Posts tagged Risk
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.
Earlier this fall we coined the phrase “sector spaghetti” to describe a phenomenon we observed in the US equity market, namely the absence of any sector leadership. The small concentration of tech shares that have driven performance for the lion’s share of this bull market started to fall sharply back in July as investors reacted badly to underwhelming earnings announcements from Facebook and others (underwhelming, perhaps, only in the febrile expectations of the analyst community, but still…). Without leadership by the enterprises that dominate the S&P 500’s total market value, the various industry sectors waxed and waned, their combined trajectories looking like a tangled pile of cooked pasta dumped on a kitchen counter. Hence, sector spaghetti.
Oh, and just how impactful was that “small concentration” of tech shares? Consider this: according to the Economist magazine, just six stocks – Alphabet (Google), Amazon, Apple, Facebook, Microsoft and Netflix – have accounted for 37 percent of the rise in value of all stocks on the S&P 500 since 2013. Think about those two numbers: 6 and 37. That’s a huge impact for such a tiny cohort.
A Picture Emerges
The spaghetti factor has cleared a bit, thanks to the pullback beginning in October that brought the S&P 500 to flirt with a technical correction on a couple occasions. A general risk-off sentiment has set in, and with it a rotation of sorts into the traditional defensive sectors including consumer staples, healthcare and utilities. The chart below illustrates the recent trend of these three sectors versus the erstwhile growth leaders of information technology, communications services and consumer discretionary.
The problem with this defensive rotation becomes clear when you look at the dotted red line in the above chart. That represents the price trend for the index itself. As you can see, it is much closer in proximity to the lagging growth sectors than to the outperforming defensives. The reason for which, of course, is the outsize influence those market cap-heavy sectors exert on the overall market: the three growth leaders account for more than 40 percent of total index market cap, compared to just over 25 percent for the three defensive sectors (energy, financials, industrials, materials and real estate make up the index’s remaining balance). A rotation out of tech is a rotation with a steep uphill climb.
What Is Tech, Anyway?
The “tech sector” is sort of a misnomer, to the point where the index mavens at Standard & Poor’s undertook a major restructuring of the S&P indexes earlier this year to better segment the various enterprises whose primary business falls somewhere on the value chain of the production, distribution and/or retailing of technology-related goods and services. The restructuring was helpful, to a point. For example, Apple, Facebook and Microsoft are all constituents of the information technology sector, but Alphabet (Google) and Netflix both fall under the newly-defined communications services sector.
But it is only helpful up to a point. Take the case of Amazon which, despite being a company entirely built on a technology platform without which it would not be a business at all, has always been and remains a member of the consumer discretionary industry sector. In fact Amazon, Microsoft and Alphabet are all industry leaders in the multi-billion dollar business of cloud computing services, yet all three are in different industry sectors.
More broadly, though, it is actually hard to think of any industry sector where “technology” in one form or another is NOT a core component of the industry’s competitive structure. Financial services companies compete in the fintech arena, while hundred year-old industrial concerns are in a race to grab leadership in the Internet of Things, whatever that winds up being. Even sleepy utilities, traditionally loved almost solely for their high dividend payouts, are scrambling to convince investors they are on top of the evolution to “smart grids” (another catchy name that mostly has yet to demonstrate an actual present-day revenue model).
The point is that technology is all-pervasive. But actual ownership of much of that technology remains highly concentrated – in the hands of those same companies responsible for a large chunk of this bull market’s gains. Any rotation out of those companies into something else is going to need a pretty compelling narrative to deliver commensurate returns. For starters, investors will be hoping next week for a second helping of strong holiday shopping results alongside their turkey and stuffing.
There were lots of think pieces leading into the US midterm elections earlier this week. We didn’t contribute to the genre, mostly because there is nothing statistically meaningful to say about an event with a very small sample size (n = 10, if you want to go all the way back to 1982 for your midterms data set) and lots of variables highly specific to each observance. Not that shoddy statistics ever got in the way of mainstream financial punditry…but we digress. In any case, the day came and went with relatively few real surprises of note. The “known unknowns” of the midterms now join the headline macroeconomic and corporate earnings trends as “known knowns” propelling what might be expected to be a net-positive narrative while the clock runs down on 2018. Always allowing, of course, for the sudden appearance of an “unknown unknown” to spoil the applecart (and thanks to Donald Rumsfeld for his contribution to the lexicon of predictive analytics).
Good Cheer and Relief?
The relief rally that began last week would seem to have some seasonal tailwinds to carry it further. The holiday retail season gets underway in a couple weeks, and it is shaping up to be a decent one. The latest batch of job numbers released at the end of last week suggest that higher wages are finally catching up to the rest of the good cheer in labor market data points. Consumer prices are still in check, despite the gradual encroachment of new tariffs onto consumer goods shelves. A good showing between Black Friday, Cyber Monday and the ensuing week or two could keep investors focused on the growth narrative.
Potential headwinds to that growth narrative are also at play, however. The Fed will meet again in the middle of December and is expected to raise rates for the fourth time this year. That by itself is not new news. In their little-publicized (non-press conference) meeting this week the FOMC reiterated confidence in the economy’s growth trajectory, which sets the stage for next month’s likely increase to the Fed funds target rate. What the Cassandra side of the investor world has in its crosshairs now is the US budget deficit, which is positioned to climb above $1 trillion in the near future.
Again – not a new fact, as this figure was well known when the Republicans implemented their sweeping corporate tax cuts one year ago. What is known with more certainty now, though, is that the higher levels of debt servicing that accompany this swelling budget deficit will happen at the same time as interest rates are heading off the floor towards levels closer to historical norms. Now, the newly known fact of a split Congress may mitigate some of the debt concerns – after all, further fiscal profligacy is unlikely in a Congress that will be hard pressed to get even the simplest pieces of legislation passed. And some optimists still maintain (without much in the way of supporting evidence) that the net effect of the tax cuts will be an unleashing of business productivity. But the debt servicing issue has the potential to be a decisive influence on US credit markets heading into 2019, which could mean trouble for risk assets.
The Big Unknown
Now we come to the part of the discussion where the specific risk factors become harder to pin down, but have the potential to overwhelm conventional wisdom. We’re talking about politics – world politics, to be sure, not just US politics. Assets in developed markets typically ignore, or at least give very short shrift to, socio-political developments. Even singular events that at the time seemed momentous – the Cuban missile crisis and the Kennedy assassination in the early 1960s come to mind – scarcely had any effect on prevailing stock market trends. The same goes for Watergate – the losses sustained by US stocks in the summer of 1974 were largely in line with the broader forces at play in a secular bear market that lasted from 1969 to 1982.
Markets don’t ignore these events because they are Pollyanna whistling her merry tune – they ignore them on the basis of a well-grounded assumption that the political institutions of modern developed nation-states are robust enough to withstand the impact of any single imaginable happening. The institutions though – and we are speaking here primarily of the US, the EU and the latter’s soon-to-be divorced partner across the English Channel – are being challenged in ways unknown since the post-Second World War Bretton Woods framework came into being.
How could the further dissolution of Western institutions affect investment portfolios? One can speculate, but with little in the way of hard data for modeling alternative scenarios. It may well be that nothing much impedes on investor sentiment in 2019 beyond the usual store of data regarding economic growth and corporate sales & profits. Those numbers may be strong enough to keep the good times rolling for a while longer. But the tension will likely form at least a part of the contextual background. However the numbers end up, we do not expect calm seas along the way.
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.
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.