Posts tagged Us Equity Market
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.
The unseen world is a very strange place. Quantum mechanics, the physics that describes the way things work at the subatomic level, has been validated as a scientific theory again and again since its discovery in the early 20th century. Quantum mechanical laws perfectly describe the workings of literally everything electronic and technology-related in our lives. For all its mainstream applications, though, the implications of quantum mechanics are positively exotic.
Particles exist here, there and everywhere. Pairs of entangled particles instantaneously affect each other across light years of distance. Single photons display wave interference patterns until observed, at which point the wave collapses into a particle with a definitive position in space. This act of observation informs the standard explanation taught to students of quantum physics. Known as the Copenhagen theory, after the home of pioneering scientist Niels Bohr, it posits that all matter exists in a state of superposition (i.e. here, there and everywhere) until observed, at which point it collapses into recognizable forms like trees, cute puppies and Bloomberg workstations. Don’t try to understand the deeper meaning of the Copenhagen theory. Bohr and his fellow pioneers didn’t. “Just shut up and calculate” is how they, and those following, have instructed every new generation of fresh-faced (and confused) physics students.
Don’t Look Now
The subtext of the Copenhagen theory – that observation creates its own reality – resonates in the present day world of stock market volatility. It has come as a painful lesson to investors who came late to the low-volatility party of late 2017 and took bets that the calm seas would carry on. The chart below shows the price trend for the CBOE VIX, the market’s so-called “fear gauge,” over the past twelve months.
When the VIX jumps in price, as it did towards the end of January, it implies a higher risk environment for equities. To look at the above chart is to surmise that something earth-shaking caused risk to jump nearly overnight as the calendar turned from January to February. And, yet, what actually happened? A jobs report showed that hourly wages had ticked up slightly more than expected in the previous month (2.9 percent versus the consensus estimate of 2.6 percent). An “inflation is back!” meme went viral and off to the races went the VIX. Pity the poor punter holding XIV, an exchange-traded note (ETN) designed to profit from a calm VIX. That ill-fated security lost 94 percent – not a typo – of its value in one day, and the ETN’s fund manager announced that the fund would shut down as a result.
Ninety four percent. On account of one lousy wages number. How could this happen? The answer, dear reader, lies in the observer. Risk is a statistical property, a measurement of variance in price. But – as we can see from securities like that poor XIV – it is also an object, a monetized claim. And that has deep implications for equity and other asset markets.
Goodhardt’s Law and the VIX
Charles Goodhardt was an economist who in 1975 made the following observation: “Once a measure becomes a target, it loses the very properties that made it a good gauge to begin with.” Goodhardt’s Law could also be called the Copenhagen Theory of Market Risk. Once you treat risk – volatility – as an object of buying and selling rather than just as a passive statistical measure, you distort what that measure is telling you. Referring back to the chart above, the world did not change in any meaningful way between Friday, February 2 and Monday, February 5. No macroeconomic statistic other than that one random wage number suggested that the economy had changed in any radical way. And yet if you held an asset on Friday morning betting on things staying more or less the same, you were wiped out by the end of the day the next Monday (even though things had more or less stayed the same). Fundamental risk hadn’t changed. But the perception – the observation – of risk created the reality of a 94 percent price drop.
This fact has profound implications for asset markets. The measurement of risk is absolutely fundamental to the models that have informed the construction of portfolios since Harry Markowitz and William Sharpe pioneered the concepts of mean-variance analysis in the 1950s and 1960s. When that measurement ceases to be a “good gauge,” in Goodhardt’s formulation, the ability to arrive at informed valuations for many other assets is itself at risk. Modern Portfolio Theory is the name given to Markowitz’s and Sharpe’s legacy. Increasingly, though, that legacy has to navigate a postmodern financial marketplace.
It hasn’t been quite the V-shaped recovery of many pundit prognostications. The S&P 500 briefly entered technical correction territory last month, and flirted ever so coquettishly with the 200-day moving average, a key technical trend variable. The ensuing relief rally has seen a couple peaks, but is still climbing the wall back to the record close of 2872 reached on January 26. A month and a half may not seem like a long time – and it’s really not a long time, in the great scheme of things. But other recent pullbacks have done a better job at channeling their inner Taylor Swifts to “shake it off.” The chart below show the pace of the current recovery (leftmost diagram) compared to the brief pullbacks experienced after 2016’s Brexit vote (middle) and the mini-freakout over Ebola in 2014 (right).
So at 42 days, we’re a bit behind the brisk pace of the Brexit (30 days) and Ebola (27 days) pullback-recovery events. But it’s not too much of a stretch to imagine the S&P 500 finding itself scaling the rest of that wall to 2872 in the not so very distant future. Over the course of the current recovery, investors have learned to build an impressive immunity to what one might consider to be bad news. In a sense this is an acquired habit, courtesy of the world’s major central banks.
It Was Just Nine Years Ago Today, Ben Bernanke Taught the Band to Play
Speaking of the “current recovery,” today is its nine year anniversary! Three cheers for the bull. On March 9, 2009 US equity markets hit rock-bottom, more than 50 percent down from their previous highs in the largest market reversal since the Great Depression. Investors in early 2009 were catatonic – many who had managed to keep their heads during the freefalls in September and October of the previous year finally capitulated in March, fearing there was potentially no bottom for risk assets.
Those who held off the demons of fear one last time were rewarded mightily as stocks found solid ground and began the long trek back. But it was not exactly easy street for those first tentative years. 2010 witnessed a handful of significant pullbacks and lots of angst. In 2011 the market flirted with bear territory (20 percent or more down) when the Eurozone crisis accelerated and the US Congress came ever so close to defaulting on the national debt. Other potential black swans lurked in the following years, from government shutdowns to the crash in oil prices to fears of a hard landing in China.
But as each news cycle came and went investors learned to stop worrying. Credit for this learned behavior can confidently be laid at the feet of Ben Bernanke, Mario Draghi, Haruhiko Kuroda and Janet Yellen, along with a supporting cast of dovish policymakers in their respective central banks. The “central bank put” was solidly in the money and increased in value throughout the recovery, even as the US Fed started to lead the way out of monetary Eden as it ended quantitative easing and began to raise rates. The investor calculus was simple: things will work out, and if they don’t, the banks will step in and bail us out. This way of thinking finally led to that unreal calm in the markets in 2017. Even the wackiest of political shenanigans failed to make an imprint on investors trained to embrace the Panglossian assurance of the best of all possible worlds for risk assets.
O Brave New World, That Hath Such Creatures In It
If the central bank put is the magic formula for maintaining calm, what to make of the tea leaves from recent statements by Yellen’s successor, Jerome Powell? The new Fed chair has been largely unimpressed by the recent market volatility and appears to see no reason for soothing bedtime stories to global investors. That should be a good sign: if the economy is doing well on its own, then markets should be able to take in stride the upward movement in interest rates and inflation that one would expect to follow from rising corporate sales and earnings. Nonetheless, it is a brave new world from the recent past.
Taken this way, it makes sense to ascribe the February pullback to nothing of any particular importance. The pullback started with a jobs report that showed wages growing at a 2.9 percent annual rate, higher than the recent trendline of 2.5 percent or so (though not particularly hot by historical standards). Trump threw some new fire on the flames last week with the unexpected announcement of punitive new tariffs on steel and aluminum. But the ingrained tendency to remain calm has largely prevailed. The general thinking on tariffs seems to be that they will fail to ignite an all-out hot trade war. Meanwhile, this morning’s jobs report had a double helping of good news, with a whopping 313,000 payroll gains alongside an underwhelming (therefore good!) average wage gain of 2.6 percent.
What if the wisdom of the crowd is wrong? What if dysfunctional politics and misguided fiscal policymaking still do matter? What if that productivity boom that is supposed to arrive any day now fails to show up, relegating the world economy to sub-par growth as far as the eye can see? Will there be another incarnation of the central bank put? Will it be as effective as it was for the last nine years? All questions without answers, for now. For the time being, though, it would appear that the news cycle will continue to leave investors unimpressed, where the smell of bad news must mean there’s a pony nearby. Your portfolio should enjoy this while it lasts.