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Uppers and Downers

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The Days Ahead: Powell for Fed? And Spain.

We've been waiting for a correction for a while and the opening on Thursday gave us a, wait for it, a 0.7% fall. We don't really like to show day charts because a short time frame has a heck of a lot more noise than signal, but here it is:

What caused the drop? Well, take your pick. There was a weak overnight in Hong Kong, the head of China’s central bank warned of a Minsky Moment when asset prices freeze and Apple reputedly cut suppliers orders, which would hit companies like Samsung, Taiwan Semiconductor and SK Hynix. But no. As a rookie analyst some, cough, 36 years ago, I would ask senior Portfolio Managers about every move in the market. Some theories sounded grand but meant nothing: stops, trading limits, consolidation, rebalancing. One guy hit it though: “Son, there are more sellers than buyers. Now leave me alone.”

And, that was probably what happened on Thursday. As the chart shows, the market swiftly recovered for similar opaque reasons. We know volatility has been exceptionally low for a while. And many people would like a correction because, you know, it was expensive six months ago, and since then it’s risen another 11% and human nature being what it is, can't bear to move in now. But volatility is low for a reason:

  1. Central bank policy is clear, communicated and confirmed on a regular basis. We pretty much know what they’re going to do because they keep telling us.
     
  2. Growth is running around 2% and a little over in Q3. There’s no obvious upside or downside surprise to the story.
     
  3. Sure, there’s uncertainty on the political side but tax/no tax, healthcare/no healthcare outcomes are not that big a deal in the short run. The market also seems to know how to parse between outrageous but not financially meaningful statements.
     
  4. All the above may change but seem good reasons why markets are not easily phased.

1. Global Growth:
We have three strong tailwinds right now. Global growth, broad U.S. growth and a lower but not weak dollar. This is the first time we've had all three since the recession. We had China coming out of 2008 very quickly, with a massive credit infusion, but Europe had two start/stop phases, then the commodity and energy sectors fell out of bed and Emerging Markets followed. There always seemed to be one laggard. Not so today and here’s one quick chart:

It shows the spread between U.S. 10-Year Treasuries and their German equivalent (Bunds). When this is wide, we can infer that if U.S. yields are high and Bunds low (e.g. 2015), then the U.S. is growing more than Germany, which is a good enough proxy for Europe and indeed overseas given its export sector. So the world is out of balance. When the spread is narrow or declining (e.g. 2001, 2007 and all the grayed out boxes), growth is more synchronized and it’s good for equities. We're in just that phase now.


2. It was 30 years ago today:
Yes, that was the 1987 crash. When the Dow dropped 508 points from 2,600. You can read about it here, which is from practitioners, not commentators, and here, which looks at the overlaps between now and then. I wish I had a great war story about staring at screens, paralysis, fear, and making or losing the firm’s annual profit in a day. I don't. I was in a classroom that day. But the school had the wisdom to bring out a professor who had worked on Wall Street in 1929. This was 1987 and had all happened 58 years before...so like listening today to someone who remembers the launch of Kind of Blue or the Mini.

His take was “Ha, 30% correction, that's nothing. Try 1929 when we watched the stock market capitalization fall from $89bn to $15bn in three years.” Which reminds us of this. He was right. A slow grinding bear market with a collapse in jobs, asset prices and trade barely registers against the quick down and recovery of stocks in 1987.

And here's the chart showing the S&P 500 30 years ago with today’s market superimposed.

I would not read too much into that. Superimposed charts are easy to do but always insightful.

What was 1987 all about? A combination of a steep market upturn, some bad news out of Germany, a weak bond market. But the big culprit was an investment strategy called Portfolio Insurance, which sold futures as long positions increased. The trouble was, markets were quickly overwhelmed and the selling momentum accelerated. In the days of person-to-person trading, no one wanted the other side of the trade. Answer, mark prices down.

The good news to come out of it was that Fed, with a newly installed Alan Greenspan, quickly dropped the Fed Funds rate from 7.7% to 6% and the 10-Year Treasury followed, falling from 10.2% to 8.7%. The Brady Commission was set up to investigate and reported in 60 days (pause for effect), recommending things we now take for granted like circuit breakers, supervision across markets (the NYSE and Futures regulators didn't talk back then) and better clearing systems.

Could it happen again? Well probably not in the same way. A one-day 30% correction would never get that far. And better information and price discovery would prevent the “get me out at any price” mentality. Also, see the highlighted section, real interest rates were high and Fed policy was extremely tight back then, unlike today.

Anyway, we still like the dividend, quality parts of the market and international and Emerging Markets, which are still quite a bit cheaper than the U.S. despite the run up.


Bottom Line:
The Dow hit the 23,000 mark but it only takes a 4% move to hit another round number these days. As we've explained, it’s a meaningless index and did well only because one its fourth and seventh largest companies rose 5% and 9%. Earnings will continue to define stocks in coming weeks and so far have kept with expectations.

 

Please check out our 118 Years of the Dow chart  

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Other:

Income equality worse in U.S. than all OECD

Betting it all on Bitcoin

Apple cuts production

  

--Christian Thwaites, Brouwer & Janachowski, LLC


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All charts from Factset unless otherwise noted.