Posts tagged Stock Market Volatility
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.
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.
Something interesting happened earlier this week – well, interesting for those who like to read meaning into round numbers. The number in question is 2, as in 2.0 percent, as in the yield on the 3-month US Treasury bill reached on July 18, the first time this widely used proxy for “cash” breached 2 percent since before the 2008 recession. The practical impact of this round-number event, though, is that it extends a trend underway since April; namely, that the yield on cash is now greater than the dividend yield on large cap stocks. The chart below shows the spread between the S&P 500 dividend yield and the 3-month T-bill over the past 5 years. After a yawning chasm for much of the post-recovery period when interest rates were held close to zero, the Fed’s monetary tightening program begun in late 2015 has now closed and reversed the dividend-cash spread.
Meet the New Spread, Same As the Old Spread
There is nothing unusual about cash returns exceeding the dividend yield; it is usually a feature of a recovery cycle. For example, over the course of the growth cycle from 2003-07 the yield on the 3-month Treasury bill was 3.0 percent, compared to a dividend yield on the S&P 500 of 1.7 percent. As we have often noted in these commentaries, though, this most recent growth cycle has been profoundly different. When short term rates started trending up at the end of 2015 the recovery was already five years old. It’s unheard of for interest rates to stay so far below dividend yields until nine years into the recovery.
But, of course, this was no accident. Rates were kept low in order to stimulate risk appetite after the 2008 financial crisis. Essentially, the Fed induced investors to move into riskier assets by making it as economically unattractive as possible to invest in risk-free securities. The European Central Bank of course went even further – they made investors actually pay – via negative interest rates – for the “privilege” of holding Eurozone credit obligations.
Welcome to the Jungle
Now that investors can actually get something in the way of a return on their cash allocations, however modest, market pundits are raising the chatter volume on whether this signals a potential cyclical drift out of equities into safer investments (similar to the very much related concerns about the yield curve we addressed last week). Another way to put the concern is this: can equities and other assets with higher risk properties still be attractive without the explicit inducement by monetary authorities? We’re back in the market jungle and ready to test the survival skills of common shares in the wild, goes this train of thought.
As with any other observation made without the assistance of a fully functioning crystal ball, the answer to that question is “it depends.” What it depends on, primarily, is the other component of value in a share of common stock beyond dividends: capital appreciation. In the chart above, the capital appreciation variable is the dotted crimson line representing the price appreciation in the S&P 500 over this five year period. While getting close to 2 percent each year from dividends, investors enjoyed substantial capital gains as well.
What the spread reversal between cash and dividends does more than anything else is to put paid to the “TINA” mantra – There Is No Alternative (to investing in stocks and other risk assets). The calculus is different now. An investor with modest risk appetite will need to be convinced that the dotted red line in that chart above has more room to move upwards. The dividend component of total return is no longer free money – there is now an alternative to that with a slightly better yield and less risk. The rest will have to come from capital appreciation.
Now, we have argued in recent commentaries that the growth cycle appears durable, given the continuity in macro growth trends and corporate sales & earnings. The numbers still would appear supportive of further capital appreciation. But we also expect that the change in the TINA equation will have an effect on capital flows at the margins. Whatever money is still on the sidelines may be less inclined to come into the market. At the very least, investors on the sidelines skeptical of how much longer the bull has to run will have a better reason to stay put in cash. If enough of them do so it can become a self-fulfilling trend.
The transition from summer to fall is always an interesting time in markets, as a consensus starts to form around what the driving trends of the fourth quarter will be. There’s enough at play right now to make the stakes particularly high this year.
At the beginning of this year we foresaw the potential for a spike in volatility. For awhile back in February and March that looked like a prescient call. Now…maybe not so much. As the predictable humidity settles into the Potomac region it would seem that the only high-octane energy around here is coming from DC’s long-suffering sports fans, celebrating their hockey team’s recent Stanley Cup victory (go Caps!). Risk asset markets, on the other hand, would appear…well, not as risky as they did a couple months back. The chart below shows the CBOE VIX index, a popular measure of market risk, alongside the S&P 500 over the past two years:
Source: MVF Research, FactSet
As we have noted in other commentaries the VIX, as a tradable entity itself, does not necessarily portray an accurate picture of market risk, particularly those Andean spikes that appear out of nowhere when algorithms hit their tripwires and summon forth the legions of trader-bots. But stock indexes appear becalmed as well when looking at internal volatility measures like standard deviation. We’re not quite yet in the valley of last year’s historically somnolent risk levels – but we seem headed that way and not too far off.
Don’t Grumble, Give a Whistle
Why the complacency? Even as we write this, the vaunted group of developed economies that call themselves the G-7 appear to be having a serious failure to communicate. Trade war rhetoric has stepped up following last week’s imposition of steel and aluminum tariffs by the US on its supposed allies including Canada and the EU. Italy, as noted in our commentary last week, is grappling with a political crisis and potentially unstable financial situation. Geopolitics are on the front page with the US-North Korea summit in Singapore fast approaching, to say nothing of the uncertainty around the Iran nuclear deal, the North Atlantic Free Trade Agreement (NAFTA), and growing evidence of China seeking to extend its economic clout in Southeast Asia, Africa and Latin America. There are headlines aplenty (even ones that don’t have to do with Trump’s Twitter account or the musings of some or other comedian) that could keep investors fidgety – and yet they calmly whistle past the bad news on the way to the sunny climes of the volatility valley. The latest bout of buying has lifted the S&P 500 comfortably above the 50-day moving average resistance level, as the above chart shows.
Nothing Else Matters (For Now, Anyway)
Actually, there is a reasonable justification for this midyear complacency, which is that for all the daily noise, not a whole lot has really changed in the macro picture. And what has changed – a little more inflation, a lot more growth in corporate sales and earnings – has largely been benign or downright positive. The tax cuts enacted at the end of last year may have a deleterious effect on the deficit, but such effect will likely not be felt for several years (“several years” being roughly equivalent to “an eternity” in Wall Street-speak). The trade war, should it come to pass, will also likely tend to have a gradual rather than an immediate effect, particularly on the domestic economy.
As for geopolitics – well, the market is extremely proficient in ignoring geopolitical concerns until they actually happen. That’s not a recent phenomenon. British merchant banks were happily extending loans to their German clients in the summer of 1914, even after the assassination of Archduke Ferdinand in Sarajevo. The Great Trade War of 2018, so far anyway, is not conjuring up images of the Schlieffen Plan or entrenched battle lines along the Marne.
The S&P 500 is up about 3.5 percent (in simple price terms) for the year to date. Earnings per share for the companies that make up the index are projected to grow at around 20 percent for the full year, with top line sales coming in at a robust 7.5 percent. That’s pretty agreeable math, and a decent reason to think that a fairly low-vol summer may be in store.