Correction Is Upon Us - Carpe Diem
Nov. 6, 2018 Commentary

The Correction is Upon Us - Carpe Diem

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“More money has been lost trying to anticipate and protect from corrections than actually in them” - Peter Lynch

Our Take On Recent Market Action

October 2018 is here in all its splendor…and clearly, I’m not talking about the beautiful fall colors. I’ve read that this season we call fall is a shortened term for the phrase, fall of the leaf (common language in England in the 17th century). This year, investors may be asking if the derivation of fall is a shortened term for what happens to stocks in the month of October. 

While October is typically not, on average, a poor month for market returns on a historical basis, it tends to be one of the most volatile months in the market. It gets its bad rep from several isolated years of very weak October results…October 1929, October 1987 and October 2008, to name the key ones. This is not one of those periods, but it is challenging this year as we seem very close to correction territory. Since the highs on September 21, 2018 the Standard & Poor’s 500 index has sold-off over 10 percent through late October. And, as of month end, the index is up less than 3 percent on a year-to-date (YTD) basis. So, what’s our take on all of this? From our perspective, the market action we’re seeing is simply a rise in volatility back to normal levels and the makings of a normal correction that we should expect to occur in the market at any time, attributable to any of the emotionally-based headlines/wall of worry items we have highlighted all year...

  • Concerns that the age of the bull market by definition implies it can’t continue
  • Angst that earnings of the S&P 500 have peaked
  • Fear that the current trade negotiations will result in a full-fledged global trade war
  • Uncertainty over the outcome of mid-term elections
  • Speculation that the yield curve will invert as a result of a major Federal Reserve policy mistake, i.e. they will hike rates too far too fast, which may in turn bring on a recession

As you know, we care about the facts and the data, which we still find to be quite positive.

That said, a combination of these headline items appears to be influencing investor perceptions at present and inspiring what we believe to be a temporary, short-lived pullback or market correction. The sell-off we have seen these pasts several weeks can primarily be attributed to the last wall of worry item cited above...is the Fed too vigilant in raising rates and will this end the good times in the stock market?

As economic growth in the United States has accelerated (which we see as a good thing, by the way) and the Fed has continued to raise short-term rates in measured fashion, the 10-year Treasury has finally risen above 3 percent (weren’t investors cheering this only days ago?) and the market has randomly chosen this moment to get apprehensive about it. That’s the stock market! Go figure. It probably doesn’t help that the media is harping on President Trump’s expressed displeasure with the Fed rate hikes and communications thereof, despite the fact it isn’t uncommon for presidents to do just that. And, of course, the close proximity to the mid-term elections is raising anxiety levels regarding the impact they might have on the political front. 

The bottom line for us is that fundamental economic and earnings data remain solid and valuation has only become more appealing, so we remain focused on the longer-term catalysts for the market. We think these wall of worry items are manageable and don’t see them spilling over into the data as yet. We believe these temporary air pockets are not only normal but help to reset the market for further gains. The bottoming process in a short-term correction, while uncomfortable for clients, is just that, a process, and it could take some time. But we expect the solid fundamentals to catch investors’ attention after we push through the mid-terms and look to achieve new highs as we move into 2019.

Economic And Earnings Data Points Are Still Positive 

The data helps us put things in perspective and drives our decision-making. First, it helps us distinguish between a short-term correction and the beginnings of a more extended and deeper bear market. The former scenario calls for holding fast to your equity positions, upgrading existing holdings, or putting excess cash to work opportunistically as prices of specific stocks become more attractive. The latter is entirely different and would inspire us to trim back on equity holdings and make adjustments within our equity positions to a more defensive posture. 

We do not see signs of the latter at present as economic and earnings growth, as well as CEO, small business owner and consumer confidence remain high in the United States. Jobs are plentiful, and wages are rising, but not at profit margin choking levels. The chart below illustrates that U.S. job openings of more than 7 million are the highest on record and higher than the total number of folks unemployed…it’s the first time that has happened since the government began tracking job openings in 2000 and speaks to the solid demand in our economy. The number of job openings generally are in decline well in advance of prior recessionary periods. Capital expenditures are rising, so improved business investment spending better rounds out the economy and may drive an acceleration in labor productivity. Earnings are robust and while we expect them to decelerate in 2019, earnings growth should remain healthy. These are not facts that normally signal market tops.

JOLTS: Job Openings: Total

Overreaction Regarding Rates

As for rates, wasn’t it only a month ago when investors’ teeth were rattling because the 10-year Treasury rate was staying stubbornly below the 3 percent threshold with no real signs of life and the yield curve was flattening? Now, we finally get 10-year rates to push above 3 percent and the curve to re-steepen a bit—all things investors wished to see as signs that growth was solid. But instead of cheering, investors cringe and extrapolate from this that runaway inflation is going to send rates to the moon and derail stocks? Seems like an over-reaction and emotional response to us…especially when signs of harmful inflation seem absent. The graph below highlights the fact that prior to other recessionary periods, rates are falling and signaling deflation and falling demand unlike today’s rising rate environment.

rates are falling and signaling deflation

Source: Factset

Midterm Elections – Historical Perspective

Several other observations may give perspective. In mid-term election years, normally the market is flat to down in the first 10 months of the year. Then, after the election outcome dust settles and it becomes apparent that gridlock is the reality and no major policy changes will result...the market has historically finished the year on a very good note (on average). This has been the normal experience all the way back to the 1960’s. Historical data illustrates that we normally have an average double-digit correction in a midterm election year, yet, on average, the market is up by double digit levels 12 months after the mid-terms. And of note, since 1946, the market has posted a positive return in every 12 month period following the midterm vote. Actually, we’ve seen, over the last few weeks, the YTD return for the S&P 500 merely revert back to this normal political year pattern of flat to slightly down prior to the election. We believe that’s a reasonable way to view this.

S&P 500 Price Return

Source: Strategas

Technically Speaking

So when might things bottom out? No doubt this is a tough question. What we can surmise from history is that the bottoming process is just that…a process. It would be quite natural for the process to take several months. The charts below show that it is quite normal to have an initial pullback like we did in October, followed by a rally, but then to have a re-test of the low before moving on to higher highs.  Great examples of this are 1998/1999, 2011/2012 and 2015/2016. What we do know from this data is that Price to Earnings ratios have fallen from 19 times earnings to less than 15, while fundamentals remain solid.  With more than half of the S&P 500 stocks at more than 20 percent below their 52-week highs, we find attractive opportunities and feel we are very close to over-sold conditions. In our eyes, this bodes well for returns over the next twelve months, though we do not expect them to come without additional moments of headline-induced anxiety.

S&P 500 2011-2016

Source: Strategas

Conclusion

Regardless, we just don’t see this as the beginning of a bear market and, given the solid fundamentals and reasonable to attractive valuation levels, we are inclined to hold positions and add opportunistically into this corrective dip. Rather than the roaring of an angry bear, this has more of a feel of the January 2016 moment when investors were in temporary “sell-off mode” due to illusions of a potential recession that never happened, but that were supposedly signaled by plunging oil prices. We realize times are a bit different as the Fed is in rate-raise mode, but they are being measured and we do believe they are still data dependent. This moment may even be a reminder to them of the prudence of continuing to be so.

Since we are approaching the warm and cozy Thanksgiving Day holiday, we would like to leave you with a list of things to be grateful for as we celebrate with families…of course these are strictly blessings from an investment standpoint and are items highlighted by our good friends at Strategas Investment Research. It’s quite a list and may reveal why we are confident:

  • Manufacturing and service-oriented demand surveys remain solidly in expansion territory
  • High-yield and investment-grade credit spreads are still tight
  • Earnings growth is rapid in 2018 and expected to remain so in 2019
  • Inflation and inflationary expectations are restrained
  • Monetary policy is far from restrictive with real rates at zero percent
  • U.S. fiscal and regulatory policies are expansive
  • Small business confidence is at near-record highs
  • Consumer confidence is robust
  • Wages are growing at a healthy pace as unemployment declines
  • Long-term interest rates are low from a historical perspective
  • The savings rate has risen to 6.5 percent
  • Capital spending is on the rise despite tariff risk
  • Government spending is stimulative
  • Banks are in better conditions than they were a decade ago
  • China is pursuing fiscal stimulus in 2019

The opinions and forecasts are based on information and sources of information deemed to be reliable, but MWA does not warrant the accuracy of the information that this opinion and forecast is based upon.

The views expressed are for commentary purposes only and do not take into account any individual personal, financial, or tax considerations. 

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