Check out this podcast by one of our top investment providers, ARK Investment Management. In Episode 9 of FYI (For Your Innovation) you are going to hear from three people. The conversation is led by moderator James Wang (ARK Analyst) as he facilitates a conversation between Catherine Wood (ARK CEO/CIO) and Dr. Art Laffer (Laffer Curve Economist). During the 33-minute talk they cover innovation cycles, tax policy, global trade, genetics and cancer. A truly inspiring, power packed podcast, on investing in disruptive innovation.
True, some of the largest single-day stock market gains come during bear markets. December 26th, 2018 marks the first time the Dow Jones industrial average gain 1,000 point in a single session. Experienced stock market investors know, one big up day does not mark the end of a downtrend.
Investors should also note, Wednesday’s advance was the first day of a rally attempt. If stocks can stage another meaningful advance in the next 7 trading days, preferably on day 4 through 7, the worst of the selling may be behind us. Rally attempts followed by follow-through days are no guarantee, but they often signal the start of a new uptrend.
There were other signs of optimism in Wednesday’s big advance. Stocks from retails, software, internet and consumer spending led the market’s upside. Growth stocks are preferred over mature, defensive sectors when leading the market out of its first bear-market correction in seven years.
The ratio of advancing stocks to declining stocks delivered wide breadth, another positive. Nasdaq winners outpaced losers nearly 4-to-1. On the NYSE, winners led by 5-to-1.
Also of note, there is a tiny but growing group of quality growth companies forming attractive chart patterns. These companies feature strong fundamentals, especially in terms of sales and earnings growth. Often, they are smaller, younger companies introducing new products and services. It is one of the more encouraging signs given the renaissance of innovation and entrepreneurship underway, something we have not experienced to this degree since the 90’s.
If stocks can hold levels this week and deliver a strong rally on any day next week, that would deliver a perfect follow-though day and improve the odds of a new rally as we enter 2019.
The investment environment continues to deteriorate despite the pickup in economic activity in the U.S. the last couple of years. As the Big Four Indicators I highlighted recently show, the U.S. economy continues to move in the right direction.
Despite the U.S. economy doing well, international economies are performing poorly with few catalysts outside of fiscal or monetary policy to drive them higher. Europe is in disarray and in a speech yesterday, China’s Premier Xi, signaled little trade flexibility.
In terms of Monetary Policy (central banks), we are in uncharted territory. On the one hand, market intervention potentially provides a mechanism to avoid financial contagion. On the other hand, it has added a lot of debt to the global economy and relies on globalization to keep the party going. The US and Europe are looking to reduce their exposure to globalization trends.
In terms of Fiscal Policy (government revenue/spending), deficit spending is projected for many years which is a concern after a 9-year economic recovery.
Constant increases in government debt, whether through monetary or fiscal policy, are likely to be a fixture of the 21st century economy. Investors should expect more market intervention going forward. My job is to manage the effects it has on investments and purchasing power. Right now, it is looking like global markets are bracing for another round of asset deflation.
The biggest telltale sign of concern about the potential for further asset deflation is not coming from stocks, it is coming from bonds. With the Fed now selling $50 billion dollars’ worth of bonds every month through Quantitative Tightening (the opposite of QE), analysts expected yields to go up and bond prices to fall. That is not happening. Money is moving to the safety of the 10-year Treasury bond. Money flows to 10-year Treasuries when it is concerned about asset deflation. 10-year Treasury bonds are again yielding less than 3%! Yields on the 10-year would be moving higher, and prices lower, if the bond market was expecting economic growth to continue.
Markets are signaling a high likelihood of ongoing asset price weakness. With each passing day more assets are breaking-down through price support levels. It is entirely possible all of 2017 gains will eventually be erased although stocks still hold on to most of them at this point.
For this reason, I believe it is a good time to be a bit more defensive and raise cash levels. Once the market settles down, available cash provides the ability to purchase growth investments at potentially lower prices. Even if you end up reinvesting at higher levels, that is a price worth paying if it provides peace of mind during a turbulent period in the global economy.
The Dshort website (part of Advisor Perspectives) hosts an incredible about of economic and market data. Periodically I feature some of their work, specifically The Big Four Indicators update. Taken together, these four indicators covering income, employment, retail sales and industrial production are thought to be an excellent monitor of the overall health and direction of the U.S. economy.
The recovery from the Great Recession has been slow but positive. The most encouraging development recently has been the strength coming from industrial production (purple line).
Let’s think about the future for a moment. After all, that is what the stock market is doing constantly. Up to this point in 2018, the stock market has had a very positive view of the future. Why wouldn’t it? Corporate sales and earnings growth have delivered in the strongest economy since 2008.
In addition to an economy that is strengthening, we are also experiencing an innovation renaissance. Quantum computing, space exploration, and organ replacement are just a few of the areas announcing major breakthroughs. If you spend any time following science and technology news, rarely a week passes without a new scientific announcement. Contrast that with the DotCom crash of 2000 where we were at the end of the personal computer revolution of the 1990. The future did not look very bright.
The most important market to watch right now, in terms of what the near-term future may hold for stocks, may be high-yield (junk) bonds. Many commentators point to the increase of debt by corporations as a major risk for the economy. So far it is holding up remarkably well which is not what you would expect if the economy was about to fall in to a recession.
At some point in the future we will see another credit event like the sub-prime debacle of 2008. That is the nature of a credit-based global economy and it will likely trigger a deep recession. Perhaps we are on the verge of such an event but the high-yield market does not seem to think so. It is holding up remarkably well considering how much corporate bond doom and gloom is being reported.
If there were serous concerns in the high-yield bond market you would expect a bigger sell-off, but instead high-yield bonds appear to have decoupled from stocks.
I shutter to think what the global economic environment would be like without the corporate tax, personal tax and regulatory reform recently implemented in the U.S. But I digress, that is the past. What is more important is will these policies allow the U.S. economic expansion to continue?
In its totality this selloff has the character of a grind down to lower valuations; not a panic selloff with no bottom in sight. I think the biggest surprise of this market could be the Dow, S&P 500 and Nasdaq reaching new all-time highs before we actually experience the next recession. There are many things that could go wrong but I continue to believe we are experiencing an adjustment in valuations that will allow this market to resume the bull market rally; not the beginning of the end of the this cycle’s expansion.
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.
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 ADP payrolls report hit 230,000 in September, beating estimates
- The Purchasing Managers Index for Services in September came in at 53.5, above the 52.9 consensus
- September’s Institute for Supply Management hit 61.6 for the service sector, ahead of the view at 58
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.)