Earlier this fall we coined the phrase “sector spaghetti” to describe a phenomenon we observed in the US equity market, namely the absence of any sector leadership. The small concentration of tech shares that have driven performance for the lion’s share of this bull market started to fall sharply back in July as investors reacted badly to underwhelming earnings announcements from Facebook and others (underwhelming, perhaps, only in the febrile expectations of the analyst community, but still…). Without leadership by the enterprises that dominate the S&P 500’s total market value, the various industry sectors waxed and waned, their combined trajectories looking like a tangled pile of cooked pasta dumped on a kitchen counter. Hence, sector spaghetti.
Oh, and just how impactful was that “small concentration” of tech shares? Consider this: according to the Economist magazine, just six stocks – Alphabet (Google), Amazon, Apple, Facebook, Microsoft and Netflix – have accounted for 37 percent of the rise in value of all stocks on the S&P 500 since 2013. Think about those two numbers: 6 and 37. That’s a huge impact for such a tiny cohort.
A Picture Emerges
The spaghetti factor has cleared a bit, thanks to the pullback beginning in October that brought the S&P 500 to flirt with a technical correction on a couple occasions. A general risk-off sentiment has set in, and with it a rotation of sorts into the traditional defensive sectors including consumer staples, healthcare and utilities. The chart below illustrates the recent trend of these three sectors versus the erstwhile growth leaders of information technology, communications services and consumer discretionary.
The problem with this defensive rotation becomes clear when you look at the dotted red line in the above chart. That represents the price trend for the index itself. As you can see, it is much closer in proximity to the lagging growth sectors than to the outperforming defensives. The reason for which, of course, is the outsize influence those market cap-heavy sectors exert on the overall market: the three growth leaders account for more than 40 percent of total index market cap, compared to just over 25 percent for the three defensive sectors (energy, financials, industrials, materials and real estate make up the index’s remaining balance). A rotation out of tech is a rotation with a steep uphill climb.
What Is Tech, Anyway?
The “tech sector” is sort of a misnomer, to the point where the index mavens at Standard & Poor’s undertook a major restructuring of the S&P indexes earlier this year to better segment the various enterprises whose primary business falls somewhere on the value chain of the production, distribution and/or retailing of technology-related goods and services. The restructuring was helpful, to a point. For example, Apple, Facebook and Microsoft are all constituents of the information technology sector, but Alphabet (Google) and Netflix both fall under the newly-defined communications services sector.
But it is only helpful up to a point. Take the case of Amazon which, despite being a company entirely built on a technology platform without which it would not be a business at all, has always been and remains a member of the consumer discretionary industry sector. In fact Amazon, Microsoft and Alphabet are all industry leaders in the multi-billion dollar business of cloud computing services, yet all three are in different industry sectors.
More broadly, though, it is actually hard to think of any industry sector where “technology” in one form or another is NOT a core component of the industry’s competitive structure. Financial services companies compete in the fintech arena, while hundred year-old industrial concerns are in a race to grab leadership in the Internet of Things, whatever that winds up being. Even sleepy utilities, traditionally loved almost solely for their high dividend payouts, are scrambling to convince investors they are on top of the evolution to “smart grids” (another catchy name that mostly has yet to demonstrate an actual present-day revenue model).
The point is that technology is all-pervasive. But actual ownership of much of that technology remains highly concentrated – in the hands of those same companies responsible for a large chunk of this bull market’s gains. Any rotation out of those companies into something else is going to need a pretty compelling narrative to deliver commensurate returns. For starters, investors will be hoping next week for a second helping of strong holiday shopping results alongside their turkey and stuffing.
There were lots of think pieces leading into the US midterm elections earlier this week. We didn’t contribute to the genre, mostly because there is nothing statistically meaningful to say about an event with a very small sample size (n = 10, if you want to go all the way back to 1982 for your midterms data set) and lots of variables highly specific to each observance. Not that shoddy statistics ever got in the way of mainstream financial punditry…but we digress. In any case, the day came and went with relatively few real surprises of note. The “known unknowns” of the midterms now join the headline macroeconomic and corporate earnings trends as “known knowns” propelling what might be expected to be a net-positive narrative while the clock runs down on 2018. Always allowing, of course, for the sudden appearance of an “unknown unknown” to spoil the applecart (and thanks to Donald Rumsfeld for his contribution to the lexicon of predictive analytics).
Good Cheer and Relief?
The relief rally that began last week would seem to have some seasonal tailwinds to carry it further. The holiday retail season gets underway in a couple weeks, and it is shaping up to be a decent one. The latest batch of job numbers released at the end of last week suggest that higher wages are finally catching up to the rest of the good cheer in labor market data points. Consumer prices are still in check, despite the gradual encroachment of new tariffs onto consumer goods shelves. A good showing between Black Friday, Cyber Monday and the ensuing week or two could keep investors focused on the growth narrative.
Potential headwinds to that growth narrative are also at play, however. The Fed will meet again in the middle of December and is expected to raise rates for the fourth time this year. That by itself is not new news. In their little-publicized (non-press conference) meeting this week the FOMC reiterated confidence in the economy’s growth trajectory, which sets the stage for next month’s likely increase to the Fed funds target rate. What the Cassandra side of the investor world has in its crosshairs now is the US budget deficit, which is positioned to climb above $1 trillion in the near future.
Again – not a new fact, as this figure was well known when the Republicans implemented their sweeping corporate tax cuts one year ago. What is known with more certainty now, though, is that the higher levels of debt servicing that accompany this swelling budget deficit will happen at the same time as interest rates are heading off the floor towards levels closer to historical norms. Now, the newly known fact of a split Congress may mitigate some of the debt concerns – after all, further fiscal profligacy is unlikely in a Congress that will be hard pressed to get even the simplest pieces of legislation passed. And some optimists still maintain (without much in the way of supporting evidence) that the net effect of the tax cuts will be an unleashing of business productivity. But the debt servicing issue has the potential to be a decisive influence on US credit markets heading into 2019, which could mean trouble for risk assets.
The Big Unknown
Now we come to the part of the discussion where the specific risk factors become harder to pin down, but have the potential to overwhelm conventional wisdom. We’re talking about politics – world politics, to be sure, not just US politics. Assets in developed markets typically ignore, or at least give very short shrift to, socio-political developments. Even singular events that at the time seemed momentous – the Cuban missile crisis and the Kennedy assassination in the early 1960s come to mind – scarcely had any effect on prevailing stock market trends. The same goes for Watergate – the losses sustained by US stocks in the summer of 1974 were largely in line with the broader forces at play in a secular bear market that lasted from 1969 to 1982.
Markets don’t ignore these events because they are Pollyanna whistling her merry tune – they ignore them on the basis of a well-grounded assumption that the political institutions of modern developed nation-states are robust enough to withstand the impact of any single imaginable happening. The institutions though – and we are speaking here primarily of the US, the EU and the latter’s soon-to-be divorced partner across the English Channel – are being challenged in ways unknown since the post-Second World War Bretton Woods framework came into being.
How could the further dissolution of Western institutions affect investment portfolios? One can speculate, but with little in the way of hard data for modeling alternative scenarios. It may well be that nothing much impedes on investor sentiment in 2019 beyond the usual store of data regarding economic growth and corporate sales & profits. Those numbers may be strong enough to keep the good times rolling for a while longer. But the tension will likely form at least a part of the contextual background. However the numbers end up, we do not expect calm seas along the way.
So October just happened. With a couple relatively calmer days seeing out the year’s tenth month and seeing in the eleventh, it is a good time to take stock of what has, and what has not, happened in the story thus far. What hasn’t happened, as of today, is a technical correction in the broader market. The S&P 500 closed 9.9 percent below its 9/20 high this past Monday, just shy of a correction (recall that we have written in the past about the technical factors leading to these occasions when the market plays footsie with a correction or a bear market without actually going all-in).
The full story on this pullback has yet to be written. But we have lived through various flavors of October fright nights over the course of our careers in this industry. Each has its own story to tell – and from these stories we may gain some insight into how to think about the current version. History does not repeat, but it does rhyme from time to time. Here, then, are three Octobers of yore plus the one just passed. They are: Black Monday 1987, the Russian debt default and LTCM meltdown of 1998, and the Crash of 2008.
1987: Bang Goes the Market
On October 19 1987, Wall Street woke up to a market in full-scale panic mode. Prices had fallen throughout the previous week after an earlier rally fell short of reclaiming the record high set back in August. But the carnage on Black Monday was like nothing traders had seen before – and nobody had a convincing answer for why it was happening. By the end of the day the S&P 500 had fallen more than 21 percent, the largest percentage drop in its history (which thankfully remains unbroken today). Modest correction one day, full-on bear market the next. Not driven by any major piece of economic news, nor a major corporate bankruptcy, nor a catastrophic act of nature. What, then?
Black Monday happened largely due to a very new, very little understood investment strategy called portfolio insurance. The basic idea behind portfolio insurance was to protect downside by selling out of long stock positions when market conditions turn down. Selling begets more selling. On October 19 everyone wanted to sell, nobody wanted to buy, liquidity dried up and the market crashed. But the damage was over almost as soon as it began. Investors figured out in relatively short order that, indeed, the global economy wasn’t all that different from what it had been a month earlier. It took a bit less than two years to get back to the previous high of August 1987, but without much drama along the way.
1998: Russia Meddles In Our Tech Bubble
Everything was going along just fine – the economy was on fire, the Internet was well into stage one in its takeover of the human brain – but while America was rocking out to “…Baby One More Time” our erstwhile Cold War foe Russia was defaulting on its government debt. Which would have largely passed by unnoticed were it not for the massive exposure to Russian sovereign bonds among many of the world’s most sophisticated investment funds, including a super-smart group of pros called Long Term Capital Management. What we all learned from LTCM was that the interconnected global market has a dark side: a failure in one place can wreak havoc in a whole bunch of other, seemingly unconnected places (a lesson to come in handy a decade later). The S&P 500 flirted with a bear market though (stop us if you’ve heard this one before!) halting just at the cusp with a 19.3 percent peak to trough decline.
Again, though, the absence of any real, fundamental change in our economic circumstances, coupled with a quick and relatively efficient bail-out to contain the toxins released by LTCM, made this a relatively short-term event. By the end of the year the market had reclaimed its earlier record peak and was set to power its way through that giddy annus mirabilis of 1999.
2008: The Almost Depression
1987 and 1998 were instances where a major market pullback didn’t lead to worse outcomes – in both cases recessions were more than a couple years away (and neither the 1990 nor the 2001 recessions were particularly deep or durable). 2008 was a different category, of course. The entire financial system came close to shutting down, millions of Americans lost their jobs and – perhaps even more consequential for the long term – a deep sense of distrust in experts and institutions took root and strengthened. 2008 was not a “pullback” – it was a long, wrenching bear market.
Though it could have been worse. It took five and a half years for the S&P 500 to get back to the prior record high set in October 2007. By contrast, investors who saw the stock market crash in October 1929 (the mother of all scary Octobers) would not see their portfolios return to September 1929 levels until the mid-1950s.
There’s more to the 2008 story, though, than the spectacular failure of investment bank Lehman Brothers and the cataclysm that followed that fall. More than a year before the events of autumn 2008, there was already plenty of hard evidence that things were not well in the economy. Home foreclosures had started to trend upwards as far back as 2006. Monthly payroll gains stated to trend down in the middle of 2007, with particular weakness in areas like homebuilding and financial services. A sudden loss of liquidity in certain risk asset markets got investors’ attention in August 2007 – a small taste of the carnage to come.
When to Hold ‘Em, When to Fold ‘Em
So while the story of October 2018 continues to be written, what lessons can we apply from the lived experience of previous downturns? One approach we believe will serve investors well would be a healthy skepticism of the relationship between cause and effect. Any pullback of a meaningful enough size is likely to generate an army of Monday morning quarterbacks, fatuously explaining “why” it was so obvious that Event X would cause the market to reverse on Day Y (thanks for waiting until after Day Y to tell us!). Even highly sophisticated quantitative analyses, while arguably preferable to insufferable blow-dried touts spinning tales on CNBC, fail to deliver on the crystal ball front with their deep dives into correlation patterns. Those algorithms can tell you the likelihood of something happening based on tens of thousands of random hypothetical simulations. But they fall victim to the law of small numbers when applied to the sample size of one – one actual event on one actual day.
Because pullbacks and technical corrections happen much more often than actual bear markets, a good starting point is to make “not bear market” the default hypothesis, and then set up tests to see how easily the default hypothesis can be disproven. Understanding the macroeconomic environment, corporate earnings trends, sentiment among businesses and consumers and the like is important. So is a sense of history. For example, a currently popular thesis among some market pros is that a 3.7 percent yield for the 10-year Treasury will be a trigger point for rotating out of equities into fixed income. Why? A cursory look at past growth cycles seems to offer up little evidence that equities will encounter impassable headwinds once yields pass that threshold. And yet, we can’t dismiss the 3.7 percent crowd out of hand, because if there are enough of them, perception can become reality whether that reality makes logical sense or not.
The best way to survive market corrections is to always stay diversified, to resist the behavioral urge to sell after the worst has passed, to be alert to red flags but careful about acting on them. Unfortunately there is no failsafe formula for deciding when a correction looks set to metastasize into something much worse. Often, though, there will be enough data to build a case against the “not bear market” hypothesis, affording a window to build some protection before the worst happens (with no certainty, of course, that the worst will ever happen). It can be a frustrating exercise in practice – but it is also what makes markets so eternally fascinating.
Be careful what you wish for, because it might come true. A couple weeks ago, bond investors were wishing upon their stars for a retreat in yields from the 3.25 percent the 10-year Treasury had just breached. Well, retreat it did, falling below 3.1 percent in early Friday morning trading. But these falling yields were clearly of the risk-off variety, dragging down everything else with them. The S&P 500 is flirting in and out of correction territory (a peak to trough decline of 10 percent or more) and may well have settled there by the end of the day, while the Nasdaq has already gone full correction.
As we noted in our commentary a couple weeks ago, corrections aren’t particularly rare events. We also noted the Tolstoyan flavor of these events – each one has its own unique story of dysfunction to narrate. “Okay, fine, so what’s the sad story accompanying the current situation?” is thus quite naturally a question that has come up in conversations with our clients this week. The narrative for the glass-half-empty crowd has indeed started to gel, but it is yet by no means clear that this will be the narrative that dominates for the remainder of the quarter (we will remain on record here as believing that it will not).
What we still have is a battle between two narratives, each looking at the same set of facts and drawing different conclusions, as if they were so many Rorschach inkblots. Let’s look first at the case for negativity.
Europe and China and Rates, Oh My
Several strands of thought weave together the bears’ case. In last week’s commentary we had an extensive discussion about the malaise in Europe, first with the Italian budget standoff that has sent yield spreads on sovereign debt soaring, and second with the spread of political unrest from the continent’s periphery to its dead center. Germany will have another round of regional elections this weekend, this time in Hesse (the region that includes financial capital Frankfurt as well as a delightful-sounding tart apple wine called Ebbelwei). The establishment center-left party, the SPD, is expected to fare poorly as they did two weeks ago in Bavaria. A really bad drubbing for the SPD could lead to the party’s exit from being the junior partner in Angela Merkel’s national grand coalition. That in turn could ratchet up the growing uncertainty about Merkel herself at a time when steady leadership from the EU’s strongest member is of critical importance.
China forms the second strand of the pessimist case. The national currency, the renminbi, is at its lowest level in a decade and poised to break through a major technical resistance level at RMB 7 to the dollar. After China’s GDP growth numbers last week came in slightly below expectations (6.5 percent versus the 6.7 percent consensus) Beijing economic officials coordinated a set of emphatic verbal assurances to investors that renewed growth measures were in place. That was enough to give beleaguered Chinese stocks an upward jolt for one day, but the lack of any specificity in the officials’ assurances didn’t hold up for a rally of more extended duration, and shares resumed their downward trend.
With the rest of the world looking particularly unappetizing, attention then turns back to the domestic environment, specifically the prospects for continued monetary tightening by the Fed and concerns that the run of news for corporate financial performance – capped off by earnings growth expected to top 20 percent for 2018 – is about as good as it’s going to get. Higher rates will tamp down the currently rambunctious confidence among consumers and small businesses, while widening spreads will also spell trouble for the corporate debt market at a time when S&P 500 companies have record levels of debt on their books. Margins will be under pressure from upward creep in wages and input costs, and weaker economies around the globe will have a negative effect on overall demand for their products and services. Faltering leadership from high-profile tech and consumer discretionary shares is the canary in the coal mine, portending a more protracted period of market weakness.
It’s not a weak case, to be sure. But there is a strong argument on the other side as well, with opportunists scouring an expensive stock market for bargains made available in a 10 – 15 percent correction environment. This is the “song remains the same” crowd.
The Big Picture Hasn’t Changed
The glass-half-full argument always starts from the same point: the unrelenting sameness of US macroeconomic data month in and month out. The latest of these is fresh off the presses of the Bureau of Economic Analysis as of this morning: a Q3 real GDP growth reading of 3.5 percent, which translates to a 3.0 percent year-on-year trajectory. Same old, same old – healthy labor market with unemployment at decades-low levels, prices modestly but not dangerously above the Fed’s 2 percent target, zippy consumer spending and continued growth in business investment.
On the subject of corporate earnings, the optimists will point out that top-line sales expectations for 2019 are actually increasing. Yes – the tax cut sugar high will lapse once December comes and goes, so bottom-line earnings won’t repeat their 20 percent gains of ’18. But if sales continue to grow at a 6-7 percent clip it underscores the ongoing health in consumer demand, here as well as abroad. And yes – to that point about weakness in China, the adverse effects of the trade war have yet to show up in actual data. China’s exports grew at a 14 percent clip in September, and the $34.1 billion trade surplus it recorded with the US for the same month was an all-time record.
The Fed is likely to continue raising rates. The reason for that, as Fed officials themselves repeat time and again, is because the economy is growing well and (in their view) cans sustain growth while interest rates rise gradually to more normal levels. It’s worth remembering that yields on the 10-year Treasury averaged over 6 percent during the growth market of the mid-late 1990s, and around 4.5 percent during the mid-2000s. There is no particular reason (despite many reports to the contrary) that money managers “have to” rotate out of equities into bonds at some notional 10-year yield threshold (3.7 percent being the number bandied about in a recent Merrill Lynch / Bank of America survey).
To be sure, there are plenty of X-factors out there with the potential to add fuel to the present nervousness in risk asset markets. There are plenty of others that could accelerate a pronounced recovery of nerve heading into the peak retail season that begins next month.
It is also possible that we are seeing the first early hints of the next real downturn – much like those occasional days in August where there’s enough crispness in the air to suggest a seasonal change, even while knowing that autumn is still many weeks away. Just remember that while the timing of seasonal equinoxes is predictable, market transitions do not operate on any fixed calendar.
An up and down week on Wall Street may end on a slightly positive note, if the sentiment we are seeing on this Friday morning makes it through the afternoon. Don’t mistake this for some kind of definitive trend, though – what’s been happening this week is much more about technical buy and sell triggers that send much of the market’s intraday volume hither and yon. At one point earlier this week the S&P 500 actually closed below its 200-day moving average for the first time since early 2016. There’s nothing magical about moving averages, of course, except that lots and lots of trading strategies are programmed to react to them. Perception is reality in the world of short term trading.
In any event, while indexes bounce up and down in search of a driving theme to provide direction for the rest of the year (which we think has a better chance of being up but a not immaterial chance of being down) we want to dig into some of the X-factors contributing to the current frisson of unease. In this week’s commentary we feature the Italian debt market. Spreads between Italian benchmark bonds and German Bunds (the go-to safe haven for EU fixed income) are at their widest levels in four years.
Return of Eurozone Mal de Mer
The above chart shows that Italy-Bund spreads are a useful indicator of unrest in the Eurozone. After ECB chief Mario Draghi assured the world that the Eurozone would stay intact with his “whatever it takes” speech in 2012, the spread tightened from the wide gulf of the crisis years to a more typical risk premium that lasted for most of the past four years. That all changed with the national elections in March 2018, which ended with a populist government sworn in two months later, in May. The coalition government of the Five Star Movement (FSM) and the League, representing different flavors of anti-establishment populism, set out some ambitious plans to deliver on its campaign promises of stimulus measures for growth and jobs. Eventually, these plans found their way into a budget the country is required to submit to EU officials in Brussels, to ensure that the terms are in keeping with EU standards and constraints. Brussels, to put it mildly, was not amused.
EU economics officials routinely issue rebukes to member country policies which they see as deviating from rules – particularly the rules developed during the crisis years earlier this decade. But the language in this Thursday’s communique from Brussels to Italian finance minister Giovanni Tria was – well, practically Trumpian in its histrionic flavor. “Unprecedented in the history” of EU budget rules! – said the stern technocrats. One would think nothing of such a seismic nature had rocked the continent since Charlemagne crushed the Merovingians.
The odd thing is that Brussels’ main sticking point with the budget is its assumption of running a 2.4 percent fiscal deficit. While not inconsiderable, that is a lower fiscal deficit than those run by EU members France and Spain, and it is also lower than what the new Italian government initially planned after the coalition came together in May. The real underlying problem is that few observers believe a fiscal deficit of this size is sustainable for a country challenged by slow economic growth and a cost of debt that is already rising. The bond investors who have been selling off Italian bonds this week anticipate further downgrades to Italian debt from S&P and Moody’s later this month, and expect further headwinds to buffet the fragile condition of large Italian banks.
The bigger contextual picture, of course, goes beyond Italian sovereign debt to the overall health of the EU. There has been little in the way of good news from Europe this year. The Brexit negotiations are an ongoing fiasco painting nobody in a good light. On the eastern periphery Hungary and Poland can fairly be called ex-democracies as their authoritarian governments consolidate one party rule. Italy and Austria are ruled by populists. Establishment darling Emmanuel Macron’s approval ratings in France are an abysmal 33 percent (that’s lower than Trump has ever fallen here back home!). And Germany is also teetering on the dividing edge between populists and technocrats. Witness this past weekend’s regional elections in Bavaria where the long-dominant CSU (the regional partner of Chancellor Merkel’s ruling CDU) suffered its biggest loss of seats in the party’s postwar history.
In this fraught landscape, the notion of a fiscal crisis or banking system collapse in Italy has the potential to inflict more damage than the original Greek economic crisis that led to the dolorous years of 2011-12. Back then those three magic words uttered by ECB chair Draghi – whatever it takes – were enough. We may see proof in the coming weeks, one way or another, whether indeed it is enough.