment darling Emmanuel Macron’s approval ratings in France are an abysmal 33 percent (that’s lower than Trump has ever fallen here back home!). And Germany is also teetering on the dividing edge between populists and technocrats. Witness this past weekend’s regional elections in Bavaria where the long-dominant CSU (the regional partner of Chancellor Merkel’s ruling CDU) suffered its biggest loss of seats in the party’s postwar history.
In this fraught landscape, the notion of a fiscal crisis or banking system collapse in Italy has the potential to inflict more damage than the original Greek economic crisis that led to the dolorous years of 2011-12. Back then those three magic words uttered by ECB chair Draghi – whatever it takes – were enough. We may see proof in the coming weeks, one way or another, whether indeed it is enough.
So here we are, with a full array of tricks and treats to test investors’ nerves as the month of October gets rolling. A quick brush-up for our clients and readers on the nature of pullbacks is in order.
Since the current bull market began in 2009 there have been 20 occasions (including the present) where the S&P 500 has retreated by 5 percent or more from its previous high (translating to roughly 2 per year). Of those 20 pullbacks, four met the definition of a technical correction, i.e. 10 percent or more from the high. On one occasion, in 2011, the index fell by more than 18 percent before recovering. As of the Thursday market close, the S&P 500 was down 6.9 percent from its September 20 record high of 2930.
These things happen. As we like to say, paraphrasing Tolstoy, every pullback is dysfunctional in its own special way. With the caveat that the final word on the current reversal has yet to be written, here are four observations we think are worth keeping in mind as this one plays out.
They Finally Got the Memo
As we wrote about in last week’s commentary, the market has been willfully slow, for a very long time, in accepting that the Fed really intends to raise rates consistent with its view of an economy gaining strength. Last week the bond market got the memo with a sudden midweek jump in intermediate yields. It seems that the bond market sat on the memo for a few days before passing it over to the stock market. In any case, we can say with a bit more confidence now that the memo has been received. Barring any significant changes in the macroeconomic landscape – which changes have yet to surface in the form of hard data – the reasonable expectation is for a final 2018 rate hike in December, followed by at least three in 2019.
More Bond Confusion Likely
Despite better alignment between market expectations and the Fed, we do foresee further confusion in fixed income, particularly with intermediate and long duration asset classes. Consider the multiple forces at work on the 10-year Treasury, a widely used proxy for intermediate-long bonds. Heightened inflationary expectations could push yields much higher. On the other hand, relatively attractive yields (compared to Eurobonds or Japanese government bonds, for example) could keep a lid on how high rates go. Any kind of emergent financial crisis could widen spreads between Treasuries, corporate bond and other fixed income classes.
During the economic growth cycle of the late 1990s, from 1995-2000, the average yield on the 10-year Treasury was 6.1 percent and it never fell below 4 percent. What should the “natural” yield be in the current growth cycle? Nobody, not the world’s leading economists and not the trader plugging buy and sell triggers into an algorithmic trading strategy, knows for sure. We’re likely to learn this from whatever we experience over the coming months, not from theoretical foresight.
Post-Sugar High Growth
Come December, we will lap the tax cuts implemented one year earlier. That will make 20 percent corporate earnings growth a thing of the past – a good part of the growth in earnings per share this year was based on the lower tax rate that flowed through to the bottom line of the corporate income statement. Right now, the consensus analyst group used by FactSet, a market research company, expects earnings per share growth for S&P 500 companies to be 7 percent in the first quarter of 2019. Now, the same consensus group predicts that top line sales for these companies in Q1 2019 will come to 6.9 percent. That tells us two things. First, it tells us that the overall global demand environment (reflected by sales) is not expected to worsen much from where it is currently. That’s good news.
The second thing it tells us is that analysts will be focusing obsessively on corporate profit margins in 2019. Sales growth is good, but in the long run sales without profits are not good. Closer parity between top line growth rates and trends further down the income statement suggests that companies will need to be increasingly creative in finding ways to make money, particularly if cost pressures (e.g. on raw materials and labor) continue to trend up.
How will this factor play out? The next few weeks will be very important as the Q3 2018 earnings season gets under way. Analysts will be digesting the most recent growth and profit numbers from corporate America. The narrative could shape up positively – more growth! – or negatively – peak margin! How you as an investor approach 2019 will have much to do with whether you think profit margins really have reached their Everest once and for all. There will be plenty of excitable commentary to that effect. We suggest tuning out the commentary and paying attention to the actual data.
As in, “market leaders going around in circles.” So far the industry sectors bearing the brunt of the October ’18 pullback are the ones that did the lion’s share of the lifting for the past couple years: tech, first and foremost, communications services and consumer discretionary. More broadly, growth stocks have been absolutely dominant for much of the latter period of this bull market. So it is reasonable to ask what might happen if the growth stock leadership falters.
We’ve seen this play out a couple times this year (see our previous commentaries here and here for additional insights on this topic). One of the considerations is that because the tech sector comprises about 25 percent of the total market cap of large cap US stocks, it has an outsize effect on overall direction. That works well when the sector is going up. But if, say, consumer staples stocks in total go up by as much as tech stocks go down, the net result is a down market (since consumer goods stocks make up less than 8 percent of the index). An orderly growth to value rotation might be a better outcome than outright confusion, but investors who have gotten used to the growth-led returns of recent years might be in for a disappointment.
So there’s a lot at play right now. As usual, there will be no shortage of “experts” claiming to understand precisely what it all means (as they claim, after the fact, how “obvious” it was that this pullback was going to happen at exactly this time for exactly this or that reason). As for us, we simply plan on doing what we always do. Study the data, think through the possible alternative outcomes based on the scenarios we have described here as well as others, and always remind ourselves of those numbers we cited at the beginning of this commentary. Pullbacks are a fixture of bull markets and they happen for any number of reasons, logical or not. Actual bear market reversals are much rarer events. In our opinion it is not time to call an end to this bull.
It doesn’t take much these days. “Pretty bad market today, huh?!” came one comment from a fellow runner during a muggy 5K outing on Thursday evening. Was it? Apparently so. Thursday’s S&P 500 posting of minus 0.82 percent was the biggest daily drawdown since the second half of June, when the index shed close to 3 percent for some vague reason long forgotten. None of this in any reasonable way qualifies as a pullback of note – we tend not to raise an eyebrow until the 5 percent threshold approaches. But after three months during which the market climbed as relentlessly as the humidity index in the Washington DC swamplands, even a modest pullback of less than 1 percent seems as rare as actual fall weather in this weirdest of October climes. Blame it on the bonds.
The catalyst for the Thursday downdraft in equities was a surge in bond yields that gained steam on the back of a couple economic reports on Wednesday – in particular, a thing called the ISM Non-Manufacturing Index, which rose more than the consensus outlook. That report, suggesting that activity in the services sector (which accounts for the lion’s share of total GDP) was heating up, set the stage for expectations about a gangbusters monthly jobs report on Friday. The 10-year Treasury yield shot up by 10 basis points (0.1 percent), which is huge for a single day movement. The 10-year yield is now at its highest level since 2011, as shown in the chart below.
That blockbuster jobs report, as it turned out, never happened. We got a headline unemployment rate of 3.7 percent that is the lowest since – kid you not – 1969, that groovy year of moon landings and Woodstock. But payroll gains, the most closely watched indicator, rose by considerably less than the expected 185K while wage growth came in right at expectations with a 2.8 percent gain. Overall, a mixed bag. Equities are roughly flat in tentative trading as we write this, while the 10-year Treasury yield continues its advance. The yield spread between 10-year and 2-year Treasuries, which earlier this year appeared on the tipping point of an inversion (in the past a reliable signal of an approaching recession), has widened to about 35 basis points.
This widening spread would be consistent with the ideas we communicated in last week’s commentary about increased inflationary expectations on the back of an ever-tightening labor market and price creep from higher tariffs on an expanded array of consumer products. So far the numbers – in particular today’s jobs data and last week’s Personal Consumption Expenditures (PCE) reading – don’t bear out the hard evidence. But the bond market could be adjusting its expectations accordingly.
Doing It On the QT
Or, maybe not. There were a couple technical factors at play this week as well, including a jump in the cost of hedging dollar exposure which had the effect of reducing demand for US Treasuries by foreign investors. This is not the first time that we have seen a sudden back-up in yields, only to dissipate in relatively short order. As for the fabled bond bull market that has endured since the early 1980s, well, there is certainly no shortage of times this has been pronounced dead, only to rise again and again.
Ultimately, of course, it all comes down to supply and demand. We know one thing with confidence – the Fed is out of the market as a buyer. While last week’s FOMC meeting didn’t produce much in the way of surprises, it did codify the understanding that the age of QT – quantitative tightening – is at hand. The Fed’s assessment of the economy is quite upbeat. The cadence of rate increases and balance sheet reduction is likely to continue well into 2019.
None of which necessarily suggests that intermediate and long term rates will surge into the stratosphere. If the domestic economy stays healthy then domestic assets should be attractive to non-US investors – an important source of demand that could keep yields in check. Indicators like corporate sales (growing at a brisk 8 percent or so) and sentiment among businesses and consumers (leading to increased spending and business investment) suggest that there is more to the current state of the economy than a fiscal sugar high from last December’s tax cuts. For the near term, our sense is that the positives continue to largely outweigh the potential negative X-factors. We may be okay in 2019 – but 2020 could be an entirely different story.