Thoughts on recent market action…

The market is back in the headlines for all the wrong reasons. The S&P 500 broke below its February lows this week and the damage just got worse. Panics like these occur from time to time. Remember 2011, when the markets fell 20% as the Euro debt crisis spun out of control and the US debt was downgraded. It was ugly for awhile, but the storm passed and the markets continued higher. This storm will pass too.

Generally, I don’t like to speculate on the causes of these panics. Investors should be worried about whats within their own control (assessing goals, time horizon, and risk tolerance). But I think this all begins with trade/tariffs and the disruptions to global supply chains along with the uncertainties they cause. The US economy is on solid footing (as we noted here), but the rest of the world isn’t. S&P 500 companies generate 40% of their revenues overseas, so sustainable global growth is important. Global growth is expected to slow in 2019, but slower growth isn’t a recession. Post financial crisis the markets have done just fine with a 2% growth economy. 2018 was a banner year for earnings and economic growth, setting the bar high for 2019 comps. What’s different this time is a growth slowdown along with a hawkish Fed. (I personally don’t believe its too hawkish because even if the Fed hikes rates twice next year, a 1% real Fed funds rate really shouldn’t put an end to this expansion. But the bond market is signaling some concern. )

Which brings me to my next point…

Fed Chairman Powell told us this week that the Fed is no longer going to placate to the markets temper tantrums. Since the financial crisis the Fed has gone out of its way to appease markets whenever they reacted badly. From unprecedented monetary stimulus (ZIRP & QE), to “Taper Tantrum”, to Yellen putting the brakes on further rate hikes in 2016. This “silent agreement” could have led to complacency among market participants, especially during an era of zero interest rate policy. The removal of the “Fed put” is something the markets are going to have to adjust to. Fed President Williams tried to appease markets on Friday, but it didn’t work. It’s going to have to come from Powell himself, and I have a feeling he will backtrack if the damage continues. But for now, the markets are trying to price in the new reality.

Add in politics, Brexit, and ECB removing stimulus at a time when they may need it most, and you have a wall of worry that the market just couldn’t continue to climb indefinitely.

2018-12-22_1728

The S&P 500 rally off the 2016 lows matched the size of the 2011-2015 rally. Perhaps the market had gotten overbought, but hindsight is always 20/20.

2018-12-22_1748

The market reached a potential support zone between 2405-2018 during Friday’s sell off. If this fails, we have one more around 2322, which would match the size of the 2011 sell off. If we can hold either of those first two support levels, I believe the bull market is intact and a rally to 3600+ will be underway. Failure could bring us back to 2195 and 2135, which would erase the entire Trump rally. Momentum is clearly to the downside, we can’t completely rule it out.

Time will tell. Hopefully 2019 will be much kinder!

Advertisements

December 2018 Market Update

The theme for 2018 is volatility. After an uninterrupted rise in 2017, 2018 is making up for the lack of volatility. The S&P 500 has now experienced two corrections of 10%+ and many are questioning whether the bull market is over. But is this justified?

The data continues to show an expanding economy, solid corporate profits, and reasonable valuations compared to fixed income. 2017 may have gotten too optimistic (and complacent), but now the market is getting too pessimistic about future growth. There is little chance of a recession in the next year.

The recent declines can be attributed to a variety of headwinds. Trade with China, potential for a messy Brexit, Italy, France, political gridlock, take your pick. This weighs on sentiment. Headlines are great for traders but not so much for investors. Investors should be focused on fundamentals and taking advantage of opportunities (such as this!) when they present themselves.

The Economy

LEI

Leading economic indicators are at an all-time high. As the name implies, this index typically rolls over before a recession.

ISM MANUFACTURING

ISM Manufacturing has been steady. The last reading of 59.3 was well in expansion territory.

ISM SERVICES

ISM Non-Manufacturing (Services) is composed of about 70% of the economic activity in the US economy. The last monthly reading of 60.7 was one of the highest on record.

fredgraph

The St. Louis Fed Financial Stress Index is still negative and well below levels that would signal potential underlying issues.

fredgraph (1)

There was a lot of discussion surrounding the inversion of the 2 year and 5 year treasury yields. It’s worth noting I guess. But the most timely and reliable yield curves are still positive, although flattening. The above chart is the yield curve between 2’s and 10’s. It’s about as flat as it’s been during this current expansion. However, this yield curve was relatively flat throughout much of the mid to late 1990’s. And stocks did very well.

fredgraph (2).png

My personal favorite yield curve (3 months vs 10 year) is still relatively healthy.

Earnings

F eps

Earnings Per Share (EPS) for all companies in the S&P 500 over the next 12 months is projected to be $170.96, for a growth rate of 19.94%.

t eps

Already reported Earnings Per Share (Trailing EPS) for S&P 500 companies is $157.83, for a growth rate 23.08%.

f ey.JPG

Forward earnings yield (forward EPS/SP 500) is currently 6.50%. Reaching the highs seen during the 2015-2016 market lows.

t ey

Trailing earnings yield is currently 6%. Not quite at the 2015-2016 highs, but getting close.

These yields are against the backdrop of a 10 year treasury bond that still only yields about 3%. Which leads me to valuations…

Valuations

f pe

The Forward Price to Earnings Ratio (P/E) has fallen to 15.4, after reaching a high of almost 19. This is due to strong earnings growth combined with a declining stock market.

t pe

The Trailing PE is currently 16.7 after reaching a high of 22. Valuations are less expensive and closer to their historical averages. But still above long term averages.

However when we factor in where interest rates currently are, competition to stocks from fixed income alternatives, stocks continue to be attractively valued.

Technical Analysis

SP 500.jpg

It’s important to remember during times like these that corrections are a normal part of the investment cycle. They always feel like the “end” but they almost never are without a deterioration in the fundamentals. The above chart shows the period of consolidation experienced between 2015-2016. This setup the next expansion and are necessary to keep valuations and complacency in check. This current consolidation phase will setup the next expansion.

2018-12-13_1312.png

Monday’s low now matches the size of the February correction (11.8%). If the market can’t hold that low, the next downside target would be the February low of 2532.

ad line

The Advance – Decline line has displayed some relative weakness recently. But still well above the February lows, even though the S&P 500 trade within a few percent of its February lows.

It’s always concerning when every major average and the NYSE AD line is trading below their 200 day moving averages. Especially in a bull market nearing 10 years old (depending on where you measure the beginning). However, this isn’t unprecedented. It’s happened plenty of times before. What’s more rare is a long sustained bear market without a recession.

Conclusion

Investors should expect a 10-15% correction to occur every year. We’ve had two such corrections this year, but we had zero last year. This is not unusual. Use these times to look for opportunities. No one likes to see the value of their accounts decline. But the volatility is what makes stocks return more than any other asset class. This correction sounds worse than what it truly is. The Dow is down about 2% for 2018, after being up 18% last year. Stocks usually rise over time but they rarely do so in a straight line.

As for the economy, I think it’s pretty clear the economy (and earnings) will slow in 2019. But slower growth is not a recession. I want to emphasize this is not a 2008 situation. There’s no recession and the banks are much healthier. For example, last weeks reading of the services part of the economy (about 70% of the US economies annual output) was one of the highest on record and historically correspond with economic growth above 4%. When will this end? Unfortunately no one knows that. Corrections are impossible to time with any consistency. But it will end. That much I’m certain of.

In summary, it’s never easy to endure corrections. But they do occur even in good times. It’s not unusual. It’s market crashes that are rare. 2008 style crashes have only happened 3 times in 100 years (1929, 1974, 2008), while corrections occur annually. Market crashes coincide with recessions and a recession is very unlikely in the next 12 months. We seem to be making up for the lack of volatility from last year.

Annual returns are impossible to predict

At the beginning of every year market commentators and analysts give their predictions on where the market will close. Research has shown that most of these forecasts did not perform significantly different than a chance forecast. (Link) In other words, similar to a coin flip. Stocks have returned about 10% nominally annually post WWII. So, the safest bet is to close your eyes and predict 10% every year. The question is, why do so many intelligent and informed analysts get it wrong?

The answer lies in the composition of stock market returns. There are 3 components 1) Dividends, 2) Earnings, 3) Change in PE. The first two can be quantified and thus predicted reasonably well. However, the 3rd and final piece of the puzzle is completely based on sentiment. Of which, no one can predict with any consistency.

  1. Dividends

sc.png

The dividend yield on the S&P 500 is calculated by taking the dividend per share of all companies in the index, divided by the price of the S&P 500. The chart above shows the current dividend yield on the S&P 500 is 1.80%. Dividend yields rise as stocks fall, and vice versa. So there are positive aspects to market declines.

2. Earnings yield

The earnings yield is calculated by taken the earnings per share of all S&P 500 companies and dividing it by the price of the index. Like Dividend yields, earnings yield increase as price declines, and vice versa.

Currently, the projected earnings per share for S&P 500 companies over the next year is $173.61. The S&P 500 is currently trading at 2837 as I type this. Therefore the earnings yield is currently 6.12%. Which is attractive given that treasury bonds still only yield 3.22%.

3. Change in PE (Price-to-Earnings ratio)

So if we have a dividend yield of 1.80% and an earnings yield of 6.12%, doesn’t that mean we should expect an annual return of 7.92%? Oh if things were that simple!

There’s a 3rd component, the change in PE ratio. This has to do with how much investors are willing to pay for those earnings. Generally, when things are going well, investors will pay above average “multiples” of earnings. But in the short term, there isn’t a reliable way to predict how investors will react.

Recent examples are Oil and Interest rates. Oil fell from $100 to $25 back in 2015, first the narrative was falling oil was great for consumers, then it shifted to falling oil being deflationary and a precursor to recession/bear market. The sentiment has shifted on the way up as well.

Investors have been nervous as the yield curve has flattened, now that interest rates are rising (yield curve widening) it appears nervousness has reemerged. These narratives may or may not have anything to do with the actual price movement. My point is that shifts in sentiment (whether it be fundamentally sound or not) can and will fluctuate rapidly from one year to the next.

If you’re an investor, it’s best to stick with the fundamental data and take advantage of the opportunities the market gives you. You can predict a market driving event right, but still miss how investors will react to that outcome. It’s best to stay diversified, stick to your plan, and take advantage of those opportunities.

Let’s stop with the lack of participation argument…

There’s not a day that goes by when I don’t hear someone talking about how this market is being led, or held up, by only a handful of stocks. Normally I wouldn’t care, but the inference is usually followed by some sort of doomsday prediction. We all know that bear markets are a natural part of the investment cycle. They aren’t fun in the midst, but from time to time they are necessary for a variety of reasons.

One can continue to predict market crashes, and eventually they will be right. But this does no good for anyone. The S&P 500 was trading around 1,000 when the end of the world crash callers (due to Fed policy, Europe disaster, etc.) were out in full force. The S&P 500 is now trading at almost 3,000. Meaning a 70% crash would be needed, just to get back to those levels. You see, this is no way to invest successfully. Rather, this leads the novice investor to make bad decisions. So, I’m going to do my best to break down, and then debunk this “lack of participation” argument.

Let’s begin by understanding how the S&P 500 index works. It’s a “market cap” weighted index. So, the companies with the largest market cap are the ones that are weighted the highest in the index. Market cap is computed by multiplying shares outstanding by the price per share. As a companies stock price increases, it’s weight in the S&P 500 will also increase. Therefore the index is dynamic by nature.

So there is a “smidge” of truth in this argument. Yes, the companies with the highest market cap will account for a higher percentage of the index’s returns. This has always been the case, and will always be the case in the future, as long as the index remains market cap weighted.

Today we find the largest companies in the S&P 500 are mostly tech companies. But that has changed numerous times in the past. And will continue in the future. Below is a list of the 10 largest companies every five years since 1980.

Historical Largest companies by market cap.png

However, the problem arises when the argument then implies that these top companies are the ONLY stocks participating in the rally. As if the only stocks that are rising are the FANG’s (Minus FB recently) of the world. As you’ll see. This couldn’t be further from the truth.

ad line

Here is a chart of the New York Stock Exchange Advance Decline line. This exchange covers just about every investable US stock. The index has far surpassed its January highs, even though the S&P 500 has only slightly breached its January high and the Dow still trades about 2% below its. This index has no weighting scheme, every stock is as important as the other. Broad participation. If it were only a handful of stocks, this index would be going down, not up.

spxew

Here is the S&P 500 equal-weighted index. Which also weights every stock exactly the same. Here to, we see the index making new highs. If it were just a few stocks, this wouldn’t be the case.

Capture

Here is a chart of the US small cap and US mid cap stock index. Again, both index’s are well above their January highs, even outperforming the S&P 500 year to date. Broad participation.

The technology, consumer discretionary, energy, and health care sectors have all taken out their January highs as well.

This market is not being held up by a handful of stocks. Yes, the largest companies account for a bigger percentage of the total return. But this is an entirely different argument.

Capture

According to S&P IQ, the top 10 companies currently account for 21.3% of the S&P 500 index. All things being equal, even if the top ten companies stock prices were going down, the market could hypothetically advance, as long as most of the rest of the companies in the index were increasing.

In fact, we’ve seen numerous examples of this. Apple fell 30% twice during this bull market. Amazon has seen numerous 20-30% declines, Facebook just lost 20% in one day, Microsoft went nowhere for about a decade, the list goes on. All the while the index continued to advance higher. This argument is another example of “paralysis by over-analysis”.

So, we’ve established that the largest companies in the index will make up a larger weight in the calculation of returns. Much like if your finals make up 25% of your final grade, those finals will be the largest contributor to your final grade. But that doesn’t mean your homework and other assignments are meaningless. And it doesn’t mean you didn’t do well on those other assignments either. This should be a pretty straight-forward point. It’s amazing to me that it’s gotten this much attention.

I hope this helps clear things up a bit.

No reason to predict yield curve inversion…

yield curve 1994-2000

Yes, an inverted yield curve has been a good predictor of recessions. And yes, the yield curve has been flattening for the last year. But no one can predict when the yield curve will actually invert. This is another fruitless endeavor that will only harm the investor.

Currently, the yield curve is only about 20 basis points away from an inversion. But, this information alone tells us nothing about the future. The above chart shows the yield curve (2’s and 10’s) during the major stock market rally of the mid-1990’s. From 1995-2000, the yield curve spent most of the time between 20 and 60 basis points. Let’s see how the stock market performed during this time:

1995: +37.20%

1996: +22.68%

1997: +33.10%

1998: +28.34%

1999: +20.89%

As you can see, stocks can perform well in a flattening yield curve environment. And an inversion can take years. Aside from this, an investor need not attempt a prediction of an inversion for two reasons.

1) Average length of time between a yield curve inversion and a recession is 16.4 months

Capture

Going back to 1978, the data shows ample time between the yield curve inversion signal and a realized recession. Including a full two years before the 2005 inversion, until the 2007 recession.

2) Stocks have averaged a 15.72% return in between a yield curve inversion and a recession.

Capture

Same time frame, stocks have posted double digit returns between the inversion and recession in all but one of these time periods.

sc

The stock market is clearly in a bull market. The S&P 500, Nasdaq, & Russell 2000, have all made new all-time highs, and the Dow is not far behind. Investors should enjoy it, and spend less time trying to predict when its all going to end.