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That was the drop.

The Days Ahead: Earnings and trade news, especially China as manipulator

 One-Minute Summary: It’s difficult to pinpoint the catalyst for the market sell-off this week. Most of the culprits were known for weeks. Trade, China, rates, tech problems, October seasonals. We knew all that. No central bank said or did anything they hadn't said already.

So what was it? We'd point to two factors. One, technical. There are plenty of algorithm strategies. They see a price break and start dumping stocks to protect the positions. So, when Nasdaq broke its 200-day moving average on Wednesday, a lot of trading strategies kicked off. Don't expect great numbers from quant or hedge funds this year.

Two, rates. Tuesday was also a day when the U.S. Treasuries fell.  There were some big Treasury auctions that didn't help. But markets panic when investments meant to move in opposite (stocks and bonds) directions start tracking together. Treasuries rallied later in the week so normal service resumed. We'd also point out that our own “Fear” measures (gold, Yen, Swiss Franc and the 2-Year Treasury) barely moved so this wasn't a wholesale rush to safety. 

We think most of the recent 25bp increase in the 10-Year Treasury is catch up. It was clearly over sold and the rally on Friday brought that back to only a 10bp increase. Many investors have played the inverted yield curve story…that, yes, short rates would increase but longer rates would remain anchored because the economy was going to peak soon. We feel that's broadly true but the 10-Year hadn't moved enough to adjust. The economy, after all, will probably grow around 3% this year, which is close to its 70-year average. Yet Fed Funds are at their lowest since 1964.

There was no major economic data. Inflation came in low and consumer confidence dipped a little. We would not consider either relevant to the week.

 1.     How can you tell if the market is overvalued? You can't. Sure, you can say that valuations seem high by standards like the CAPE Shiller ratio, Price to Book Value, Tobin’s Q, yield, narrow leadership or any number of metrics. None are thoughtless. None infallible. One may be very good at calling an overvaluation but, as we've pointed out in our recent “16 Lessons” blog, being right and early is the same as being wrong. What we try to do is balance out the risks of being in a successful, but perhaps long-in-the-tooth bull market, with diversification and protection. Clients know we’ve been investing in structured notes recently, and while they take a few years to mature, they at least put a band around performance results.

As for diversification, we’d also note that a 60/40 portfolio of stocks and bonds has had a very decent risk return for many years. Here's the chart:

The black line is the 60/40 portfolio. Above it is the S&P 500 and below it a widely followed bond index. As one would expect, the 60/40 portfolio weathered the severe draw-down in the two (shaded) bear markets better than a stock-only portfolio. Mind you, twice in the last 20 years, stock-only investors were enjoying some spectacular highs in 1999 and 2018. But the 60/40 portfolio has done very well and we'd expect it to serve investors well.

Back to the vexed question of valuation, one set of data that has been a useful guide is the real earnings yield. It’s not complicated. It’s the reciprocal of the widely used price earnings (PE) measure deflated by the CPI.

The logic behind it is:

  1. Stocks should return more than bonds because they're riskier.

  2. We can define a return to shareholder as the company’s earnings divided by its value...the earnings yield (above at 6.36%).

  3. But because we want real returns from stocks (bonds provide the nominal returns in our portfolios), this needs to be adjusted for inflation (above at 3.65%).

 We can also compare that yield of 6.36% to the 10-Year Treasury but it gives the same answer. Stocks were expensive for most of the 2004-2006 period and very cheap in 2011-2012.

 So where are we now? Stocks are not cheap but they are certainly not in the danger territory where the black line is below 3%. That fits with our opinion for most of this year. We think stocks still have some upside. After all, earnings are in good shape, the economy thriving and the Fed’s actions, while tightening, are predictable. We do, however, expect some of the quality and dividend aristocrats to perform better than some of the high-growth names (step forward FANG gang) that recently rolled over.

 2.     Have stocks suddenly become more volatile? Yes, compared to recent history. No, compared to long-term averages. We just experienced a week where stocks fell 3.3% on Wednesday and 1.5% on Thursday. Days on either side had intraday peak-to-trough downdrafts of 0.5% to 1.5%. That’s a lot when 1% is equal to $230bn these days. The decline since the September 21st peak is around $800bn or 4% of GDP. Here's the daily percent change of the S&P 500 over the last few years:

So two things stand out. One, last week’s price action was big. We've only had daily price swings of that size four times in five years. But, two, note the shaded area. That’s 2017, when stocks had a strong year, up around 20%, with no set back. It was about as calm as we've ever seen. Compare this to the same chart using the halcyon days of the 1980s, when the market powered ahead by 150% in six years.

That was a period of falling rates, strong earnings and reduced political risk. Not much to worry about in hindsight. Yet, the daily swings were much greater. In the last five years, the average daily move was 0.04% with a standard deviation of 0.77 (in other words, it would vary most of the time from down 0.74% to up 0.81%). In the ‘80s it was 0.06% and 0.87, which was 13% higher.

 The reason that we've had such low volatility is mostly down to interest rates being low. Stocks had no real competition. Now they do, especially as U.S. rates are increasing. The week was also notable for how nearly all stocks were caught in the sell-off. Last week, only 19 stock were positive and most of those were stocks that had an awful year-to-date performance, so were more in the nature of a short-term bounce.

 Followers of this note know we've argued that we’re in a higher volatility regime. Certainly higher than we've seen but not unusual in stock market history.

 Bottom Line: Fundamental buyers should return soon. Some will like the new prices and some will rebalance portfolios. Earnings will take most of the news flow. There are still 470 companies to report in coming weeks. We would still look at protecting the portfolio where we can and are currently looking at Treasury FRNs.

 Please check out our 119 Years of the Dow chart  

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 Other:

Sommeliers are stripped of title

 --Christian Thwaites, Brouwer & Janachowski, LLC

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

Ronnie Lane - The Poacher

Floating in a most peculiar way

The Days Ahead: More vol. U.S. CPI: We get to see if there’s any inflation.

We're writing this Friday after a tough week. Yes, there was a return of volatility and corrections. Only 32 S&P 500 stocks are up on the week and 18 of those by less than 1%. Most stock indices are in the red for the year, except some Emerging and European markets. The Euro and Yen continued to strengthen.

So what’s still in place?

  • Economy heading up
  • Earnings coming through. The market is cheaper now than it has been in nearly three years. Put that down to a 15% increase in earnings
  • Bond yields are stable around a 50bp band (yes, in a low yield environment)
  • Global growth upswing
  • But…

1.     We have to talk Monday: We had a minor market meltdown on Monday. Like many of these, the explanations that roll in over the next few days are many and plausible. But the truth is, when they're going on, no one has any idea why a market goes down so violently.

  • In 1987, it was something called portfolio insurance. But on the day, barely anyone had heard of those esoteric and thankfully defunct instruments.
  • There was a near 2000-point drop in the Dow in August 2015, a 10% correction. That started with a 36% drop in China. What caused that? Well, fears of a Fed tightening, low copper prices and a weak Renminbi. But…no one was saying that in real time. It was just one sell order after another.
  • Flash crash in 2010? When the Dow fell 1000 points in minutes on May 6, 2010, I was on the NYSE floor and no one said “Oh, it’s a bloke sitting in his London suburban bedroom, quietly spoofing and front running.” No, it was full-on panic.

So, post-hoc explanations are easy. Real-time explanations are confused.

But we do have a smoking gun of sorts. For some time, stock volatility has been low, as in below 10 on the VIX and almost no correction or down day. Up to late November 2017, the S&P 500 hadn't moved more than 1% for 54 straight days. And there had not been a 5% correction for 396 days. The last time we went that long without one was 1996 (“Wannabe” by the Spice Girls) and before that 1965 (“Ticket to Ride”).

So, if you think low volatility is here to stay, you sell volatility and plan to rebuy it at a lower price. Some big managers believed this and traded volatility in their funds…here’s PIMCO on the subject.

Then some fund companies said, “Hey, this low vol game looks fun. Let’s create an ETF so punters can trade volatility. But let’s make it interesting and lever it up and have it make money when the market goes down. The marketing folk will love it and investors will make money when things go down. We'll charge 4.9% because, er…we can.” And that's how Velocity Shares Inverse VIX (ticker XIV, geddit?) and ProShares Short VIX Short-Term Futures (SVXY) came to be born and attracted and $3.6bn assets.

Now, the basic problem was that the funds bet on the VIX going down. It didn't. And after the business close, the futures they bought for the day were worthless and so the ETF closed at $6.00 having opened at $115. But investors weren’t finished because they then shorted the ETF overnight, which sent the VIX higher and that meant Credit Suisse (aka Velocity) had to liquidate the fund for pennies on the dollar. Game over and thanks for playing.

Oh, and Credit Suisse’s stock dropped 10%. If you happen to own it, don't. It’s worth less than it was in 1985.

These ETFs aren't really ETFs at all. They're ETNs. The “N” stands for note and that means it’s unsecured. When you buy an ETF of, say, the S&P 500, you buy a sliver of Apple, Google and all the way down to Pitney Bowes. When you buy an ETN, you get cash at the end of the day and the cash is determined by how much the futures were worth at the end of the day. You never own the future, you own the cash. They don't always track the index very well either. Velocity’s VIX long fund is up 28% this week. Nice. But the actual VIX is up 41%.

Anyway, we feel that volatility had been a coiled spring for months (one reason we kept Treasuries) and would unwind quickly. This is what the S&P 500 looked liked on Tuesday:

Remember, we hadn't seen a 1% day for months and then we had six 1% moves in a day. To give an idea, the MACD (it measures moving averages) graph scale is about 10 times bigger than normal.

So, we have some volatility, which is good because it flushes out complacency. But we do not have “fear.” A fear trade is when gold, the Yen, the VIX and Treasuries all rally. As this shows, only VIX was active on Monday.

In September 2008 (the Lehman crisis) all four went through the roof.

What have we learned?

1.     Volatility is normal for equities. If it stays too low for too long, it will return.

2.     When markets are moving fast in one direction, it’s best to stay out of the way.

3.     No important fundamentals changed (inflation, employment and growth).

4.     Profit taking is normal.

5.     New financial instruments (ETNs this time, CDOs in 2008 etc.) create risk.

6.     Short-term investors (the ETNs, the hedge funds) can distort prices.  They are not investors.

7.     Volatility is back. As it should be.

2.     What ticked up inflation fears? It is no accident that the correction occurred on the same day as Jerome Powell was sworn in as Fed Chair. Markets like to test the resolve of a new Chair. Will he keep with the rate hikes if stocks crater? We don't know yet. The market would have to fall longer and deeper.

We do know the Fed is on the look out for inflation. They can't find it in PCE or CPI. One area is in wage inflation and last Friday, the average hourly earnings rate jumped up 2.9%.

That’s it over on the right-hand side. Now I have a problem with this.

First, yes, it’s up year-over-year but these are not adjusted for inflation. Real hourly earnings are published separately and they're up 0.3%. 

Second, look at the numbers to the left of the 2.9%. Nothing to write home about. The 2.9% number may just be some catch up. The six-month moving average is stuck around 2.5%.

Third, the biggest gains are in some pretty low-paid industries. The average hourly rate for hospitality workers (11% of the work force and with a 7% unemployment rate) is $15.73 and they work 24.9 hours a week…so $19,580 a year. A 3% increase is an extra $11.70 a week.

Fourth, average hours worked fell. We've made this point before. If you’re paid 10% more but you work four hours less, you have no more money. But the BLS says, nope, you got a pay raise.

Anyway, we could go on, but the takeaway is that deflationary forces remain in play, there’s no wage increases, we don't think companies are about to give them and the workforce is still under utilized. These are not the conditions for wage push inflation.

Bottom Line: Not to be that guy who says “ Remain calm, don't make any rash decisions” but we think that most of this week’s movement was a healthy return of volatility and a better pricing of some of the new risks (e.g. deficits, shut-downs, can kicking). It’s one reason why we like Treasuries in the portfolio and would remain with them.

Please check out our 119 Years of the Dow chart  

Subscribe here for our investment updates

Other:

Fed to Wells Fargo: Stop growing

And writes Stumpf a letter  

--Christian Thwaites, Brouwer & Janachowski, LLC

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.