Stock Futures looking decidedly lower (Bloomberg)
What a week. The equity markets, both domestic and global, were decimated. The S&P 500 lost 5.8% over the past week (leaving it down 4.3% year-to-date). Emerging markets were hit extra hard losing a whopping 7.8% over the week while developed overseas markets followed suit with a –6.3% one week performance.
Investors now want to know whether it’s time to panic. Unfortunately, I can’t definitively provide an answer on whether it is or isn’t. In fact, no one can. Sure, you’ll hear the typical financial pundits on CNBC declare with exact certainty the direct cause of the selloff and how equities will perform over the short term. Some of the explanations as to the cause of the selloff will be correct, but the prognostications won’t. Just white noise in an overly uncertain world.
But what I can be certain of is this: the complexion of the market has changed. The price action of the equity markets has been as revealing as a slap in a face. The past week has brought a substantial amount of technical damage that must be dealt with no matter the cause of the market drubbing.
Don’t get me wrong, the cause of the selloff is important. It does matter, for example, whether the price decline resulted from just a healthy and normal correction (as equity markets don’t go straight up in a line, with the exception of the last, um, 6 years—part of the problem as it’s lulled investors into thinking this is the norm), or whether it’s fear of an increase in domestic interest rates, or major economic problems with China, or even worse, a beginning of a global recession. Each of these causes will bring a varied longer term set-up to the direction of the market. Time will reveal the direction, but for now we relied on the technical damage of the market as an indicator to pare back exposure to the equities.
Further technical damage to the market will beget further defensive posturing in an attempt to preserve as much capital as possible. Remember, as we have always managed money in corrections, the intent is not to take all exposure off. Overly timing the market is dangerous, but reducing risk on the margin is prudent. And if the correction proves to be short lived, we will be nimble enough to add equity exposure.
Here are links to some other articles about recent market developments:
- Five Hundo (TRB)
- Is the bull dead (BigPicture)
- This week’s market selloff may not be such a bad thing (NYT)
And as always, feel free to call or write with any questions or concerns.
Have a nice weekend!
Former Fed Chairman Ben Bernanke is now blogging. His first post should be a required read for everyone in Congress as they know close to nothing about how our economy works.
Do you want to know more than congress? Click here for a fairly simple take on why interest rates are so low: Brookings.
Some things I’m reading this morning:
- Apple: revenue up & profit margins at the top end of range (MarketWatch)
- Paul Tudor Jones: U.S. stocks will outperform other equity markets for the remainder of this year (Bloomberg)
- Value investors hoarding cash (Bloomberg)
- Cautious optimism on the economy (WP)
- Poster children for buybacks-trump anything investing (TRB)
- W.H.O declares Nigeria free of Ebola (NYT)
- Update on Europe’s Quantitative Easing initiative (Zerohedge)
- Bill Murray’s words of wisdom (TheDailyBeast)
Who is Ben Stein? He’s a lawyer, a political commentator, President Nixon’s speechwriter, the economics teacher from Ferris Bueller’s Day Off (click here for a clip of his role) and even a self-proclaimed economist. He has been so successful at selling himself as an economist that he landed a coveted role writing a weekly column about finance and the economy in the NY Times. He has since moved on from that assignment, but I have seen him recently talking economics and markets on Fox Business.
Why does this matter? Because on August 7th in 2007 Ben Stein penned an article in the NY Times titled Chicken Litttle’s Brethren, on the Trading Floor. You can click the title for the full article or just let me briefly summarize the crux of Stein’s argument: when the article was written, the subprime mortgage market was experiencing some cracks and the equity markets had sold off some 6% from their highs. Mr. Stein basically argued that the subprime mortgage market, at only 13% of the total mortgage market, was too small to cause damage to the broader economy and stock market (“these subprime losses are wildly out of all proportion to the likely damage to the economy from the subprime problems.”).
The rest, as they say, is history. The S&P 500 peaked a few months later in October of 2007 and proceeded to sell off 60% over the next year and a half. The problem, as we all know now, was in large part due to the problems with subprime lending.
What’s noteworthy about Mr. Stein’s argument is not that he inaccurately calculated the implosion of the subprime market that was really only just beginning during that summer of 2007. 99.9% of us made a similar mistake. As Michael Lewis documented so well in his book The Big Short, there were only a handful of people that recognized the impact of the credit problem and actually had the conviction to trade on their belief. No, what’s striking about Mr. Stein’s argument is how naive it was to dismiss the interconnectedness of financial markets in addition to the emotion/human psychology that drives investors to hit the sell button. As an “economist” he should have been aware of leverage ratios at banks. As an actor he should have seen the movie It’s a Wonderful Life with its bank run scene.
Fast forward to today. Over the weekend “The Trader” column in Barron’s described reasons to dismiss the “wall of worry” in today’s markets. Ebola, the end to QE, etc. Well reasoned arguments, for sure, about these concerns. But here’s what was said about Europe:
“The next worry is deflation in Europe spreading to the rest of the world. First, sustained deflation is not common and Europe isn’t there yet. True, the euro zone is recessionary in some countries and basically is showing no growth as a whole.
‘Yet, how is this different?’ asks Chris Hyzy, chief investment officer of U.S. Trust. The euro-zone economy has shown 1% growth to 1% contraction for the past three years. On the margin, Europe is a negative factor, adds Dan Morris, global investment strategist at TIAA-CREF, but the U.S. isn’t a trade-dependent economy. U.S. exports are about 13% of gross domestic product, half of Germany’s ratio.”
There’s the 13% figure again. Obviously it’s by coincidence that we see this identical statistic as the one referenced in the aforementioned 2007 article. But it’s eerily reminiscent of Stein. What’s really at stake is not the relatively small exposure that the U.S. has to the Eurozone, but how a such a small percentage can metastasize based on fundamental issues (implosion of European banks will impact U.S. banks) and a spreading of fear should the worst happen.
It’s too early to panic. But there are signs of real risk in the Eurozone as growth continues to slow. If problems persist, a policy response by the European Central Bank President Draghi will likely stave off any potential disaster for the near term. However, that response involves convincing 18 European countries–including Germany–to commit to such a response. At this point, we can’t be overly confident that this will happen, and thus, the Eurozone remains our largest fear for equity markets.
This weekend’s Barron’s had two bullish articles about the prospects for continued stock market price appreciation. Below, I’ve copied the introductory paragraphs to the first of those two articles. The second article eerily reminds me of another optimistic piece written prior to the market rout in the fall of 2008. I’ll comment on that one in a later post, but for now here is a take that succinctly & reasonably highlights some positive aspects to this current market.
A four-week losing streak has sent the Standard & Poor’s 500 index down 6.2%, and stoked investors’ fears of a looming bear market. To many market pros, however, the dip has been like a Halloween horror movie—worth watching but not to be taken too seriously.
In fact, they now see a chance to load up on stocks after such indiscriminate selling. Even after Friday’s 1.3% rally, lots of quality stocks appear to be good buys.
Fundamentally, the market is fairly valued, but not overvalued, and the economic backdrop remains healthy. The U.S. economy looks to be growing at a healthy pace—4.6% in the second quarter and an estimated 3% in the third. Third-quarter earnings are expected to rise 5.1% year to year, according to FactSet. Employment and manufacturing growth reaffirm the trend, and while retail sales slipped 0.3% in September, falling gasoline prices have boosted consumer confidence.
“There’s a disconnect between the sharp market drop and the still-improving fundamentals of the economy and earnings growth,” says Kate Warne, a strategist at Edward Jones.
Trading patterns also indicate confidence in the longer-term outlook for stocks. Investors are paying more to hedge risk now than four months down the road, says Thomas Lee, head of research at Fundstrat. That “inversion of the VIX,” or volatility index, historically has been a sign that the market is nearing a bottom, so long as the economy isn’t in recession.
“Even if I don’t know whether we’ve bottomed, I’d still rather close my eyes and buy,” says Lee.
The S&P 500 traded for 14.6 times forward-four-quarter estimated earnings as of Thursday’s close, according to Yardeni Research. That’s down from 15.5 at the high, and up from 10.2 times at the March 2009 low. Today’s multiple is a slight premium to the 13.8 average multiple since 1978, the first year that data were compiled.
With 10-year Treasury notes yielding near 2%, investors also have more incentive to look to stocks for income, as well as price appreciation. The average S&P 500 stock yields 2%, and 35% of S&P 500 components had a dividend yield greater than the 10-year Treasury yield as of Thursday’s close, according to Lee. That’s twice as many as the long-term average.
The Federal Reserve has begun to hint that, should fundamentals falter, it might delay raising interest rates. The market currently is expecting the central bank to lift rates in mid-2015. A fourth round of quantitative easing, or bond buying by the Fed, can’t be ruled out, either.
“If people realize the world isn’t going to come to an end, you’re going to see them roll back into the market,” Yardeni said.
Investors have dumped shares in some sectors far more than in others. Energy stocks, for instance, have fallen 11% since a Sept. 18 high, and 15% since the start of September. Industrial and materials stocks also have tanked on concerns about a possible global slowdown.
Some things I’m reading this morning:
- European stocks rise amid pressure for stimulus (Bloomberg)
- Even oil stocks are surging (BusinessInsider)
- Morgan Stanley’s revenue doubles, shares up big in pre-market (USAtoday)
- 5 reasons to worry about deflation (WSJ); see also, Europe is flirting with deflation (BusinessInsider)
- Calm returns to Wall Street, but Europe remains a worry (DealBook)
- What markets will (NYT)
- How to ruin your life (MotleyFool)
- Wilco to play 6 shows in early December at the Riviera. Tickets go on sale this morning at 10 am (WXRT)
Over the recent past we’ve seen significant outperformance in the small cap stocks versus the large caps. The above chart shows that the Russell 2000 Growth Index (IWO, which is the proxy for small caps) is up 2% versus an almost 3% drop in the SPY (or large cap S&P 500 index) over the past three days.
This might suggest that even the riskier parts of the market (small caps being riskier than large caps on a relative basis) have been beaten down so much and are looking to bottom.
A glimmer of hope and a development to continue to watch closely.
Some things I’m reading this morning:
- Doug Kass: 7 reasons a recession is more likely than you think (TheStreet)
- The benchmark 10-year Treasury traded below 2% for the first time since June 2013 (Bloomberg)
- U.S. oil producers may drill themselves into oblivion (BusinessWeek)
- Ebola virus disease in West Africa–the first 9 months of the epidemic and forward projections (NewEnglandJournalOfMedicine)
- Jim Cramer: why Ebola is behind the selloff (CNBC)
- Is Wednesday’s market selloff a sign of global slowdown or a correction? (FP)
- Wall Street might know something the rest of us don’t (NYT)
- What if there is no tomorrow? (TRB)
- Which movies to see–& skip–at the 50th Chicago Intl Film Festival (ChicagoReader)