Despite continued skittish trading behavior and large daily gyrations, shares of US equities concluded the week ending October 19 roughly unchanged from where they began. The S&P500 finished less than -0.01% lower while the more concentrated Dow Jones Industrial Average added +0.4%; perhaps the broadest domestic measuring stick, the Wilshire 5000, also concluded essentially flat for the week, but is off -5.5% month-to-date and brings the year-to-date performance to a very scant +2.8%. With the reality that markets look dramatically more concerned than just 3 weeks ago (at September 30), the most natural question one might ponder is, “what is so different to justify the dramatic tone change?”
Answering that question always feels increasingly complex during times of market stress and huge extraneous uncertainty. Emotion, and feeling unsettled always causes one to focus more keenly on the risks rather than any positives no matter how conspicuous they are. At the moment, the list of worries seems to be growing. Key among those are: a Fed who’s communicated preference and stance remains toward more rate increases even though inflation is only just now reached their long-term target of roughly 2% annually; an economic expansion and current bull market are long relative to average; economic conditions abroad (most notably including China) are soft or appear to be peaking; and prevailing trade & tariff friction. Now adding to that list is soft housing data that suggests the weakest activity (purchases, construction, etc.) in 4 years amid rising mortgage costs, low inventory, and high prices. Autos, another sector with broad economic impact, also look soft most likely because of rising cost of borrowing. Also, while quarterly earnings for 3Q are again coming in robust, that strength seen in 2018 is becoming old news and is arguably already baked in following consecutive quarters of strong growth; sales growth also appears to be slowing across some sectors. While still positive, year over year comparisons will get more challenging with tax reform no longer being new. Lastly, the much anticipated midterm election is just about here, and voter enthusiasm appears to be surging.
At the risk of sounding too pessimistic, there remain positives. An economic recession has never begun when corporate earnings were still growing. That suggests even if growth is not as robust moving forward, economic recession still seems an improbable near-term event. Consumer sentiment also remains elevated and unemployment is low; so those factors provide support. Also, despite low unemployment, wage growth is not yet problematic and by extension not translating into troubling levels of inflation – so the Fed does not need to be too aggressive. Also, from a sentiment perspective, it would be hard to call this environment in any way euphoric; Financial Times noted recently that “a record proportion of investors believe the global economy is in the late stage of the business cycle”. Attending a CFA presentation last week, we were struck by how true it usually is that when investors (as a group) are very fearful of a small loss it is generally bullish. Another quote: when no one is talking about risks it is time to be guarded because it’s the things you don’t see coming that hurt the most. Today, there is more than enough discussion of risks, and investor sentiment is clearly nervous; evidence of that lies in the elevated put/call ratio in options markets (a form of portfolio insurance against pullbacks). We are also reminded that there has been no negative 12-month period following a midterm election since 1949 (always positive). And, it does not matter which party wins a midterm election but rather it was the elimination of a key uncertainty that helped advance stocks forward.
As hard as it may be to believe, history suggests time remains for this cycle and that the upcoming midterm election should be an investors friend. We remain vigilant, but true to our philosophy that one cannot successfully and repeatedly time when to get in or out of the market. We can however be prudent with our asset allocation with awareness for the risks that are present.