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Who could have imagined that last week, when we wered reminded of the specter of thermo-nuclear strikes in a casual throwaway comment, that markets stayed strong? This week it was racism, violence and top CEOs abandoning the administration. Finally, the markets broke stride. The S&P 500 was down 2% and NASDAQ down 3%. Both bounced from their lows. Bonds did what they're meant to do. 10-Year Treasuries rallied from 2.28% to 2.16% or up about 1.5% in price.
What we saw in stocks up until a month ago was strikingly low single stock correlation. Basically, all stocks moved independently of each other. This is usually an example of investors running into stocks for multiple, different reasons and ignoring the overall direction of the market. This makes sense in an ETF world. A stock like Amazon can appear in momentum, retail, Internet, large cap, growth, market cap/debt and numerous other ETF factors. Lots of buyers for lots of reasons but not because they just “like” the market.
This changed last week. My colleague, Nick Prieto, ran some numbers on the top 20 stocks. Last month, for example, Facebook moved totally independently of the top 20 stocks (or -0.04 correlation for the CFAs out there). This month 20% of Facebook’s move is explained by other stocks. For the top-20 basket as a whole, correlations rose 20%. That's a big move in one month.
It appears that correlations moved up as investors took an overall view of the market and didn't like what they saw. The good news is that there is very little mileage in reacting to political events like last week. It's true that the hopes for healthcare, taxes or infrastructure faded fast. But the market gave up on those months ago. What we see now is economic numbers come stumbling in with a sort of “good enough for me” feel.
As far as market corrections go, last week barely registered. We've been used to low volatility in equities, bonds, economic numbers, rates…in just about everything this year. So, it felt bad. But it really wasn't a tough correction and we don't think it’s a canary, swallow, first leaf or anything else presaging a downturn.
1. What's up with Small Caps?
Large caps have made the running this year. The Dow is up 10%, the S&P 500 up 8.6% but all small caps (Russell 2000) are flat and quality small caps (S&P 600) down 2%. Partly it's because they had a blistering 2016, up around 20% and outperforming large caps by 11%.
But some is exposure to the dollar and overseas markets. The S&P 500 gets around 37% of its $10 trillion in sales from overseas. With small caps, it's around 20% on $740bn. This group benefits most from tax cuts and the least from a weak dollar. Throw in some disappointing consumer expenditure and the heavy weighting in financials (27% vs the S&P 500 of 15%) and low weighting in tech (13% vs the S&P 500 of 23%) and the underperformance, while disappointing, makes sense. So we looked at how small caps look against large caps:
Busy chart, sorry. But this shows the S&P 600 (small cap) PE relative to large caps. It's now about 90% of the S&P 500 PE and has been as high as 115% a few years ago. That seems cheap. There are other reasons to keep the exposure. Debt is generally lower and cash to market cap higher. So the opportunities for dividends and share buybacks seems better.
2. Over in Europe:
The ECB published the minutes from the July meeting. The strength of the Euro was high on its agenda given the 12% appreciation this year. We found lots to like in the minutes. Inflation is still low. So the QE will continue. Labor market slack was still considerable. So, again, on with QE. The concern with the Euro (“concerns were expressed about the risk of the exchange rate overshooting in the future”) means they want to keep economic prospects favorable. Which is good because we’re on a run. Here's the latest GDP numbers.
For most of the last 10 years, U.S. growth (the green line) has comfortably exceeded the EU (blue columns). But the rate of change in Europe has accelerated and is well above its 20-year average. Also, remember the basic math that a change from 1% to 2% growth is a 100% improvement. And that's what we’re seeing in Europe.
3. How’s the U.S. doing?
Quite well, thank you. Retail sales had a good month, up 0.6% on the month and with June’s numbers revised up. There are many shifts going on in retail. Here's one chart we put out earlier in the week.
It shows retail sales in stores, declining at an average rate of 6%, compared to sales in non-stores. Those “non-store” sales are everything from door-to-door sales to vending machines but are clearly mostly e-commerce. They're up 8%-10% every year for the last seven years. Industrial production was also well up on a year ago and has maintained a 2% growth rate for four months. The Fed minutes showed some splits between the “inflation too low” and “don't overshoot on inflation” camps. Given the Fed’s truly awful inflation prediction record, we think they’ll just start adjusting the balance sheet in the fall and hold off a rate hike until December.
We're surprised at how sanguine markets remain. I’m not sure how many ways we can define “dysfunctional.” We'll leave it to Washington to show us. Meanwhile, it's good to see bonds firm while risk assets falter.
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Carl Sagan: time traveler
Hilarious endorsement of Cohn for Fed job
Apparently there is a solar eclipse coming.
--Christian Thwaites, Brouwer & Janachowski, LLC
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