Posts tagged Stock Market Volatility
It wasn’t all that long ago that Davos Week was a big deal. Confident, important communiqués about the state of the world delivered by important, impeccably tailored men (and a few women here and there). The rest of the world’s inhabitants might live out their quotidian habits in a perpetual fog, but the great and good who assembled in the little Swiss Alpine town every January were there to tell us that it was all going to be okay, that the wonders of the global wealth machine would soon be trickling their way. Now the fog has enshrouded them as well. While their status as influencers was getting sucked down into the lowest-common-denominator Twitterverse, their ability to explain the great trends of the day was upended by the improbable turn those trends were taking away from the comfortable Washington Consensus globalism of years past. “The mood here is subdued, cautious and apprehensive” reports Washington Post columnist (and Davos Man in good standing) Fareed Zakaria from the snowy slopes this year. Apprehensive, not confident, which is an apt way to sum up the present mindset of the world.
Never Underestimate the Power of Kick the Can
Yet, for all the fretting and fussing among the stewards of the world’s wealth pile, some of the key risks that have been plaguing investors in recent weeks seem to be turning rather benign. Consider as Exhibit A the state of the British pound, shown versus the US dollar in the chart below.
The pound has rallied strongly since plummeting in early December last year. If you go back and track the history of Brexit negotiations since that time, you find that the actual news about a Brexit resolution is almost all dismal. The deal PM Theresa May brought back from Brussels was panned as soon as it reached Westminster; that same deal formally went down to one of the most ignominious defeats in UK parliamentary history last week.
All the while – the pound sterling has rallied! Why? Because the Brexit deal’s unpopularity means that there are only two ways this whole sorry affair plays out between now and March, when the Article 50 deadline comes into effect. One is that the UK crashes hard out of the EU, which would be a disaster for the country. The other – and far and away the most likely, is to kick the can down the road. Extend the Article 50 deadline, probably to the end of the year, and see what kind of fudge can be worked out between now and then. Maybe (most likely, as we have been saying for some time now) a second referendum that scotches Brexit for once and all. Maybe something else. Maybe someone has to make a bold decision at some point. But not yet, not yet, as that fellow said in “Gladiator.” Thus the strong pound.
March Without the Madness
The month of March has in fact been looming large over Davos think-fests and cocktail parties this week. In addition to Article 50, there is that self-imposed deadline by Washington’s trade warriors to reach some kind of deal with China on the terms of cooperation going forward – absent which, according to Trump’s protectionist acolytes, there would be hell to pay in the form of new tariffs. Yet as the days go on, the evidence mounts that this administration’s tough talk on any number of fronts is all hat and no cowboy. This administration has plenty of other troubles with which to contend, and by now they know that actually following through with tough trade rhetoric will spark another pullback in the stock market. We don’t think it’s being Pollyanna to say that this trade showdown at high noon will likely not come to pass.
Finally, the other risk event that could befall markets after the Ides of March would be the Fed meeting that month with the potential for another interest rate hike. While that is a possibility, the Fed’s actions in recent weeks have been very cautious and non-confrontational with edgy markets. Recent inflation numbers have come in a bit below expectations. We’ll see what happens with Q4 GDP next week, but indications are that it will settle back somewhere in the 2-plus percent real growth range. In other words, the Fed will have plenty of flexibility if it decides to join in with the kick the can fun and hold off until next time. Even on the question of the Fed’s balance sheet there have been some recent indications that it may not wind down as quickly or deeply as previously thought.
“Never make tough decisions today that you can punt down the field for later” – this instinct is alive and well in the world of global policymaking. As long as that remains the case, Davos Man, you should take a deep breath and go back to enjoying your cocktails and canapés.
What do global capital markets and the Warrumbungle National Park in New South Wales, Australia have in common? Topology, for one. In the chart below we have juxtaposed an image of one of the best-known features of Warrumbungle, known affectionately as the Breadknife, with yesterday’s price trend graph for the S&P 500. The similarity, we think you will appreciate, is remarkable.
The Topology of the Twitterverse
What exactly was it, shortly after 2:30 pm on Thursday, that sent the broad-based US stock index into its best imitation of an eastern Australian rock formation? Something on Twitter, of course, because that is where most news headlines land a few microseconds before they make it into the pixelated pages of mainstream news outlets. The little item in question was a report from Steve Mnuchin’s Treasury Department suggesting that sanctions on China should be lifted in order to encourage a settling of the trade dispute between the US and China. The chronology goes thus: a snippet of the Treasury report made its way onto Twitter, where it was gobbled up by a vast gaggle of tradebots that feed solely off the effluvia and attendant waste products of social media. Stock prices jumped by some three quarters of a percent from where they had hitherto been ambling along.
Almost immediately afterwards came a countervailing comment from Robert Lighthizer, the US Trade Representative, throwing cold water on the idea that sanctions should be lifted. The White House, for what it’s worth, chimed in to quash the idea that lifting sanctions was a possibility in the immediate future (it’s worth noting that the only other meaningful piece of trade-related news earlier in the day was a report that the US, in trying to pressure the EU to buy more agricultural products to offset declining exports to China, was thinking of slapping some new tariffs on automobile imports). The Breadknife crested and shaped the contours of its downward slope back close to where it had begun. Trading ended on a reasonably optimistic note because, apparently, the winning theme was “if someone’s even talking about sanctions at all it must mean the atmospherics are a bit better than they were.” Or something to that effect. Win!
Life In Volatile Times
To be clear: there was technically no news – nothing of any substantial meaning – that transpired between 2:30 pm and the banging of the antique gavel on the floor of the New York Stock Exchange at 4 pm with whatever invitees of the day slow-clapping the close of another trading session. Nothing to merit that Breadknife of 75 basis points up and down. So it goes in a jittery market where rumors, counter-rumors and the sudden catalyzing of vague sentiments one way or the other drive share volumes on any given day. For most of the year thus far (all two weeks and change of it) the prevailing sentiment has been mostly of the glass half full variety. Last month was quite the opposite, where every little X-factor that bubbled to the surface on any given day was a raven foretelling the imminent arrival of the Four Horsemen of the Apocalypse. Expect more of these back-and-forth reels as the year goes on.
Early next week we will be releasing our 2019 Annual Outlook, the main theme of which is that the principal characteristic of risk assets this year is likely to be volatility. Volatility goes up and volatility goes down – just like the Breadknife in Warrumbungle National Park. When markets gyrate excessively in response to the continuous stream of drivel that courses through the Twitterverse, what matters most is staying disciplined and focused on the things that do matter.
In May 2018 the US economy achieved a milestone of sorts, outlasting the growth cycle of 1961 to 1969 to become the second-longest expansion in the country’s history. In 2019 an even more auspicious accomplishment is in sight. If the economy does not experience a recession between January and July of this year it will become the longest-ever expansion, supplanting the decade of growth enjoyed between 1991 and 2001. From where we sit today, the odds appear rather strongly in favor of July arriving without a recession along the way. Indeed, for a recession to officially begin as early as July we would need to be experiencing nearly uninterrupted negative GDP growth between now and then – a possibility that would appear remote to the point of being negligible. Barring the catastrophically unexpected, this recovery looks set to claim the gold medal for longevity, if for nothing else.
What Have You Done For Me Lately?
Not that we should expect investment markets to be toasting the newly-minted longest-ever recovery with Champagne and noisemakers, though. Markets are forward-looking by nature, and they are already looking well past July in anticipation of when this economic cycle does turn. In some corners of the developed world outside the US, initial signs of the turn are already at hand. Five developed-market economies – Germany, Japan, Italy, Switzerland and Sweden – saw negative GDP growth in the third quarter of 2018. The IMF has lowered its outlook on global growth in 2019. At 3.7 percent the outlook is still relatively rosy, but the effects of slowing international trade, including the potential impact of a trade war yet to be actualized, give cause for concern. As the effects of fiscal stimulus in the US wear off, the persistent absence of meaningful growth in productivity – the one viable source of long-term growth – will come back into focus.
As the World Turns
There is a growing dissonance between markets and the economy based on deeper issues than headline macro data and other short-term sentiment drivers. There is a case to make that the world is in the early stages of a transition not unlike the unraveling of the Bretton Woods framework that guided the global economy’s first quarter century after the end of the Second World War. By the late 1960s the US was losing its grip as the great stabilizing force of the world economy. The waning of US preeminence was underscored when then-president Nixon took the US off the gold exchange standard in August 1971. What ensued for the next decade was a period of great uncertainty, including four recessions of varying degrees of intensity with persistently high unemployment accompanied by soaring inflation. Equities fell in and out of bear market territory, finishing this miserable stretch more or less where they began it – in nominal terms, that is. On an inflation-adjusted purchasing power basis, an investor in a basket of S&P 500 stocks was much worse off at the end of this cycle than he or she was at the beginning.
Eventually the fog of uncertainty lifted and the era of what former Fed chair Ben Bernanke termed the “Great Moderation” began. Neoliberal politics and relatively unfettered global capitalism – known as the “Washington Consensus” – flourished as the dominant model for the next quarter century. That model got its comeuppance with the 2008 market crash and deep recession. The institutions emblematic of the Washington Consensus have become increasingly strained. As in the early 1970s, there is a sense that what worked once is no longer working. And, likewise, a growing uncertainty about what comes next.
We believe heightened volatility will be the principal characteristic of asset markets in 2019. Volatility cuts both ways – up and down – meaning that predictions about market directional trends will be subject to high amounts of variability. Developments to which markets typically pay little heed – including political dysfunction and foreign policy crises – potentially will come under greater scrutiny. Outside the US, China and the EU may be sources of increased instability. Risk spreads are positioned to widen between benchmark government credit and various tiers of corporate, mortgage-backed and other debt types. The corporate debt market could be particularly tricky, and we will be paying close attention to trends in lower-investment grade paper. Central banks will be following these developments closely and may turn more dovish than expected in efforts to mitigate the impact on global markets. What central banks do – and do not do – will in turn influence investor sentiment back and forth between risk-on and risk-off. Currency and commodity markets will likely find themselves in the cross-winds of these sentiment shifts – again, volatile swings have the potential to impede the formation of durable directional trends.
Reasons (Maybe) to Smile
A prediction for heightened volatility does not necessarily translate into a doom-and-gloom outlook. For starters, we do not see compelling evidence of imminent financial risks on par with those that catalyzed the massive market sell-offs in 2000-02 (absurd asset valuations) or 2007-09 (overleveraged and intertwined credit markets). Valuations, in fact, are relatively attractive: the S&P 500 price-to-sales (P/S) ratio is currently below its 5-year average on both a twelve trailing months and forecasted basis. With the consensus forecast for FY 2019 sales still in the mid-high single digits, there are buying opportunities aplenty for investors willing to look past the short-term fury of the past two months.
Inflation – or rather its absence – could be another positive influence in the months ahead. The Core Personal Consumption Expenditures (PCE) index, which is the Fed’s preferred inflation gauge, has remained fairly closely tethered to the central bank’s two percent target in recent months, with little upward pressure thus far from continued tightness in the labor market. As long as inflation remains in check, the Fed will have flexibility to pause its monetary policy tightening in response to other potential developments, without increasing the risk of overheating the economy.
Finally, one wild-card boost to sentiment (though relatively limited in terms of real economic impact) could come between now and March if UK Prime Minister Theresa May’s government manages to either succeed in bringing about a second referendum on Brexit (i.e. with the potential to avoid Brexit altogether) or at least push the March deadline for Article 50 down the road. As things stand right now the only viable options on the table are a deal loved by precisely nobody, or a hard crash out of the EU with potentially dire economic and social consequences for Britain. Popular support for a second referendum has grown markedly, offering at least some hope that Britons may wake up, breathe a sigh of relief and say “it was all just a bad dream.”
The Big Unknown, Even Bigger
Any such positive X-factors as may emerge will, however, have to contend with plenty of negative possibilities. In our view the biggest of these resides at 1600 Pennsylvania Avenue. We say this with no regard whatsoever for ideological reasons or personal preferences, but simply as an assessment of the current power dynamics in Washington and sufficient existing evidence of a willing recklessness on the part of this administration with scant regard for consequences. Global trade, geopolitics and the independence of the Federal Reserve are examples of where and how what happens in Washington could matter to markets far more than is typically the case. Markets are used to political dysfunction as long as it stays within the sausage-making policy factory inside the Beltway. That assumption worked in 2017, but it has steadily unraveled since.
In conclusion: while the direction of risk assets in 2019 could plausibly end the year in either positive or negative territory, we believe the going will be bumpier than usual. If we truly are in the early stages of a tectonic shift in the socio-economic environment similar to what happened in the late 1960s, then there will potentially be an increased tendency to interpret new information through a glass-half-empty rather than half-full perspective. There will be opportunities, but it will be harder to capitalize on emergent trends in the presence of higher volatility – and this could well be equally true for equity, credit and alternative asset classes. In this environment we believe a more defensive position is warranted than one year ago, and that careful diversification among both riskier and low-risk portfolio segments can help buffer the impact of multiple cross-winds.
If you are a regular reader of our weekly column you may recall a somewhat nitpicky piece we penned back in August called “What Record Bull?” where we took issue with the much-trumpeted theme in the financial press that week about the apparent new longest-ever bull market. It wasn’t, as we took pains to point out. During the recession of 1990 the S&P 500 came ever so close to that 20 percent bear market threshold, surrendering 19.9 percent from its previous high. But it didn’t cross over the threshold, leaving the bull market that began in December 1987 fully intact until the dot-com implosion of 2000.
Market Corrections Don’t Repeat, But They Do Rhyme
And so, the events of this week. On December 24 US stocks had their worst Christmas Eve ever, to cap of the worst (to then) December since the dark days of 1931, in the middle of the Great Depression. At the end of that trading day the S&P 500 was down 19.8 percent. Just like 1990 – and a handful of other occasions, as we will illustrate in the chart below – the broad-based US large cap index approached, but did not cross, the threshold into bear territory. “Just shy of 20 percent,” be that 19.8 or 19.9 or 19.7, seems to be a regular visitor to market correction events.
Sometimes this just-shy-of-bear phenomenon happens during a recession, as in 1990. Sometimes it happens when the economy is holding up but other factors muddy the waters, as in 1998 (Russian debt default and LTCM collapse), 2011 (Eurozone crisis) and now 2018 (political uncertainty, trade war and whatever else). And there are, of course, the exceptions, arguably the most striking being the one day in October, 1987 when the market lost 22 percent in the course of one trading day. The two bear markets of 2000-02 and 2007-09 witnessed both recessions and specific financial crises, as we pointed out in a column several weeks ago.
The Importance of Silly Numbers
These thresholds – 10 percent for a correction, 20 percent for a bear market – are not meaningful in and of themselves. An investor’s mood is unlikely to improve much if you tell her that her stock portfolio is down ONLY 19.9 percent rather than 20.1 percent. As silly as these arbitrary definitions are, though, they do matter. They matter because the preponderance of trading volume out there on any given day is wired to trade off them. Think about what happened on December 26, the next trading day after Black Christmas Eve. Twice during the morning session the market tested the 19.8 percent support level, and then it surged in an insane rally to close the day up more than four percent.
A rational person might ask, what happened in the world to suddenly make the projected future cash flows of S&P 500 companies that much less, or that much more, valuable in such a short period of time. The answer is: absolutely nothing. These movements are all noise, no signal. More than three quarters of the total trading volume on any given day is driven by algorithms programmed to react to specific trigger events. It doesn’t “mean” anything that sellers put the brakes on as prices converge on that minus 20 percent support threshold. That’s just a particularly prominent trigger, and it was busy at work on both 12/24 and 12/26.
Spin the Wheel
Trying to game the system in these short term bouts of spasmodic price lurches might be fun for people who enjoy rolling the dice. But since the likely payoff is more or less the same as rolling actual dice on an actual craps table – why not just head out to Las Vegas and do exactly that, with a nice meal and fun entertainment afterwards? A prudent long term investment strategy, on the other hand, blocks out the noise to the extent possible and focuses on the factors that matter for each investor’s particular goals around growth and risk mitigation.
We wish our clients and friends a very happy New Year, with joy and good health in the year ahead.
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.