Posts tagged Current Market Trends
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.
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.