Week In Brief: October 19th

October 24, 2018

Ouch? Easily an understatement. The recent sequence of events has had global investors screaming like a gaggle of teenage girls at the Haunted Insane Asylum.
The last two weeks have been a classic Halloween Horror Show. The S&P 500 closed Friday at a shockingly oversold level. More than 3.7 standard deviations below its 50-day average. For context, one standard deviation below the 50-day average is considered a normal oversold condition. Two standard deviations are considered extreme. So, when you go to almost two times extreme, you're into adjectives like colossal, apocalyptic and ridiculous.
Weakness in U.S. stocks these past two weeks can be traced to multiple factors. Trade issues with China. The risk of an Italian debt blow-out. Brexit or not. The risk of a spike in oil prices exacerbated by the Saudi situation. Together, they've given rise to enough uncertainty to explain the sudden decline in stocks. Historically, the uncertainty of a mid-term election is also enough for stocks to fall into Election Day and then start to rise as uncertainty lifts. Add in the Fed's interest-rate hikes and, presto! A ready-to-order souffle of fear and uncertainty.
Of course, the media and its viewing public never quite recall that pullbacks are a healthy facet of any bull market. In fact, the 1999 culmination of the nineties bull saw the Nasdaq double in value over the course of a calendar year. During which the index also experienced five separate ten-percent corrections. Of course, we don't remember those. Only remembering the pleasant fact that the index doubled during that crazy year.
The S&P 500 remains only 6.5 percent from its September high. And sits right on its 200-day moving average. Marking this as a classic retest of the low set earlier this month. Exactly what you want to see in order to wipe the slate clean and set the stage for the next move higher. If we don't get that bounce? Or, in fact, a move lower? Then we'll begin to enact some of the contingency tactics in place for what could be a deeper, more sustained downward move.
That said, we expect the market to hold here. If it doesn't, we'll stick with our playbook and act accordingly.
The most dynamic recoveries happen when stocks spike higher off a panic low and never look back. Defying demands for a "re-test" of the lowest levels. Which occurred when stocks bounced off the panic low in mid-February this year. Though ultimately, a month later, the lows were re-tested. And it was only then that markets raced higher for the next five months.
The following chart by market-sentiment expert Jason Goepfert reveals that following sharp, brutal declines (like the current one), V-shaped recoveries have been historically common. Almost 40 percent of volatile sell-offs from a 52-week high formed a bottom with a couple of sessions. And all but a few of the precedents ended up with a positive return over the next several months.
Goepfert looked at stretches when the S&P 500 had been at a 52-week high, then within four weeks fell to at least a 3-month low. Out of 32 such occurrences, almost half formed a one-month low within two days. And most of those bottoms lasted at least three months.
On average, he reports, it took the S&P 500 four days before bottoming, from the time it first fell to a multi-month low. That was October 10th in our current scenario. So, we're already two weeks in. The average gain one month later was 2.9 percent, 3 months later was 7 percent, and a year later was 13 percent.
From that first low day, Goepfert adds, the S&P 500 showed a positive return three months later after 27 of the 32 signals. An 84 percent win rate. Which is very high. Some of the thumbnails of months in his study are shown below. They paint an optimistic picture. The general trend was a bottom fairly soon, with consistent upside to follow. Of the last 10 signals, only 1998 and 2010 suffered meaningful downside in the month to follow.
The bottom line is that sharp market pullbacks from record highs typically do not unravel into serious bear markets. That's not to say it can't happen. Because it can. If it does happen, it would be an outlier. So, while history sides with the bulls, we must keep our guards up. Watch your downside protection parameters. And be prepared for anything.
And yet, despite Goepfert's positive analysis, there remains some very smart money on the other side of the sentiment fence.
We recently received some skeptical commentary from Bob Prince, the chief investment officer at Bridgewater, the world's largest hedge fund.
Prince told the Financial Times that his team believes "we are at a potential inflection point where the economy is moving from hot to mediocre."
He said the U.S. economy faces a looming deceleration as tighter monetary policy starts to weigh on business and consumer activity and ratchets up pressure on financial markets.
Prince believes the recent market turmoil was triggered by investors realizing that this year's strong economic growth and robust corporate earnings were likely peaking, as interest rates rise and the boost from tax cuts fades.
"A lot of optimism about future earnings growth has been baked into equity valuations," Prince said in the FT interview, implying that the hopes are overdone and should be faded.
Bridgewater is not always right. But its analytical acumen is respected by the Street. Which often prompts lesser managers to adopt its point of view. One that, in this case, appears quite skeptical.
The tea leaves, of late, were trying to tell us something. As the performance disparity between U.S. and foreign stocks was markedly cut by the volatility in domestic markets. That divergence between U.S. stocks, which had powered to record highs, and most of the world's markets, which had crumbled, was greatly dissipated. The factors that helped U.S. stocks to solidly outperform faded sharply last week. Belying the question: do those factors still exist, and will they serve to reinvigorate U.S. equities? Or, is Bridgewater's "inflection-point thesis" accurate?
Despite such speculation, stocks have not - contrary to popular narrative - become wildly overvalued.
The price-to-earnings (P/E) ratio of the U.S. stock market, based on analyst estimates of stock market earnings over the next two years, sits at 13.8. Which is lower than its average value going back 22 years.
That bears repeating... The two-year forward P/E ratio today is below its average value going back to 1996. Yet, how can the two-year forward P/E ratio be low after 10 years of solid equity market growth?
Quite simply, earnings growth.
According to Bloomberg, U.S. corporate earnings are growing at an astounding pace. And the consensus of analysts surveyed by Bloomberg is that earnings growth will continue.
Specifically, analysts expect S&P 500 earnings to grow from 138 this year to a 197 by the end of 2020. So, when we look at the P/E ratio, if we leave the "P" the same, and we plug in those future numbers for the "E" - we end up with a radical result: Stocks are below their average value since 1996.
Will these analysts be right about future earnings? Who knows. But short of a crystal ball, analyst projections provide a decent projection of what we're working with.
Many investors continue to look at the CAPE ratio, which provides a 10-year lookback at P/E ratios. And includes the terrible earnings data from the Credit Crisis. But the forward projections tell a different story. One that posits that stocks can, in fact, continue rising from here. Doesn't mean they will. Nor does it mean that investors should let their guards down. But it does refute some of the collective negativity permeating today's airwaves.
What will drive continuing positive earnings? Consumer spending. And American consumers are feeling pretty good right now. Confidence is high, job growth is strong, wages are advancing. -and are likely to power the economy through a solid third quarter of economic growth. NatWest's Michelle Girard and Kevin Cummins estimate that overall consumer spending in the second and third quarter of the year will notch the best back-to-back performance since late 2014: "Encouragingly, consumers along the entire income spectrum are finally feeling the benefits of sustained growth."
Bottom line? We believe the bull market will, in fact, continue. But VOLATILITY has returned. As we've long anticipated it would. This whole "Dire Straights" investment mentality (Money for Nothing and Your Chicks for Free) could never last. All upside. Little downside. Bloomberg noted that last Wednesday was the "8th time this year when the S&P 500 fell more than 2 percent. It's already the highest frequency since 2011, when the European debt crisis swept the market. In comparison, last year we had zero 2 percent down days."
As poorly as October's market has performed in the United States, the carnage is worse in the eurozone. The iShares Europe (IEV) is down 14 percent from its January high. The German market (EWG) is down 13.6 percent year to date, while Italy (EWI) is 13.8 percent lower.
In China, things look even bleaker. Where that nation's burgeoning debt crisis has seen its market drop 26.3 percent overall this year. That on the day that The Middle Kingdom opened the world's longest sea-crossing bridge. At a tab of $20 billion. We appreciate the idea that China plays the long game. But when the national debt situation appears stark, the completion of such a massive capital outlay may not play well with international debt markets in the near term. Or, maybe we're just old fashioned.
All of which sound bleak. So, how about some good news... If you remain among the optimists, buying when markets are at or just under their 200-day average has been a winning trade throughout the bull market that began in 2009.
In other news?
Signs point to a slowdown in an already sluggish housing market. Mortgage rates are rising, home prices have shot up, the tax law passed in December reduced homeownership incentives, foreign buyers have pulled back, and an ample supply of rental apartments has made buying less urgent for many. And housing stocks reflect these trends. With the Home Construction ETF (ITB) down -27 percent on the year.
Still, American consumers remain optimistic. With the University of Michigan's Consumer Sentiment Index sitting just below all-time highs.
And Americans feeling optimistic regarding the government's current economic policies.
Moreover, the U. Michigan measure of long-term consumer inflation expectations is back to post-recession lows. One of the reasons the Fed is not expected to accelerate its rate increases despite tightening labor markets.
China's trade surplus with the U.S. hit a new record as suppliers try to get ahead of the tariff hikes. That's why we see rising wholesale inventories in the U.S.
So, where does the U.S. economy stand in terms of near-term recession probability? Let's seek counsel from the well-regarded team at Oxford Economics. Their recession-probability models currently point to the highest odds of a recession since 2007. However, they remain well shy of critical thresholds that would have us concerned about an imminent economic downturn. Brian Wesbury, chief economist at First Trust Advisors, places the current recession odds at 10 percent. In other words, causes for concern have elevated. But not to the point of losing sleep.
Sears filed for bankruptcy protection from creditors, marking the collapse of a company that dominated American retailing for much of the 20th century. Sears reached a deal with lenders that allows the 125-year-old company to keep hundreds of stores open for now. The company operates roughly 700 Sears and Kmart outlets. And employs about 70,000 people. Controlling shareholder and hedge-fund titan Edward Lampert has stepped down as CEO but will remain chairman. More here.
Following last week's resignation of U.N. Ambassador Nikki Haley, the Trump administration appears to be giving serious consideration to Kelly Crat, the U.S. ambassador to Canada, as Haley's replacement.
In the Middle East, it appears that one tense standoff begets another.
American Pastor Andrew Brunson was freed after two years of detention in Turkey. His release marked an end to a diplomatic standoff that jeopardized relations between the NATO allies.
Concurrently, Saudi Arabia on Sunday threatened to retaliate against possible punitive measures after President Trump vowed "severe punishment" if an investigation implicates the kingdom in the suspected death of prominent Saudi journalist Jamal Khashoggi, who disappeared after he entered the Saudi consulate in Istanbul on October 2.
At risk? The Saudi dream of becoming an investment hub in the desert. JP Morgan CEO James Dimon represents one of many prominent executives who backed out of the kingdom's premier business conference.
Summarizing: We believe this bull market will continue. It may not be until after the midterm election. But regardless, volatility has reclaimed his seat at the table. What are you doing about it?
Remember: if it were easy, it wouldn't be worthwhile. Stay tuned...
Weekly Results
Major indices finished mixed last week. The DJIA gained 0.41%. The S&P 500 rose 0.02%. The Nasdaq fell 0.64%. While small cap stocks lost 0.30%. 10-year Treasury bond yields rose 3 basis points to 3.195%. Gold closed at $1,229.60, up $7.60 per ounce, or 0.62%.

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