The Days Ahead: The last of the year’s economic data. Not a week to trade.
One-Minute Summary: Yes, that was nasty. All the fears of the year came through last week. The Fed said it saw slower growth and was not as dovish as people would have liked. No light on the political issues. So that's Brexit, Italy, government shut down, resignations and trade all lurking in the background. A disappointing core inflation report. Lower business activity in some Fed regions.
Yet the market is not on a “fear trade”. For that we would have to see a rush into gold, the Yen, Treasuries and a big spike in the VIX. What’s happening is a correction to a slower growth, normalized rate environment. There is nothing particularly wrong with the U.S. economy. All this would hardly deserve the market pessimism we’re seeing. But if we add the trade and China tensions, then market nerves make more sense.
We'd go further. If we see a trade deal with China, which is almost certainly likely even if the details won't be as impressive as the headlines, and some wage growth, we’ll see a snap back in the market and the economy.
1. Crikey, what did the Fed say to move the markets? Pretty much what everyone thought a month ago.
Look, the Fed was always going to raise Fed Funds in December. They had four planned for the year and it was going to take serious deflation or deterioration in financial conditions to stop them. A 10% correction in stocks simply did not count. And a good thing too. It’s time the Fed stopped underwriting stocks every time they have a perfectly normal correction. The President’s advice merely hardened their resolve. What Fed Chair want’s to go down doing the bidding of a mercurial economist-in-chief?
The Fed changed two items in the announcement.
First, that the Committee “judges that some” further increases will happen. Last time it was that the Committee “expects further” increases.
Second, they added that they would monitor economic developments…which means nothing more than “look, we know markets have sucked and we’ll keep an eye on it, but we don't need to do anything yet”.
All fine and pretty innocuous. But then came their economic projections in the famous dot plots. Here they are in December and three months ago:
I know it’s tough to read but the bottom line is that 1) they lowered growth and inflation expectations and 2) they expect two increases in 2018, not three. The Fed said what everyone knew but didn’t want confirmed: the economy is slowing. The bond market’s reaction was entirely logical. Short term rates up, long term rates down. The 10-Year Treasury is now at 2.78%, up 3% over the last month and the yield curve is at its lowest for the cycle.
Stocks wanted a bail out and didn't get one so promptly sold off 2%. It didn't stop there. By week’s end, the S&P 500 was down 7%. But there was a lot of other bad vibes in the air of which we would list as:
Turmoil in the White House
No end to trade tension
Prospect of a government shutdown and
Some stock specific hits at Johnson and Johnson, Xerox and FedEx, the biggest stock in the Dow Jones Transportation index.
All the Fed did was provide the timing.
2. FedEx on trade: For those interested, here’s the full quote from Fred Smith CEO and founder of FedEx. He should know a thing about trade, politics and its effect on business.
“And I'll just conclude by saying most of the issues that we're dealing with today are induced by bad political choices, making a bad decision about a new tax, creating tremendously difficult situation with Brexit, the immigration crisis in Germany, the mercantilism and state-owned enterprise initiatives in China, the tariffs at the United States put in unilaterally. So you just go down the list and they are all things that have created macroeconomic slowdowns.”
3. It feels like a bear market. Is it? No. But it sure feels like it. We asked this question last week but we’re down again. Not to pile it on, but the S&P 500 is down 8.5% this year. That's a weighted average, of course. The average share was down 9% and the median share was down 10%. But this was a year of the market coming in strong, a fall, a slow recovery to peak and two legs down, one in October and one in December. So the drop in the S&P 500 from the all-time high is -15% but the average stock (i.e. not cap weighted) is down 26% from it’s 52-week high. There are only four companies within 3% of their all time high and 65% of the stocks in the S&P 500 are in their own bear market i.e. down more than 20%. No stock is at it’s all time high.
This is not quite a capitulation. We'd need a wider, deeper and longer fall for that to happen. But it does mean some bargains are beginning to appear. As we've mentioned before, there is no single way to gauge the over or under valuation of the market. If there were, we'd all be following it. But one we like is the earnings yield. This flips the traditional PE (price earnings) measure and tells you how much a company earns, expressed as a yield. It’s not the same as a dividend because a company does not pay out 100% of their earnings. Then you take that number and compare it in real terms. Here’s the chart:
It’s the yellow and black lines we’re interested in. Both have moved sharply upwards, showing the market is around 30% cheaper than a year ago in nominal terms and 40% cheaper in real terms. More, the earnings yield is at its cheapest in nearly 6 years and in real terms in two years.
This doesn't mean jump in with both feet. But there is no way companies will report 30% lower earnings in 2019. In fact it's more like a growth of 8%. For now the market is living on fear and stocks are getting cheaper. That feels uncomfortable but may be a very good set up for 2019.
4. Is Brexit any better? No.
Bottom Line. Stocks will finish the year at about the 25th percentile of historical performance. That means a 2018 happens 25% of the time. For volatility it's at a 66th percentile, meaning it’s above median but not alarmingly so. As we've said before, 2018 feels bad because 2017 was so good. We had a year of low volatility and high returns followed by somewhat higher volatility and flat returns (source AQR) . Our guess is that in a few years, we’ll barely remember this year. Treasuries did fine. Here’s to a better 2019.
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--Christian Thwaites, Brouwer & Janachowski, LLC
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