Posts tagged Us Equity Market
The financial news headlines on this, the first Friday of the second half of 2018, seem fitting. Appropriately contradictory, one might say, providing a taste for what may lie ahead in these next six months. First, we have news that Donald Trump’s splendid little trade war is happening, for real now! Tariffs have been slapped on the first $34 billion worth of products imported from China. On the other side of the ledger, an American ship full of soya beans was steaming full-on to reach the Chinese port of Dalian in time to offload its supply before facing the retaliatory tariffs mandated from Beijing. Too bad, so sad, missed the deadline. Apparently the fate of the ship, the Peak Pegasus, was all the rage on Chinese social media. The trade war will be Twitterized.
The second headline today, of course, was another month of bang-up jobs numbers led by 213K worth of payroll gains (and upward revisions for prior months). Even the labor force participation rate, a more structural reading of labor market health, ticked up (more people coming back into the jobs pool is also why the headline unemployment rate nudged up a tad from 3.8 to 4.0 percent). Hourly wages, a closely followed metric as a sign of potential inflation, recorded another modest year-on-year gain of 2.7 percent.
So there it is: the economy continues to carry on in good health, much as before, but the trade war has moved from the theoretical periphery to the actual center. How is this going to play out in asset markets?
Manufacturers Feel the Pain
The products covered by this first round of $34 billion in tariffs are not the ones that tend to show up in Wal-Mart or Best Buy – so the practical impact of the trade war will not yet be fully felt on the US consumer. The products on this first list include mostly manufacturing components like industrial lathes, heating equipment, oil and gas drilling platform parts and harvester-thresher combines. If you look at that list and think “Hmm, I wonder how that affects companies like Caterpillar, John Deere and Boeing” – well, you can see for yourself by looking at the troubled performance of these companies’ shares in the stock market. As of today those components will cost US manufacturers 25 percent more than they did yesterday. That’s a lot of pressure on profit margins, not to mention the added expense of time and money in trying to figure out how to reconfigure supply chains and locate alternative vendor sources.
Consumers Up Next
The question – and probably one of the keys to whether this trade war inflicts real damage on risk asset portfolios – is whether the next slates of tariffs move from theoretical to actual. These are the lists that will affect you and me as consumers. In total, the US has drawn up lists amounting to $500 billion in tariffs for Chinese imports. In 2017 the US imported $505 billion from China – we’re basically talking about the sum total of everything with a “Made in China” label on it. Consumers will feel the pain.
If it comes to pass. The collective wisdom of investors today has not yet bought into the inevitability of an all-out trade war. US stocks are on track to notch decent gains for this first week of the second half. The job numbers seem to be holding the upper hand in terms of investor sentiment. Sell-side equity analysts have not made meaningful downward revisions to their sunny outlook for corporate sales and earnings. Sales for S&P 500 companies are expected to grow at a rate of 7.3 percent this year. That reflects an improved assessment from the 6.5 percent those same analysts were projecting three months ago – before the trade war heated up. The good times, apparently, can continue to roll.
Since we haven’t had a global trade war since the 1920s, we can’t model out just how these tariffs, in part or in full, will impact the global economy. Maybe the positive headline macro numbers, along with healthy corporate sales and profits, can power through this. Perhaps the trade war will turn out to be little more than a tempest in a teapot. We may be about to find out.
Did you hear the news this week? General Electric, one of the world’s oldest going concerns, was dropped from its august perch in the Dow Jones Industrial Average. That index of 30 companies will no longer include the only company still in business today that was a constituent member of the Dow Twelve – the companies Charles Dow fashioned into a market index back in 1896. GE will be replaced by Walgreens, which is probably not a bad idea since retail pharmacy is currently under-represented in the index (Wal-Mart being the only company in the heretofore 30 where you can get a prescription filled).
As with just about anything Dow-related, though, the news about GE and Walgreens matters more for stock market historians and storytellers than it does for actual investors.
A Quaint Relic
To the mind of the typical retail investor, “the Dow” is interchangeable with “the market.” Round number days on this index – when it, say, breaks 20,000 for the first time – are feted like national holidays in the financial media. When the stock market experienced a technical correction earlier this year, commentators were breathless with the report that the Dow had fallen by more points (1,179 to be exact) than ever before in its history.
None of which matters for any reason other than idle water cooler gossip. In fact, the media’s fixation on the Dow’s points loss on February 5 was not only pointless, but potentially harmful if it induced anyone to actually sell out in a panic. The percentage loss corresponding to that decline of 1,179 points was nowhere close to the all-time record loss of 22 percent, on October 19 1987.
Yes, it’s fun to study the Dow to gain a perspective on how the US economy has evolved over the last 122 years. It’s nice to arrive at cocktail parties armed with trivia like Distilling & Cattle Feeding or Standard Rope & Twine (two of the original twelve companies that didn’t have quite the staying power of GE). But that’s where the usefulness ends. Consider the fact that of today’s market-moving FAANG companies (Facebook, Amazon, Apple, Netflix and Google) only one – Apple – is represented in the Dow. Technology stocks make up about 25 percent of the total market capitalization of the S&P 500 (and an even greater percentage of the NASDAQ Composite). The tech names represented on the Dow – Apple, IBM, Cisco Systems, Microsoft and Visa – are not exactly unimportant, but they are less representative of the full spectrum of what is arguably the most influential sector of the US economy in 2018.
Price of Everything, Value of Nothing
The other major problem with the Dow, in addition to the somewhat arbitrary and backward-looking nature of the 30 constituent names, is the way the index’s performance is calculated. Whereas the S&P 500, NASDAQ and most other broad market indexes calculate performance based on market capitalization (number of shares outstanding times share price), the Dow is a price-based index. This means adding up all the share prices of the 30 stocks and dividing them by a divisor (which changes over time to reflect share splits, share dividends and the like).
The basic flaw in the price methodology is that it gives stocks with a higher price more impact on returns than stocks with a lower price. If Company A has a stock price of $100 and Company B has a stock price of $10, then Company A’s share price movements have a bigger impact on the index than those of Company B. But those raw share prices tell you absolutely nothing about the economics of either company. If Company A has 1,000 shares of stock outstanding and Company B has 10,000 shares of stock outstanding then both companies have the same market capitalization -- $100,000. In a market cap-weighted index like the S&P 500 their share price movements would have the same impact, not the skewed outcomes they produce on a price index like the Dow.
Here Today, Here Tomorrow
Of course, we do realize that all our carping about the Dow Jones Industrial Average will not stop it from being “the market” in the popular lexicon. Humans gonna be humans, after all. And that’s fine, as long as you make sure that your actual portfolio pays more attention to today’s economy than to the colorful past chapters of US stock market history. Now, there are times, of course, when the Dow will outperform the broader benchmarks, and there are times when it will underperform. As the chart below shows, right now is one of those times when it is underperforming – actually in negative territory for the year to date while both the S&P 500 and the NASDAQ Composite are in the black.
It’s a nice bit of history, but there’s no reason to have it in your portfolio. Exposure to large cap US stocks is best achieved through a broad market cap index like the S&P 500 or the Russell 1000. Adding other distinct asset classes like small caps, developed and emerging international equities can help achieve long term risk-adjusted return goals. That’s prudent diversification, to which the Dow is just a frivolous sideshow. A fun sideshow (hello, Nash Motors, inductee of 1932!), but a sideshow all the same.
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.
It’s a very good thing for US large cap equity investors that consumer staples companies make up only 7.4 percent of the S&P 500’s total market cap, while the tech sector accounts for 25.4% of the index. The chart below shows why.
Tech stocks have outperformed the market for most of the year to date, while consumer staples have experienced a miserable couple of quarters. Here’s where those market cap discrepancies really matter: the fact that tech stocks make up a quarter of the total index means that their performance “counts” for more (we explained this in one of our commentaries a couple months ago). So, even though the magnitude of underperformance for consumer staples is greater than that of tech’s outperformance, the heavyweight sector pulls up the broad market (the dotted red line represents the total S&P 500) and, for the moment anyway, keeps it in positive territory.
So what’s going on with consumer staples? By one yardstick – market volatility – the sector might have been expected to outperform over the past couple months. Consumer staples has long been regarded as a defensive sector, i.e. one which tends to do better when investors get jittery. The logic is easy to follow. A volatile market signals uncertainty about the economy, which in turn leads to households tightening their budgets. So things like expensive vacations and designer labels (which would show up in the consumer discretionary sector) get the axe, but folks still have to buy toothpaste and breakfast cereal (which are manufactured, distributed and retailed by consumer staples companies like General Mills, Sysco and Costco).
But two technical corrections of more than 10 percent didn’t send investors flocking into defensive stocks. Other traditional defensives, such as utilities, also fared relatively poorly during this period. There is one driving variable common to a variety of traditional defensives, which is rising interest rates. But there are a couple others that are particularly relevant to the woes in consumer staples.
Hard Times for Dividend Aristocrats
The connection between interest rates and defensive stocks is fairly straightforward. These stocks tend to have higher dividend payouts than more growth-oriented shares. For example, the average dividend yield in the consumer staples sector is around 3.1 percent, compared to an average yield of 1.8 percent for the S&P 500 as a whole. The relative attraction of dividends diminishes when income yields on high quality fixed income securities (like Treasury bonds) increase. This relationship is then exaggerated to an even greater extent by the abundance of algorithmic trading strategies that mindlessly key off small changes in rates, sending cascades of buy and sell orders beyond what many would see as the actual fundamental value shift.
The Worst of Times
Two other variables with a particularly pernicious effect on consumer goods companies are inflation and changing demand patterns. These variables are closely related. While inflation is still relatively low by historical standards, it has ticked up in recent months. Cost inflation – basically, higher input costs for the raw materials and the labor that go into the manufacture of consumer goods – puts downward pressure on profit margins. If companies can pass those cost increases on down the value chain – i.e. from manufacturer to distributor to retailer to end consumer – then they can contain the effect of cost inflation. But that means, ultimately, having consumers willing to pay up for the staple items they buy from week to week. And this is where that second variable – demand patterns – comes into play.
Simply put, consumers have become pickier about what they buy and how they buy, and they have a far greater spectrum of choices from which to curate their own particular needs and preferences. Time was, the weekly shopping cart was pretty predictable in terms of the packaged goods with which Mom and Dad filled it up, and also where the shelves containing those goods were located. Established brands carried a premium that was a predictable source of value for the likes of Procter & Gamble, Coca-Cola or Kraft Foods. That brand premium value hasn’t disappeared – but it has become diluted through an often bewildering assortment of products, categories and messaging. The emotional tie between a consumer and a favorite brand dissipates when the products and the messaging are constantly changing, popping into and out of existence like quantum matter.
That dynamic makes it much harder, in turn, for companies to convince their customers to accept the passing on of cost inflation. The logical outcome is lower margins, which have been the wet blanket souring quarterly earnings calls this year. Unfortunately for the companies in this sector, these are not problems that are likely to disappear with the next turn in the business cycle. Even the elite leaders, such as P&G and Unilever, have daunting challenges ahead as they try to leverage their storied pasts into the unforgiving environment of today.
We’ve sort of gotten into the habit of referring to the 2018 equity market pullback in the past tense, which is not technically correct as the S&P 500 still languishes around 7 percent below its late-January record high. But the sense of drama that accompanied those big plunges in February in March, alongside the breathless narrative of a global trade war, is no longer clear and present. Is it too early to do a post-mortem and contemplate what may lie ahead? That’s entirely possible – whatever the market decides to do on May Day and the rest of next week is as murky as always. Nonetheless, we have our forensic tools out and will do a little dissecting of the present state of things. As volatile as things have been, this has so far been a remarkably well-behaved little correction.
Highly Relevant Nonsense
Perhaps nowhere is this well-tempered aspect more visible than in the market’s price performance vis a vis its technical moving averages, particularly the 50-day and 200-day averages. Now, we have made the point before and we will make it again: there is nothing magical or transcendental about moving averages. They are just methodical calculations. But they are given relevance because short-term trading strategies make them relevant – another example of the “observation affects reality” phenomenon we have described in other recent commentaries. The chart below shows the year-to-date performance of the S&P 500 along with the 50- and 200-day averages, and also the yield on the 10-year Treasury (which we will discuss in further detail below).
The 200-day moving average often serves as a support level. Technical traders get worried when the market breaches this downside support and fails to reestablish a position above it. No such worries this time: the index breached the 200-day average a handful of times in intraday trading but only closed once below it. Enough of those algo strategies were wired to kick in at this level, and there wasn’t enough prevailing negative sentiment to push prices into further negative territory. This played out most recently during this past week.
Our takeaway message from this is more or less what we’ve been saying throughout this period; namely that the catalyzing X-factors of this pullback – first the inflation fears after the February jobs report and then the new US tariffs – weren’t convincing enough to detract from the background narrative of continuing global growth and healthy corporate earnings.
On the other hand, though, the S&P 500 has had a similarly hard time staying above the resistance level of the 50-day moving average. Sentiment then, while not bearish, is also not wildly bullish. Investors wanting to see a clear “W” shape emerging from the pullback may have to bide their time for a while longer, or at least until the momentum strategy funds that got burned in February have worked through all their pain trades and those moving averages become less relevant to the daily flow of things.
Stocks and Bonds: Not Quite a Pas de Deux
Another observation that’s done a few laps on the financial pundit circuit recently is the idea that stock prices and bond yields have been moving in the same direction for much of the year. Well, sort of. In the aggregate that observation is clearly not true: stock prices are struggling to break even for the year to date, while the 10-year Treasury yield is up sharply from where it was in early January. But the chart above does show some degree of correlation during different sub-periods, most especially in the first three weeks of January when they did seem to move almost in tandem. Yields also reverted to traditional safe haven behavior during the second (trade war) prong of the pullback in mid-late March.
The correlation pattern diverged more prominently during the S&P 500’s mini-retreat of late last week and the first half of this week. The 10-year yield spiked to puncture the 3 percent level for the first time since 2014. Meanwhile, stocks fell back as investors, digesting a healthy stream of corporate earnings, did their best impression of a bratty kid who didn’t get the exact Christmas present he was expecting. “Peak quarter” seems to be the phrase of the day: the idea that this is about as good as it will get, even though the hard evidence for that glass half empty conclusion appears sparse.
What’s the overall takeaway? There’s a whiff of 2015 in the air. In that year stock prices set a record high in May and didn’t break new high ground until June of the following year (ironically, in the immediate aftermath of the Brexit vote, go figure). Cautious sentiment – neither pessimistic nor optimistic – may keep share prices in a sideways pattern. Those silly moving averages may continue to restrain directional breakouts. This kind of environment often suggests a return to quality, where things like free cash flow and debt ratios actually matter again and careful stock selection can pay off.
Then again, none of that could be true. If there’s anything one learns over the days and years in this profession, it is to always expect the unexpected.