How Stocks Fared Following Midterm Elections
Bob Carey, from First Trust Advisors, provides the following chart on stock market returns for the calendar year following midterm elections.
Bob Carey, from First Trust Advisors, provides the following chart on stock market returns for the calendar year following midterm elections.
Back on October 15th in market commentary I wrote, “A scenario is developing which could push stocks further into the red in the coming days and weeks…”
On October 20th I wrote, “I do not expect the current situation to resolve itself quickly.”
To be fair, the stock market could have moved higher from each of those dates, but it hasn’t, the selloff has intensified. There is one primary reason I felt it could get worse before it gets better. This is a mature market. I don’t believe the I bull market is over. I do believe, for it to continue advancing, values need to be reset and that is what is happening.
Those investors with more than a few years of investment experience know that periodically we enter into corrections and occasionally bear markets. The difference between a correction and a bear market has to do with the degree of the decline. Bear market also usually last much longer.
The primary culprit of the current sell-off is interest rate related. The good news is that a statement by the Fed that they are going to review future rate hikes and reconsider their plans could stabilized the market. This is likely to happen if the situation deteriorates any further. A credit/consumption-based economy is very sensitive to interest rates. Like a ballast, interest rates have the potential to tip the stock market if they rise to far too fast. Several real estate reports have recently indicated a slow-down in activity being attributed to higher interest rates.
Corrections are a necessary part of investing. They allow the market to reassess value. Higher interest rates require future cash flows for stocks to be discounted at a higher rate causing them to be worth less. Once the market has revalued stock prices based on higher interest rates the bull market underway should continue. A pause in rate hikes could make this process smoother.
It is possible we could see the situation deteriorate further. If it does investors are best served to hold tight. Often the market overreacts in this type of situation but eventually sprints higher. You don’t want to be out of the market when that happens.
Of course, investments in money markets, bonds and gold can provide some refuge during difficult stock market conditions.
Immediately at the open this morning I had two alerts trigger. One alert was for stock based investment that was under selling pressure. The volume of shares traded immediately at the open was much larger than normal. Overall, the price was down around 2%; firmly below the 200dma (black line). As I suggested in recent commentary related to the current selloff, the additional selling I thought had a good chance of materializing has arrived.
The other alert I received this morning was related to gold. The ETF GLD gapped up at the open and looks poised to continue climbing. This is the type of action you look for from gold in a portfolio. According to ETFReplay.com, the ETF GLD has a correlation to the S&P 500 ETF SPY of +0.08, which is only slightly positive. Correlations have a tendency to change and right now gold appears to be delivering a negative correlation, which is what you what to see during a stock market selloff.
Stock market trading settled down this past week providing an opportunity to evaluate trading levels and set technical alerts for support and breakout points.
Below is a snapshot of a equity investment I follow closely.
As you can see in the chart, it has been seven days since the investment closed below the 200 day moving average (Black Line Below Price Bars). During the last 5 trading days support has been held at this line. Notice the investment has closed just above this support the last two days and at the bottom of the range of the trading range (Small Horizontal Line Across The Longer Vertical Blue & Red Lines Represents The Closing Price). Volume has been heavy (red and blue vertical bars in the section below the price) which suggest sellers were met with an equal level of buying at these prices.
The first support level for this investment is currently near the 200dma (day moving average). There is also support at the bottom the price range where this investment traded below the 200dma. It is too early to tell if we will revisit those levels again but so far buyers have been willing to come in and support a price above the 200 day line. Continued support at the current price level would suggest the worst of the selling is behind us.
Trading this last week has also provided a potential break-out price level. If the price of this investment moves above the trading level from 3 days ago, that would indicate buyers have regains some control which may indicate the worst selling from this correction is behind us, increasing the likelihood we rally into year end.
I do not expect the current situation to resolve itself quickly. I believe investors are reluctant to come into this market because so many commentators are suggesting this is the beginning of the end of this bull market. It believe they are wrong and those investors that take an overly defensive position into 2019 may be leaving money on the table.
We have two big dynamics at play that are supporting this market. A strong U.S. economy, which we have not had since the Great Recession of 2008, and a technology renaissance touching a wide variety of industries.
There are a lot of technical indicators used by stock investors. Some screens are so filled with colors, lines and data it tough to make heads or tails from what you are looking at.
It is helpful to remember there are only two data inputs. Price and Volume. Price determines the trade direction and volume establishes conviction. Focusing on these two variables and adding a simple relative strength indicator can yield a great deal of information about the potential near-term price action.
Take the example below. This is a high-growth tech stock that has delivered outstanding returns to investors over the last couple of years. This stock when public in 2015.
In weekly chart above we can see three different basing patters (identified by the green dots and curved line). Two of these bases were consolidation types and the middle base was a cup w/handle type (the handle slopped upward which is a potential concern). The most telling part of the current late stage base (also a warning) can be seen when comparing it to the prior consolidation base of about a year ago.
Notice how the current base is downward sloping (current price is near the bottom of the base range). The base this stock produced over a year ago featured the price staying more in the middle and then upper range. You should be able to see an upward sloping trend just looking at it. The current consolidation is producing the opposite, a downward slope.
Below the price bars you see the blue relative strength (RS) line. The RS line measures the price performance of a stock with the price performance of the S&P 500. If the line is trending higher it is outperforming the market. For growth investors often a new high on the RS line is a bullish buy signal. It is extra bullish if this line hits a new high ahead of the price.
In this example, the RS maintained an upward slope during the first two bases. Now it is starting to exhibit a downward slope. The red lines over the RS were drawn to show the change in slope. Notice how in the first base the slope of the RS line initially weakened. This is normal and to be expect as a stock rests. It is possible the stock above will still move higher and the RS line will turn higher. But, if the price of this stock moves below the bottom of the current base consolidation, that would increase the probability this stock is going to see weaker price performance in the near-term.
The stock market experienced swift and deep downward action last week. Part of the market selloff points to typical action by institutional investors and looks very similar to the February decline. This type of trade action includes Option Gamma Hedging strategies, where traders profit from increased sensitivity to an option’s price change measured by gamma. Much of this type of selling is believed to be behind us.
You also have the Trend Following crowd, once indexes made a strong move below the 50-day moving average selling and short exposure increased, which aggravates moves to the downside.
This week Volatility Sensitive Strategies (investment allocations that shift between cash and the S&P 500) and Risk Parity Strategies are expected to be active. Some trading desks suggest there’s around $355Bn allocated to this category of trading. Stock exposure for these strategies is believed to already be down to around 65% from 100%. Another 15% reduction is still expected.
Goldman Sachs reported good flows into their Corporate Buyback desk but as you can see in the chart below (Stockcharts.com & Dightman Capital), it was not enough to establish firm support. Trading volume on Friday was significantly below recovery rallies earlier in the year and selling volume for S&P 500 stocks was significantly higher.
The Tech Premium, the higher cost an investor is willing to pay for tech exposure versus other areas of the stock market has faded a bit and may have further to fall. One area contributing to the compression in tech stocks involves international growth. There is concern international market are going to fall into recession before they kick into a higher growth mode. Rising Costs are also weighing on tech. While top-line growth is steady, margins are being compressed as costs, like wages, are rising.
On the geopolitical front, Trade Talks with China should be quiet (but probably won’t be) leading up to the November G-20 meeting but Saudi trouble and the Price Of Oil is a new issue for the market to digest. Brexit talks are not progressing well with many obstacles remaining so that may be causing traders in Europe to sit on the sidelines.
Q3 Earnings ramp up this week, so we will know more about the health of corporate finance throughout the week. Disappointing results or poor guidance could send stocks lower.
A scenario is developing which could push stocks further into the red in the coming days and weeks, or at least mute any recovery. More downside for the stock market would provide cover for The Fed to become more dovish and slow interest rate hikes. This would likely be a welcome development for stock investors but in the meantime, we may see a bit more pressure on stock prices. From a longer-term perspective this looks like it may end-up being a buying opportunity on the strength of the U.S. economy, a renaissance in innovation and low interest rates globally.
Continued economic growth has led the Federal Reserve to raise the Fed Funds rate to 2.25%. This is the biggest issue facing asset markets right now even though the rate remains well below levels that led to recessions twice during the last 18 years. For that reason, I believe the Fed is going to be cautious with moves above 3%. Remember, one of their stated goals initially was to be able to “normalize” short-term rates. I believe they will have accomplished that goal when they reach 3%.
The 30-Year Treasury bond broke price support with the latest Fed announcement which pushed up interest rates at the long end of the curve. The silver lining for the current rate environment is a steepening yield curve. The interest rate spread (the difference between short-term and long-term rates) makes it possible for banks to borrow at low rates and lend at a higher rate. A strengthening banking sector should benefit the broader economy.
Here is a look at the Treasury market yield curve and 30-Year Treasury Bond price chart.
Real estate price appreciation should also slow as financing costs rise. There is some evidence in certain markets that price increases have slowed or stalled. Stocks too, will compete with higher bond yields as rates move higher (more on this below).
In terms of Inflation, globalization has kept most inflation measurements in check (aside from asset prices like real estate and stocks). Low inflation should provide the cover the Fed needs to slow rate hikes in 2019-20. On the operational side, companies do benefit from low and stable input costs, which helps drive earnings growth. An increase in input costs could result in higher prices.
Trade disputes may influence inflation but it could be temporary in many cases. There remains a lot of capacity in the world so moving production, for example, out of a country is an option for some. Other products might require special machinery or expertise and those product markets might see higher prices, potentially much higher. Those individuals in the market for new electronics might want to make a purchase now if higher prices is a concern. It is possible we could see higher prices in a wide mix of products from trade negotiations; so far the effects have been negligible. Early 2019 is when we might start to feel the pricing pressure from ongoing trade disputes.
The U.S. Economy remains healthy; October started with a trio of good news.
The U.S. Stock Market continues to like the economic environment. Three months remain in 2018 and if stocks can hold on to the gains they have generated, it will be a decent year.
It is important to remember a diversified portfolio will have a mix of investment returns. While certain parts of the stock market are delivering nice returns, some categories are under performing. Many dividend stocks have not had a particularly strong year. Bond yields are part of the reason. The relative safety of bonds, combined with their now higher yields, compete with stock dividend yields. Also, value stocks are not favored in the current environment; both of those factors should eventually become attractive as market character shifts.
Earnings-Growth Expectations for Q3 remain strong. The view from FactSet suggest earnings growth between 20-25% for the period.
So no, I don’t believe stocks are going to be derailed by higher interest rates in 2018. We remain in a very constructive economic environment despite ongoing trade negotiations. As we start Q4 stocks have pulled back; expect more selling in the days and weeks ahead. This is a normal and healthy process which should eventually allow stocks to rally as 2018 comes to a close. Don’t be surprised if this pullback ends up being 5-10% deep. Primarily due to interest rates and trade talks. As of the close on October 8th, the S&P 500 was down less than 2%.
The U.S. stock market has come under pressure despite good Q2 earnings and the continuation of strong economic numbers. The price declines are especially prevalent in tech industries while other sectors of the stock market have held up over the last week. What is the market telling us?
In simple terms, technology stocks may be going on sale.
It is clear Facebook and Twitter face unique and systemic business challenges, but the massive declines they have experienced in the last few days seem to be taking down other tech related stocks. The software industry, for example, is down nearly 5% from highs reached just 5 days ago. More specifically, Cyber Security is down nearly 6% from highs it reached on July 18th. Biotech is another example, down 6% since July 12th.
Company valuations are also a concern. Technology stocks have become expensive and those companies with strong growth fundamentals, primarily sales and earnings growth, generally trade at a premium to the market, during rising markets. There’s little evidence business conditions for tech companies are contracting so the decline in price appears to be a typical correction bringing tech valuations closer to the broad market.
Other sectors of the stock market do not appear to be impacted by the tech selling, at least so far. How can we tell? For one thing, other stock market sectors have been able to avoid the selling: Materials (XLB), Industrial (XLI), Consumer Staples (XLP), Energy (XLE), Healthcare (XLV) Utilities (XLU), Financial (XLF) have all generated positive returns over the last 5 trading days. 7 out of 11 sectors delivering positive returns. These are not just defensive sectors either. The Financial Sector participation is a bonus, suggesting these financial companies have not been impacted significantly by problems in the tech space and valuations in this sector are actually quite reasonable.
Other groups have also been able to side-step the selling over the last 5 days. Transportation, Healthcare, and Consumer Staples, just to name a few.
Below is a look at the price performance over the last two months of the 11 SPDR Sectors, considered a good proxy for the entire U.S. stock market. Recent selling appears to be focused on technology related companies; However, talk of a government shutdown has the potential to aggravate the situation; it would be wise to proceed cautiously with any new investment.
(NOTE: The recently introduced eleventh “Communications Services Sector” (XLC), has an 18.5% allocation to Facebook, and 26% to Google. The largest traditional “Telecommunications” holding is Verizon, which only represents 4.8% of the sector ETF. A good example of why it is important to know the actual holdings of any mutual or exchange traded fund.)
Stock and bond market performance has been more volatile in 2018. After an amazing run in 2017 stocks have become more sensitive to interest rate hikes and potential disruptions in global trade because of ongoing trade negotiations by the Trump administration.
Bonds too have seen an increase in volatility as the Federal Reserve increases the Fed Funds rate and sell bonds from their balance sheet.
The start of the year was extremely volatile for both asset classes but over the last month U.S. stocks and bonds have settled down. Other asset classes are still struggling. Emerging market bonds are down over 4% and emerging market stocks have declined nearly 10% according to statistics from ETFReplay.com.
Over the years I have tracked the performance of 4 classical investment strategies from pillars in the industry. Here is a quick look at how they are doing so far in 2018.
Note: This data is historical and does not reflect actual account performance. Please see the performance disclosure below for additional detail. The benchmark for each strategy is the iShares Moderate Growth ETF (AOM). It is important to remember the CAGR (Compound Annual Growth Rate) for all these strategies are only using approximately 6 months of data. Year-To-Date (YTD) performance and volatility is provide below each summary.
We start with our baseline “Classic” Strategy Year-To-Date (YTD) performance. This strategy is considered a blue-chip approach to investing by several well respected investors. This mix of investments represents 60% U.S. stocks and 40% U.S. Bonds.
YTD: Classic Return: 2.8% vs. AOM Return 0.0% Volatility: 9.7% vs. AOM Volatility 6.0%
Next, we will look at the YTD performance 3-asset class strategy we call the “Cycle” strategy. This strategy holds 5 investments from 3 asset classes. It is the lowest volatility strategy I manage. The benchmark for this portfolio is the iShares Moderate Growth ETF, AOM.
YTD: Cycle Return: 0.6% vs. AOM Return 0.0% Volatility: 5.5% vs. AOM Volatility 6.0%
Adding more asset class, next we feature a “risk parity” strategy YTD performance. In this approach 7 asset classes are weighted based on their volatility (or risk) with lower volatility investments receiving a higher weight. The benchmark for this portfolio is the iShares Moderate Growth ETF, AOM.
YTD: Risk-Parity Return: -1.7% vs. AOM Return 0.0% Volatility: 4.1% vs. AOM Volatility 6.0%
Finally, the most diversified of the bunch, the 10-asset strategy YTD performance. This approach invests equally in 10 asset classes. The benchmark for this portfolio is the iShares Moderate Growth ETF, AOM.
YTD: Ten Asset Return: -0.4% vs. AOM Return 0.0% Volatility: 5.8% vs. AOM Volatility 6.0%
It is clear 2018 has not favored highly diversified strategies. Those strategies that focus on U.S. stocks have performed better.
For a real shocker, here is how 10 select industry groups I incorporate into my strategies have performed YTD. This is an all stock selection, so the benchmark has been changed to the S&P 500 (SPY).
YTD: Industry Group Stocks Return: 16.3% vs. SPY Return 5.6% Volatility*: 19.5% vs. SPY Volatility 16.1%
*Note the significant increase in volatility associated with the portfolio of Industry Groups. That is the trade-off for exposure to high-growth areas of the economy.
We don’t know what the future holds but as we embark on a new generation of product and service innovation, along with stronger economic performance in the U.S., I have been guiding clients to overweight U.S. stocks and incorporate industry groups from areas of the economy expected to grow faster than the general economy. It has been working well and has the potential to add value for years to come. In addition, I can include industry group exposure to any of the strategies above where risk-management characteristics should generally reduce volatility.
All the statistics provided by ETFReplay.com.
Past performance does not guarantee future results. Investments and the income derived from them fluctuate both up and down. Investments at Dightman Capital are subject to risks including loss of principal. No specific investment recommendations have been made to any person or entity in this written material. This presentation is for informational purposes only and is neither an offer to sell or buy any securities. Benchmarks or other measures of relative market performance over a specified time period are provided for informational purposes only. Dightman Capital does not manage any strategy toward a specific benchmark index. A variety of sources we consider reliable have provided information for this presentation, but we do not represent that the information is accurate or complete. Dightman Capital Group does not provide tax advice to its clients. Conduct your own research or engage an investment professional before making any investment decision. Investors are encouraged to discuss any potential investment with their tax advisors. The material provided herein is for informational purposes only. Data Sources: IDC, Dightman Capital.
One of the strategies I developed for my investment management services is closely related to what has been called the “All Season” or “Permanent” portfolio. The idea behind this type of investment approach is to deliver a low volatility, reasonable rate of return that can weather any type of market environment: bear market, inflationary, stagflation, etc. This investment approach has been featured by many different successful investors including Ray Dalio, Cliff Asness, & Harry Browne. I studied their work and developed my own version.
What make the approach work is using high volatility but low correlated investments. Take gold for example. It’s long-term rate of return is mediocre, especially given its high volatility. What can make gold glimmer, however, is its historically uncorrelated nature.
I recently heard a popular investment newsletter podcast suggest this approach has not worked since 2009. The shows presenters claimed that correlations have risen, and the strategy has not been performing as expected. I was surprised by the claim because it has been performing exactly as expected, both as a stand-alone strategy and also as a multi-model approach.
Just to be sure, however, I tested correlations from pre-2009 through 2018 and found very little evidence correlations have risen. I am not sure if they were mis-informed or just trying to sell more newsletter but I though it was a disservice to highlight “All Season” and “Permanent” portfolio creators and then suggest the approaches don’t work anymore. So let me be clear, my version of the “All-Season” and “Permanent” portfolio continues to deliver low correlations between asset classes.
Here is a look at the matrix I created comparing correlation of the four asset classes in my approach.
ETFReplay, Dightman Capital, July 6th, 2018
My strategy has not experienced a high degree of correlation and the numbers above suggest the environment has not been one of high correlation.
It is important to understand correlations change. In my test I looked at 60-day correlations, that is, the price movements between the two assets over rolling 60-day periods going back about 12 years. As you can see from the examples below, correlations change a lot during short periods, which is a good reminder why a long-term investment perspective is needed. Perhaps the newsletter writer in the podcast happen to peak at the numbers during a period where correlations moved higher. As graphics below illustrate, correlations between gold and stocks , for example, do bounce around.
If we extend the rolling period to 120-day, we see correlations smoothed considerably.
I refer to my strategy as the Cycle Strategy. It is one of the most conservative investment strategies I manage and compared to an all stock benchmark like the S&P 500, is has experienced an incredibly low correlation of +0.36% over the last few years. Meaning, approximately 2/3 of the time the strategy does not move in the same direction as the S&P 500. The maximum draw down is approximately ½ the S&P 500 while also capturing approximately ½ the return. (Statistics courtesy of ETFReplay.com, Last 36 months through July 11, 2018) I am also able to provide the same data going back to 2009, which looks terrific.
Three of the four asset classes in this strategy can be extremely volatile at times. Yet, more often then not they experience their volatility at different times. Therefore, as a group they can be less volatile.