Bad things can happen to equity prices in October and 2018 is no exception. All the equity indices we follow – both domestic and global – performed poorly, even as prices rebounded in the final two sessions of the month. The selling was not confined to stocks as bonds and commodity prices were down as well. The one area of strength for the month: US Dollar index.
U.S. & International Stock Index Returns
|Index October 2018 Year-to-Date|
|Dow Industrials (5.44%) 1.60%|
|S&P 500 (7.56%) 1.43%|
|S&P 400 (Midcap) (10.23%) (3.97%)|
|S&P 600 (Small Cap) (11.96%) 1.46%|
|MSCI World (7.40%) (3.87%)|
|MSCI EAFE (7.73%) (11.49%)|
|Bloomberg Agg. Bond (2.38%)|
|CRB Commodity Index (1.50%)|
|US Dollar Index 4.83%|
All data as of 10/31/2018, Source: Wells Fargo Investment Institute. [Wells Fargo Investment Institute, Inc. is a registered investment advisor and wholly-owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.]
The “October Effect” – the theory that equities go down in October – is more of a psychological phenomenon than an observable reality. Historically September is the worst month for stocks with the S&P500 having an average loss of (1.0%). October has averaged a gain of 0.5%. The reality is September has printed more down months than October, but the volatility that can and has accompanied many an October gives the perception of poor returns.
How much volatility? October has been when some of the largest market crashes (Panic of 1907, 1987s Black Monday) have occurred, as well as the start of the Great Depression. The positive side of the volatility is that many an October has been the start of a new beginning for the markets as bear markets reverse and turn to bull markets.
Last month the stock market saw some real volatility with the volatility index (VIX) more than doubling over the month as all the major indices broke down. The selling was uneven as the damage to growth stocks was more pronounced than the value names. The sectors which had been leading the market for years (info tech, consumer discretionary), not surprisingly, lost the most. Defensive areas of the market (consumer staples, utilities) held up much better. Small and mid-cap indexes were also big losers.
The recent 10% drawdown, in our opinion, was different than the one in February for a few reasons. Back in February was saw selling across the board with every sector taking a big hit. This time around the selling had a feeling of some sector rotation into the more defensive sectors. Still, the NYSE Composite Index (chart #2), which covers all common stock listed on the NYSE (including ADRs, REITS, tracking stocks and foreign listings), has broken down more substantially than the less diverse S&P 500. And from a technical perspective, the major stock indices we follow have all broken below the current uptrend line and below the 200 day and 50 day moving averages, suggesting a change in market sentiment.
The 10-year Treasury yield ripped higher to start the month, before pulling back as stock indices sold off. There has been a lot of talk in the news about The Fed and where short-term rates “should be” with everyone from the casual market observer right up to POTUS seemingly having a strong opinion on the matter. While we believe that we will see a quarter point increase come December, we do not have a strong opinion on where this rate will go in 2019. We agree with Warren Buffett when he says it is a fool’s errand to predict what The Fed will do.
Long term rates are set by the market and not by bankers and, thus, are based on supply and demand. Chart #3, the weekly chart of the 10-year Treasury Yield Index, suggests the uptrend in yields that started in mid-2016 could be coming to an end. The rising wedge pattern is a bearish pattern that typically resolves itself to the downside. Fundamentals – rising UD dollar strength, weaker global economic growth vs. the US, Chinese tariff escalation set for January, etc. – also suggest lower Treasury yields. No guarantee, of course, as fundamentals can change quickly, but very much something to keep an eye on.
The possibility of a breakdown in US dollar strength we have been discussing for a few months has not materialized as the US Dollar Index ($USD) strengthened by more than 1.50% in October with a clear uptrend in place. Assuming the US economy stays strong (both in real terms and vs. global economies) and trade issues with China do not get resolved, we would expect the trend to continue.
Dollar strength is not the friend of commodity prices. In October the CRB Index was weaker by more than 2% as the dollar strengthened substantially against other currencies. For US consumers and producers this is not necessarily a bad thing. Lower commodity prices mean businesses have lower costs in manufacturing. For the consumer, items like heating oil and gasoline – to name two significant expenses for many – drop in price. With a strengthening dollar (see previous section) and the index below both the 200 day and 50 day moving average we expect more weakening in the months ahead.
“Life and investing are long ball games.” – Sir John Templeton
“Looking towards the future
We were begging for the past
Well, we know we had the good things
But those never seemed to last
Oh, please just last” – Modest Mouse (Missed the Boat)
At the top we discussed the volatility that has historically accompanied equity investing during the month of October, taking note of how many of these disruptions have led to the start of new bull market trend. While true, new up markets is not always the case. There are times where the poor performance in October has been the start, not the end, of poor market performance. See October 2000 and October 2008 as the two most recent examples.
This observation leads us to ask: Are the good times over for the equity investor or was this just a short blip in the bull market?
Let’s take a look …
Where are we in the economic cycle? After 9+ years of steady economic growth, low levels of unemployment, high levels of consumer spending, all-time high profit margins for corporate America, and the return of both inflation and wage growth, we think it is safe to say that we are close to, or in, the late stages of the economic cycle. The added stimulus of the 2017 tax cuts has clearly extended the cycle. It is always hard to tell exactly where we are in the cycle, but if the current rotation into more defensive areas of the market continues it suggests that the market believes 2018 to be the peak for this cycle.
How are company earnings? How is the market reacting to earnings? Earnings have been outstanding with S&P 500 earnings growth in the 27% range. Even if one pulls out the estimated 10-12% bump from the corporate tax cut, earnings are great. Which, of course, is what one expects when the economy is at its peak. Our experience tells us that bull markets grow on earnings going from bad to less bad, continue to move higher as earnings expectations are exceeded, and die as the investor community becomes dissatisfied with better than expected earnings. Bluntly put, one should start to get cautious when earnings are better than good but stock prices react negatively to the great news – which is exactly what we are starting to see.
How are market valuations on an historical basis? The simple answer is good not great. Stocks are not historically cheap or expensive as earnings have exploded higher.
What is current and expected forward interest rate policy by The Fed? It has been a steady move higher for interest rates for some time. We believe Chairman Powell when he says to expect a December rate increase then three more rate increases in 2019. Guidance is just that, and will surely change if the economic background dictates a new course. Assuming no changes, higher interest rates are still forthcoming.
Ideally, Central Bank policy keeps the economy in a Goldilocks scenario of steady economic growth, tame inflation, and low unemployment. In reality policy making is an art, not a science, in an imperfect world. Policy makers react to what they see at the time by making the best decisions they can. Inevitably expected policy outcomes don’t turn out as expected, having a negative effect on the economy.
So … can the good times last? Maybe. While there are times our four indicators decisive, we are at a time where they make us certainly uncertain about the likely market direction. At times like these we like to take a big picture look at the charts for some clarity.
Looking at a long-term chart of the S&P 500 (chart #6) the long uptrend channel is very distinct. Still in an uptrend, the market could very well be heading back down to again test the support line. If it holds we are good and the uptrend continues. The negative divergence in two secondary indicators – MACD and RSI – give us caution but no confirmation of a market change. A break below the trendline would change our opinion. For now we remain positive but cautious on the equity markets.
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Robert I Cahill, Managing Partner Rob.Cahill@wfafinet.com
Jeffrey T. Bogert, Partner
Jonathan D. Soden, Partner Jon.Soden@wfafinet.com
Robert Sweeney, Financial Advisor Bob.Sweeney@wfafinet.com
Jay Knight, Associate Financial Advisor Jay.Knight@wfafinet.com