I had wanted to take this week off from the normal writing and recordings but market conditions this month would have none of it. We spent a half-market-day on Monday (Christmas Eve) dropping 650 more points on the Dow, getting a whisker's distance away from a 20% drop in the S&P 500 from the high closing point to the low closing point (more on this in the Dividend Café). Of course, we were closed on the Christmas holiday on Tuesday. Then, Wednesday saw the largest daily point increase in market history, as the Dow rose 1,086 points in a day (+5%). As I type now, markets are set to decline Thursday morning 350 points. December has been the worst December for the markets since the Great Depression (so far). I can't dare call the end of the year yet as the time we have remaining this week and the half-day we have Monday, the 31st, represents an eternity of market time these days (two or three days is enough for 2,000+ points of market movement up, down, or both). What we do know is this: 2018 has been a wild ride. I am not interested in recapping 2018 until next week, but for now, want to delve further into the very here and now of markets and market sentiment.
So in the afterglow of what I hope was a beautiful Christmas holiday for you and yours, hold on to that eggnog, and let's jump into this week's Dividend Café.
What happened in December?
The beginning of the December sell-off was December 4 (Tuesday), when markets were greeted with a “I am Tariff Man” tweet from the President. Markets had rallied 1,000 points higher the week before and entered December with strong momentum after a positive-performing November. As I type, the Dow is now down 3,000 points (over 11.5%) from its early December high and is expected to close out the month as the worst December since the Great Depression of 1931.
I cannot tell you how different December would have been and felt if it had been a month where bond yields flew higher as stock prices collapsed. That would have indicated a rapidly growing economy, concerns about inflation, and the re-pricing implications of Fed actions. In other words - the exact negative environment we had back in February! But this time, despite Fed tightening, bonds responded exactly how they traditionally do in a risk-off pummeling - they rallied (as yields fell). The reason for the market drop in December is categorically lower than the reason for the market drop in February … Investors are not fretting runaway growth; they are fearing global weakness.
About that balance sheet ...
I made the argument in last week's Advice & Insights podcast that the far more relevant matter in present monetary policy impacting markets is their unwinding of the quantitative easing that they have embarked upon (often referred to as balance sheet reduction, or quantitative tightening). The initial pace was just $10 billion per month (of bonds that would mature, and that the Fed would not reinvest the proceeds, essentially allowing that liquidity to evaporate, and be removed from the banking system). The pace has not picked up to $50 billion per month, and the total stated goal has been to reduce about $1.5 trillion from their balance sheet (money that never entered the money supply, but sat on the Fed's balance sheet or served as excess reserves in the banking system). I am sure you find the nuances captivating.
But here's the thing ... $430 billion (so far) of reduced liquidity on the balance sheet amounts to about five additional rate hikes in terms of its impact to monetary contraction. So if we have seen seven rate hikes in the last two years, the fact of the matter is that markets are digesting more like twelve rate hikes as the combined impact of the fed funds rate tightening and quantitative tightening makes its way through markets.
Why? Just why?
There is plenty to at least wonder about Fed policy and actions right now, and perhaps in 2019, there will be plenty to criticize - I don't yet know. But this much has to be said: Years and years of easy money were never going to be unwound easily. Staying at the zero-bound in 2014, 2015, and 2016, the latter years of which seemed very much driven by global market fears, not domestic data, delayed the days of reckoning, and the Powell-Fed is presently cleaning up much of the Bernanke-Fed that the Yellen-Fed did not want to deal with. Now, understand what I am saying (and not saying), please: That does not mean Yellen was right, or wrong, it just means that this is what is going on now - we left the punch bowl on the table for hours after everyone was drunk, and even added more sauce to the punch. And NOW we wonder why there's a hangover??
The economy vs. the market
The key predicate in believing this to be a fear-driven meltdown in risk assets vs. a secular bear market is that the U.S. economy is not facing a recession any time soon. Global economies are, in many cases, weak (or weakening). The U.S. central bank is tightening monetary policy. And the trade war has created a severe level of economic anxiety and uncertainty. But the U.S. economy has not shown signs of weakening or vulnerability (yet), and that will be the key determinant of where things go in 2019.
No-recession by any other name
The Leading Economic Indicators are up 4.4% over the last six months (annualized), and generally will go negative 9-18 months before a recession ensues.
But sentiment is so bad!
Exactly. And this is perhaps the biggest argument stock market bulls have going for them! What generally precedes a market top is not negative sentiment, but irrationally euphoric sentiment. Momentum picks up into a top, and in this case, the mood was highly skeptical all the way through. If this period were to turn into a bear market, it would apparently be the most anticipated one in history. Investors have a lot more to fear when sentiment is good than they do when it is bad, especially investors with a timeline for investing longer than this week or next.
High Yield is Highly Important
My early 2019 white paper reviewing 2018 in full and laying out our roadmap for 2019 will dive deeply into the relevance of corporate credit in 2019, and what it all will mean for how 2019 plays out the big picture. But one thing I can say is that we dramatically reduced (and in some cases eliminated) high yield credit exposure back when spreads got as low as 250-300 basis points. They now have gotten as high as 450-500 basis points (more in line with historical averages), and you could argue that at these levels are reasonable in terms of a risk/reward trade-off. Should risk assets improve in the months and quarters ahead, I could see a nice rally in the space; yet should U.S. economic conditions take a downturn you could easily see 300-500 basis points of more spread widening (meaning, more price decline in the high yield space). We will maintain a very small exposure here in our taxable fixed income allocation, but we will be writing a lot more about this in the weeks and months ahead - not because of what it means for high yield investors, but because of what high yield means for all other investors!
To spell out that last sentence, widening high yield credit spreads in recent weeks have been of the garden variety, not indicative of a crack in credit availability. The same is true in the levered loan market - the indicators do not at all point (at this time) to a systemic breakdown in credit. Business activity is needed to sustain this economy, and suppression of credit would be the best indicator we will get that that is breaking down. But so far, it hasn't been in the cards.
The safe haven of … emerging markets?
Notice the only equity class to NOT be underwater in the last three months … Now, Emerging Markets had far underperformed U.S. equities all year, but to see this kind of risk-off rally this last quarter and see EM stay above the flat line with the S&P, Nasdaq, and small-cap all down 11-18% is quite peculiar but noteworthy.
Is this all about the trade war???
Very few conservative Republicans like me have been as critical of the President for his 2018 trade policy as I have been. And in addition to calling out what I personally consider the bad policy of it all, I also have pointed out the significant disruptions it has created in business spending and capital expenditures, and what that has done to reverse the momentum of tax reform.
But even a free trader like me has to acknowledge that not all of the recent market woes can be explained by the trade war. European banks have been getting clobbered all year - is that U.S./China driven? Everyone's beloved FANG stocks are down 40% (not a typo) from market highs - are they trade-correlated? The fact of the matter is that a wide array of circumstances are all at play, and many of them have fed on each other to create negative feedback loops (most significantly, fear of excessive Fed tightening in tandem with fears of the cycle slowing due to global trade slowdown). I am committed to unpacking the lay of the land more exhaustively in our early January 2018 summary white paper, where a more exhaustive treatment can be done. But no, it is not all about the trade war, no matter how problematic that has been to confidence in the U.S. economy.
Equity risk premium says what?
The earnings yield of the S&P 500 is now a full 3% higher than the 10-year Treasury yield - a new high level that has historically led to an average in forward returns in excess of 12% (average). (ERP = equity risk premium, and that is the difference between the earnings yield of the S&P 500 and the 10-year treasury bond yield). If this sounds like mumbo-jumbo to you, I promise it is not. It speaks directly to the heart of what drives stock performance relative to how assets everywhere are priced.
Volatility, meet Valuation
I don't want to lose you here, but I also do not want to forfeit the chance to explain a very important investment concept. "Beta" measures the volatility of a given security relative to the overall market. The fact of the matter is that a high valuation does not merely mean there is likely to be a lower return in an asset going forward, but it also means the volatility will likely be higher as well. Inversely, when valuation has collapsed, the volatility (relative to a given benchmark) should be lower, too. Emerging markets, for example, have a higher Beta to the market, but have experienced lower volatility in recent months. Why? Because they were starting with a such a low valuation relative to the market …
Investors understandably want attractive return prospects for their investments, but they also want less volatility (variance) around that return. On both fronts, the valuation matters.
I have spent inordinate hours the last twenty years studying the great investors of history, and believe those lessons tie closely into what we intuitively know to be the right investor behavior during times like these. I look back at the various market dips that have looked like this month's collapse - post-Brexit, January 2016, August 2015, July 2011, May 2010, of course the horrific financial crisis (categorically different event), and go back to the one this period most seems to rhyme with - August 1998 (I can explain why that is) - and time and time and time again, the right play has been the following:
(a) Understand if at all possible why this is happening (that is not always possible),
(b) Make sure you know what is happening (it's one thing to say, "the stock market is dropping!" - it's quite another to look at what sectors are down, what high yield spreads are doing, what is happening with commodity prices, and where all the puzzle pieces fit in),
(c) Avoid any temptation to rash behavior or overreaction,
(d) Stay deeply connected to history and reality (mainly, that market drops actually do happen, a lot, and that markets recover)
(e) Then, look for ways to exploit the downturn to one's advantage (cash deployment, rebalancing, adding new positions to one's portfolio that "went on sale," etc.
The playbook doesn't seem very complicated to me, but it sure has been lucrative. What seems to disrupt it more than anything is looking at one's portfolio online every ten minutes, getting sucked in to media hype and misinformation (someone should make up a term for that), and failing to disconnect the noise of the markets from the real-life goals and objectives actual human being investors have. We live to be this antidote.
Politics & Money: Beltway Bulls and Bears
- The government has "shutdown," meaning, 25% of government has had about 60% of its functions shut down from operations (and funding). If you care, this is different from past "shutdowns" in that 75% of government was already funded coming into this so is totally unaffected, and then of the 25% that is affected, a high percentage is deemed essential and receives exemptions from the shutdown. That said, there is little reason to believe this will resolve itself before January 3 (which is when the new Congress is sworn in).
- If any of you believe after the last three years you can forecast the political, have at it (hint: you can't), but there is more to the market ramifications of the political environment right now than just this small-level government shutdown. Through a number of politically controversial or divided-opinion issues, President Trump's consistently upheld claim has thus far been (with good support behind it) "Yeah, but the economy is strong!" With the recent resignation of General Mattis, the collapse of the stock market in December, whatever is happening with Mueller, etc., it is reasonable to assert that economic progress becomes that much more politically important to the President in 2019. Enough said, for now.
Chart of the Week
I've lost count at how many rallies have been sustained or sell-offs reversed by an outperforming earnings quarter (relative to expectations). Now, the opposite can most certainly occur as well, which is why risk is not to be taken lightly. What the Q4 earnings season demonstrates by way of earnings growth will be quite relevant to the mood and positioning in the market.
Quote of the Week
"Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy, and time of maximum optimism is the best time to sell."
-- Sir John Templeton