As we noted in these pages at the beginning of last week, we find it simply remarkable how quick the market’s mood can change against a fluid and stressed environment like the recent two months. Entering the week, the stars seemed to be aligning for those hopeful a more dovish Fed and collaborative tone between the US and China over ongoing friction about trade might develop. As recent as last Monday, optimists were starting to feel as if the storm clouds were receding during the final week of November, and a much longed-for Santa Rally in December might be starting to take shape. Then, with seemingly little warning, the bears were awakened again with declines throughout the balance of the week. The carnage began to unfold Tuesday, with blame by the media mostly being attributed to investors having second thoughts about the trade truce with China, although less recognized was a troubling development in Europe with British Prime Minister May suffering a setback in her government and undermining the Brexit proposals. We also believe that the inversion of the yield curve among some shorter maturities likely triggered indiscriminate and heavy risk-off program selling of US equities exacerbating any fundamental concerns. Despite the tail end of a strong multi-day rally on Monday, and the market being closed in honor of the passing of the 41st President Bush on Wednesday, the major US indexes still found themselves -4.6% in the hole to conclude the first week of December. From a psychological standpoint, the market backdrop is feeling increasingly pessimistic. Most challenging however is for investors to try and keep in mind how quickly the environment could take a turn for the better again seeing as how so many of the worries are “man-made” and policy-related.
All the historical hype surrounding favorable mid-term election year investment returns is yet to materialize as we conclude 2018. Since 1950, every mid-term election (17 of them) resulted in strong end-of-year stock performance because the unknown of political change concluded. A different stock market stat, again since 1950, reflects that 75% of December returns are positive; that is the highest single month probability of upward performance for any of the 12 months (next highest is April at 71%, and November with 68% of the time being positive – see chart below). This year, the 4Q experience to-date seems stark opposite.
In our November market commentary entitled “Shake or Break”, as well as periodic updates in recent weeks, we’ve spoke extensively about how the market’s October swoon and elevated volatility were not without justification. The sudden awakening by investors following conclusion of the 3Q can be linked to persistent worries that the economic strength being witnessed in the US for 2018 might be “as good as it gets”, set to fade as we anniversary tax reform; when paired with the lack of constructive progress between Trump and China over trade and the Fed communicating in a way that felt decreasingly data-dependent and instead on autopilot with respect to additional interest rate hikes it makes sense why so many market participants were in bad moods. We’ve stated throughout the duration of this corrective phase that the economic data in the US remained supportive and the probability of recession in the near-term would still appear remote. But the financial markets needed to quickly see a more conciliatory tone begin to develop from both Trump and Fed Chairman Powell before further psychological confidence damage and any meaningful stock market recovery could develop. That’s exactly what we received last week and financial markets responded strongly with their best week in two years.
Domestic equity markets remain up +1.1% in November, but the sailing is anything but smooth. The S&P500, along with most international markets, struggled for direction throughout most of last week. In fact, most days were characterized by sharp reversals – either beginning a session favorably but bleed throughout the day; or sharply negative only to bounce higher. Short-term intra-day reversals are just one symptom of a market that is uncertain how to reconcile still strong US data, against signs that same data may be peaking or is at risk if various policy stress points such as trade or interest rate policy do not diminish soon.
At the end of October, one could almost gather that a some modest relief was returning to the financial markets as the ugly but much anticipated US midterm election drew near and uncertainty over its outcome would be no more. As it turned out, election day generally went as predicted by political pundits – that Democrats would take back the house, but Republicans could hold their majority in the Senate. The fracture of Republican control renews what is often referred to as political gridlock. Citizens will often complain about gridlock or political dysfunction, but investors see it more favorably because the probability of significant policy changes are perceived lower when political parties are at odds with each other. In this day, it also mostly removes the possibility of Democrats pursuing impeachment of Trump or a wholesale rollback of policies implemented during his first two years (which would not in any way be market friendly). On the split-power result, US equities enjoyed a strong start to the week and post-election bounce on Wednesday. That bounce, which led some to cheer that a hoped-for 4Q rally might now get underway, were cooled Thursday and Friday as the Federal reserve reiterated its intent to continue raising interest rates. Still, the strength by markets early in the week was enough to help the S&P500 conclude firmly in positive territory for the week with an advance of +2.2% on the S&P500.
Shake or bake; not! Shake and/or Break is a fitting title for the frightful market action in October. Markets may “shake” because of tariffs. But, the Fed can cause the market “break.”
Much of the blame for October is aimed at President Trump and/or Federal Reserve Chairman Powell. Investors are concerned that the Fed remains inclined to raise interest rates further – 1 more hike in December, and presently communicates 3 additional times in 2019. There are even forecasts of one more rate increase planned in 2020. Investors are also concerned about tariffs because they are like a tax to American citizens. Both issues are viewed as punitive to economic growth over the next 12 months. Some wonder if the recent economic strength is “as good as it gets.” That suggests that economic and business growth will be shifting into slow expansion again (even though this expansion will become the longest running in US history next year). The economy is probably able to handle slow rising interest rates, to a point. But the stock market will show stress earlier, as witnessed by action in October. In essence, the market tone was altered due to these two concerns. Again, markets may “shake” because of tariffs; but markets could “break” because of the Fed.
In recent days we executed several tactical adjustments in the fixed-income sleeve of client portfolios. We sold or reduced exposure to short-maturity bond funds and reinvested proceeds into position-traded money funds. These adjustments take advantage of attractive yields available on short-term money funds relative to the variable return potential on short-maturity bonds in a rising interest rate environment.
One word comes to mind when thinking of the drawdown endured in October: relentless. It was the worst month for US investors years with 16 of the 23 trading sessions during the month being negative. Worse than that, since the S&P500 made its last all-time high on September 20, 75% of all trading days were negative and the major US stock indexes flirted with technical correction – a term defined by a drawdown of -10% or more. The retreat was most severe in those areas of the stock market that to this point, performed the strongest. “FAANG” names (Facebook, Amazon, Apple, Netflix, and Google) were punished one after the next for either softer-than-hoped quarterly earnings or more sober forecasts of quarters to come. As bad as it was, perhaps the most discouraging development was that diversification provided almost no relief. Even the safest of bonds, which historically offered investors a destination of safety and could be counted on to rise during times of severe market stress, also forfeited ground during the month muting their benefit. International equities, of course more risky than bonds but experiencing troubled times throughout most of 2018 fared even worse than domestic (how much further can they fall?!). One story appearing in the Wall Street Journal went so far as to call diversification “dead”.
We last wrote a “Market Alert” about large stock market movements on August 24, 2015. That fact in itself highlights that it’s been an infrequent occurrence over much of the past two years that investors felt much discomfort. Large market swings or accelerated volatility in stock prices is never a welcome experience – even if we admit they are more common than witnessed throughout much of 2016 or all of 2017. Even long-term investors who are aggressive, maybe opportunistic, and sitting on a lot of cash to invest do not welcome market drawdowns. Yet, market downturns provide opportunity to invest when companies are on sale.
The weakness that began to unfold in early October continues on is arguably intensifying as the month matures. As noted in our update earlier this week investors increasingly seem acutely focused on the well discussed risks rather than what can or is still going right (seemingly old, boring news). In recognition that our notes earlier this week (notes for week ended 10/19) and in the prior (Halloween Arrives Early) did a fairly comprehensive job of highlighting those key fundamentals and risks the market is weighing, the bottom line is that we believe as this pullback matures it is increasingly of technical nature. Said differently, it is decoupling from fundamentals and being fueled off what is mostly technical behavior. This includes program/computer/algorithmic trading; the type of trading that causes “babies to be thrown out with bathwater” (or all stocks trading similarly, despite unique business characteristics of each company). Being that it increasingly appears a technical pullback, it seems appropriate to highlight some technical signposts of what to look for when trying to understand how much longer weakness may persist – a question likely on most everyone’s mind following a session like today.