Week In Brief: October 5th

October 17, 2018

Beware October 10th. Historically, 10/10 has been to stocks what The Bogeyman is to children's nighttime affairs. Downright spooky.
10/10 has been the nexus of many historical highs and lows. In 2002, it served as the nadir of the dot-com bust. In 2007, it proved the apex of the bull market. And the start of a year-long descent into the steepest bear market of our lifetime.
This year, 10/10 yet again refused to recede into the calendar year without making its presence known.
Accordingly, yesterday saw the S&P 500 fall for the sixth straight day. Plummeting 3.29 percent. While the Nasdaq completely gave up the ghost, losing 4.08 percent. U.S. equities fell the most in a single day since February. When markets experienced a 10.02 percent pullback. Today, more of the same. With the S&P 500 and the DJIA falling 2.06 2.13 percent respectively.

Surveying the carnage requires some perspective.
First, some volatility was required. In the way that a fever helps a patient to heal. Volatility can recalibrate an overheating market.
Since February's 10-percent correction during which the CBOE Volatility Index (The Fear Index) skyrocketed from 9.5 to 39, the index has drifted steadily lower. Having reached 11.3 last week before shooting higher to today's level at 23.14. When volatility spikes, it removes burgeoning enthusiasm from the market. Separating the wheat from the chafe. Lowering valuations. And furnishing fuel for future rallies as recent sellers acquiesce, buying stocks and sending prices higher.
Since February's 10-percent decline, markets have recovered. With the S&P 500 beginning this week up nine percent on the year. And the S&P 500 having posted better than 30-percent returns since breaking from a two-year trading range following the November 2016 election.
It stands to reason -- nearly ten years into a bull cycle -- that investors should have to sweat a bit. So, what's currently bringing the global investment community to such a lather?
First, fast-rising bond yields and signs of inflation have made investors worry that profit margins could narrow. Which has sparked one of the biggest downturns of the year among shares of fast-growing companies that have benefited from a decade of near-zero interest rates.
Further, tensions rise as investors consider what's next for Jerome Powell and the Fed. Which will likely be a steady series of interest rate hikes from the Federal Reserve as it tries to bring the price of credit back to a "neutral rate." Markets ebb and flow on the availability -- or lack thereof -- of liquidity. And the last decade has seen the global marketplace awash in easy credit. A rising tide which has elevated all asset prices. Housing. Commercial real estate. Stocks. Bonds. Currencies. And crypto-currencies. All rising upon the incoming tides of cheap money. So now, as global central banks (starting with the Fed) begin to reign in that liquidity and those tides of easy money begin to recede, it only makes sense that those here-to-now inflationary asset prices decline as investors speculate on how this grand experiment will end.
Second, the idea that the continuing "trade-war" talk could, like a real war, actually ignite a greater conflagration that adversely affects the U.S. market (which has been the "last man standing" in the global marketplace) and drag the global economy into a deeper morass.
In the near term, China's precarious economic situation (China currently suffers from burgeoning indebtedness) render it very sensitive to the Trump administration's body blows. Which have landed in the forms of tariffs, and threats of escalation. Remember, however, that China recently made Xi Jinpeng "president for life." Essentially granting him the ability to focus on the long game. A game that China plays very well. And with 2021 marking the 100th anniversary of the People Communist Party, and 2022 hosting the 20th National Congress of the Communist Party, China believes it can defer gratification today in order to ensure that the economy is sound during these critical, iconic future dates.
China cannot enact tit-for-tat tariffs with the U.S. as they export so much more than we do. Yet, at some point, China will have had enough. And will likely devalue the Yuan. And force American companies -- and the economy they drive -- to face the consequences of an unfair playing field. A tactic that the Chinese have historically put to productive use when backed into a corner.
At which point the question will become: can the administration, seeking re-election, survive the caterwauling that will surely arrive from American corporate and commercial constituents?
Third, there is an underlying consensus opinion being bandied about that says U.S. earnings have peaked. And will soon begin to decline. Rendering valuations even uglier than they are today. And removing wind from the sales of Tech/FANG stocks which have served as rocket boosters for stocks throughout the bull market.
We believe this opinion is contradicted by empirical evidence.
Many analysts use inflated CAPE ratios (cyclically adjusted price/earnings ratios) as their evidence of equity market overvaluation. And yes, CAPE ratios, which take a ten-year look-back at valuations in order to smooth out the best and worst numbers and provide a rolling average, do appear slightly overvalued and getting more so. However, next year will see the terrible earnings data (the denominator in P/E) from the 2008 and 2009 Great Recession cycle out of the data. Immediately improving that metric, regardless of whether earnings improve or not.
Moreover, and contrary to the popular narrative, equities actually trade at below-average CAPE ratio valuations when you consider future earnings estimates. With analysts estimating that the earnings number used in the CAPE ratio will leap to a level of 163.1 by the end of 2019, from a current level of 122.5.
In other words, regardless of whether equities rise, fall or trade sideways, the denominator in the P/E ratio will soon become much more attractive. Showing stock valuations to be considerably more palatable than they appear today.
Taking a broader perspective, we historically use four indicators to track the probability of recessions, and the bear markets that accompany them. Those indicators are:
1) Sharp declines in ISM data
2) Sharp rises in weekly jobless claims
3) Inverted yield curve
4) Year-over-year deterioration in the Conference Board's Leading Economic Indicators
Currently, none of these indicators are flashing red. Leading us to conclude that, while markets are certainly trying to tell us something, impending recession and a bear market is not the message.
Perhaps this drop, temporary as we suspect it will be, will catalyze a sector rotation from Tech/FANG stocks into another sector(s) that will assume market leadership. Or maybe September's expected volatility just arrived late. Using the bewitching date of 10/10 to send a message to investors. That being, "Let's not get too apathetic, people. I can turn on you at any time."
Either way, November and December tend to be among the most positive periods for stocks of the calendar year. And we believe that, despite the fear and loathing prevalent in today's marketplace, this bull market ain't over yet.
As the following chart reveals, intra-year pullbacks (in red) occur annually. Even the bigger pullbacks often signify nothing more than a temporary bout of volatility. Setting the stage for a a continuance of the upward trendline.
As with all stock market pullbacks, crashes and corrections, investors must maintain perspective. Yes, an 800-point Dow drop looks scary. Yet, such declines have become more common. As the Dow itself has risen to record highs of nearly 27,000. In fact, yesterday's drop doesn't come close to ranking as a market crash. Or even an official five percent correction. Nor are we on the verge of a bear market. Even after Wednesday's bloodbath, the Dow remained up 3.6 percent this year. While the S&P 500 had gained 4.2 percent. And the Nasdaq had risen more than 7.5 percent.
For now, the bull continues. As it has since 2009.
That said, at some point it will end. And the time to prepare for that inevitability is not when the shooting begins. So please peruse the white paper below, "Alternative Thinking Required." As we believe it begins to provide a road map for investors eager to successfully navigate all market environments: good, bad and indifferent.
Weekly Results
The major market indices finished down last week. The Dow Jones Industrial Average lost 0.04%. The S&P 500 Stock Index fell 0.97%. While the Nasdaq Composite fell 3.21%. The Russell 2000 small cap index lost 3.80%. The 10-year Treasury bond yield rose 17 basis points to 3.232%. And gold closed at $1,203.22 up $10.72 per ounce, or 0.90%.

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