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:
Stocks should return more than bonds because they're riskier.
We can define a return to shareholder as the company’s earnings divided by its value...the earnings yield (above at 6.36%).
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.
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--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.