Depending on which average you look at, last week was the worst for stocks since the bottoms in August 2011 or November 2008 during the Great Recession.
But unlike 2011, at the peak of the European debt crisis, or 2008, when we were in the depths of the Great Recession, one cannot look at the economic data for an answer to what might be causing the decline in stock prices. One also can’t look around the world. While other markets were down 1-3%, most related to selling in our markets, declines elsewhere were nowhere near the 7-8% declines in our markets. It wasn’t just stocks. Oil has been in free-fall for almost two months dropping over 40% over that period.
So, what is the cause? Actually, it appears to be a confluence of causes.
- When selling began in October, stocks were overvalued by historic standards. To some extent, therefore, this began as a valuation correction.
- Computer and algorithmic traders feed on heightened volatility. As volatility increase, computer selling increases as well.
- As declines persisted and escalated, weaker equity holders capitulated and sold. Net withdrawals from actively managed mutual funds have totaled in excess of $50 billion over the past two weeks.
- Margin debt, at least at the start of the decline was high. As selling led to larger declines, margin calls have escalated forcing even more selling.
- Lower prices have led to increased tax-loss selling.
- Events in Washington added to the turmoil and uncertainty. These include a partial government shutdown, the resignation of James Mattis, the sudden withdrawal of troops from Syria, and other signs of unrest, chaos and uncertainty within the Executive Branch. While none of these events individually have significant economic consequences that should disrupt markets, the accelerating flow of bad news doesn’t inspire confidence.
- The Federal Reserve’s messaging of its shift toward a slower pace of future rate increases has been poor, to say the least. With that said, the Fed news is now in the rear view mirror. Barring outright collapse in financial markets, the Fed isn’t going to alter the near term future.
With all this said, the economy continues to hum along. Third quarter growth was well above 3%. While non-defense related durable goods orders have slowed along with economic uncertainty, strong final demand will ultimately lead to a rebound in spending. Another industry that has slipped lately in housing. Demographics, high employment and a strong economy suggest that demand for housing is still there. But prices need to come down a bit after several years of above average increases, and mortgage rate increases have put pressure on buyers. With that said, recent declines in long term bond yields are likely to bring mortgage rates back down. Housing starts in October rose contrary to expectations and that was before mortgage rates started to fall. At the moment, home sales are low seasonally and won’t pick up again until February. But if mortgage rates stay low and lumber prices remain under pressure, we could see a surprising rebound in housing.
At the start of the market decline, there was a lot of focus on yield curve inversion. While there has been some flattening of the curve in the 2-5-year range, the yield on 2-year Treasuries has actually declined since the most recent FOMC announced Fed Funds rate increase and the spread between 2 and 10-year bond yields has moved back up to 14-15 basis points, a signal that bond markets don’t see an imminent recession.
Over the weekend, Treasury Secretary Stephen Mnuchin tweeted that he spoke to heads of the largest banks and wanted to assure everyone that the banks had no liquidity problems. Sources also said that President Trump was considering firing Federal Reserve head Jerome Powell. If these two steps were designed to show that government had the backs of equity investors, the outcome was just the opposite. First, Mr. Trump can only fire Mr. Powell for cause. Since there clearly isn’t any other than the President’s disagreement over the last rate increase, Mr. Trump has backed off that position. As for the Mnuchin statement, since no one thought that the recent decline had anything to do with bank liquidity, a lot of people in the financial world are puzzled as to what precipitated the statement. Follow up conversations with media confirm that Mr. Mnuchin made calls as part of routine policy but liquidity was hardly the primary conversation. At any rate, his tweet is just one more example of how Washington unpredictability can exacerbate nervous markets.
Today is a half day for investors as markets close at 1 pm. Many European markets will be closed Wednesday for an extended Christmas holiday. Many hedge funds and U.S. trades will be winding down between now and year end. Normally, that suggests like volume with some momentum to the upside as tax-selling comes to an end and investors position optimistically for the next year. But 2018 is far from normal. What is logical to expect today is more volatility although volume will be lighter than last week when volume set multi-year highs. Futures were higher very early on, then fell the equivalent of 200 points before rebounding slightly. Any large buy or sell program today could overwhelm markets temporarily. That is a risk, not an expectation.
Here’s the reality. Stocks today sell at a P/E ratio below historic norms both related to recent or expected earnings. In other words, based on history, stocks are cheaper than normal even assuming conservative forward-looking earnings assumptions. Interest rates remain low by historic standards. The combination of low interest rates (and therefore low expected bond returns barring a sudden further drop in bond yields) and low P/Es suggest stocks should become the preferred investment once markets calm down. But, no one can tell exactly when calm will be restored. With that said, declines like we saw last week don’t often repeat themselves. Stocks are way oversold. Just a rebound to declining 50-day trend lines would mean a rally of 5-10%. Selling rallies rather than buying the dips is the normal order in bear markets and it appears that we are in one now. Markets could be forecasting a recession in late 2019-2020 or they could be dead wrong. We don’t know. A reasonable prediction is for slowing economic growth both here and around the world but slower growth isn’t the definition of recession. If growth simply slows and stabilizes at 1-3%, stocks will rebound strongly over the next year. By strongly, I mean year-over-year returns from here will be double digit.
There isn’t going to be a recession if employment stays near record levels and consumers keep spending. If one looks at Main Street and not Wall Street, there are no signs whatsoever to suggest the consumer is frightened or going into a cocoon. I don’t see anything in natural economic order that would cause a sudden change in behavior. The risk, in my mind lies in Washington behavior. A heightened trade war that increases tariffs massively would be an example. Even more discord between Democrats and Republicans probably won’t rise to a level that will undermine economic confidence but I can’t say that with any degree of certainty. The Fed isn’t likely to be the villain. It is done raising rates for now and, as New York Fed President John Williams noted last week, it will be very responsive to markets going forward. It isn’t chasing a preordained policy on autopilot as some suggest. Brexit could cause some noise but, whatever happens, it will be history before mid-year. Logically, there is every reason to expect stocks to rally soon, perhaps after Q4 earnings season. Emotionally, the mood of the moment is as sour as it can be. But times of peak fear are often the best buying opportunities. With that said, I don’t think we will reach true bottom until the past leaders, namely the FANG stocks, find a bottom. The good news is that process is well along.
Today, author Stephanie Meyer is 45. Ricky Martin is 47. Since I never publish on Christmas Day, I thought it might be interesting to note who was born on Christmas. The list includes Canadian Prime Minister Justin Trudeau, singer Jimmy Buffett, actress Sissy Spacek, Rod Serling of Twilight Zone fame, and film legend Humphrey Bogart.
James M. Meyer, CFA 610-260-2220
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