No Holiday Cheer Yet, As Panic Mode Does Major Technical Damage Despite Attractive Valuations

Last week was the market’s worst since March. After Q3 had zero trading days with more than 1% move (up or down), our cup runeth over in Q4 with the stock rollercoaster so far offering up 22 days that saw a 1% move. Volatility seems rampant, but the CBOE Volatility Index (VIX) has not even eclipsed the 30 level during Q4 (whereas it hit 50 back in February). Even after Friday’s miserable day, the VIX closed at 23.23. Of course, the turbulence has been driven primarily by two big uncertainties: the trade dispute with China and the Federal Reserve’s interest rate policy, both of which have the potential to create substantial impacts on the global economy. As a result, investor psychology and the technical picture have negatively diverged from a still solid fundamental outlook.

For about a minute there, it seemed that both situations had been somewhat diffused, with Presidents Trump and Xi agreeing at the G20 summit to a temporary truce on further escalation in tariffs, while Fed chairman Powell made some comments about the fed funds rate being “just below” the elusive neutral rate. But investors’ cheers soon switched back to fears (soon to be tears?) with the latest round of news headlines (e.g., Huawei CFO arrest, Trump’s “Tariff Man” comment, Mueller indictments, and the imminent federal debt ceiling showdown). The uncertainty and fear-mongering led to a buyers’ strike that emboldened the short sellers, which in turn triggered forced selling in passive ETFs and automated liquidation in quant hedge funds, high-frequency trading (HFT) accounts, and leveraged institutional portfolios, which removed liquidity from the system (i.e., no bids), culminating in a retail investor panic. As it stands today, the charts look woefully weak and investor psychology has turned bearish, with selling into rallies rather than buying of dips.

Ever since June 11, when the trade war with China escalated from rhetoric to reality, stocks have seen a dramatic risk-off defensive rotation, with Healthcare, Utilities, Consumer Staples, and Telecom the only sectors in positive territory and the only ones outperforming the broad S&P 500 Index. It’s as if investors see the strong GDP prints, the +20% corporate earnings growth (of which about half is organic and half attributable to the tax cut), record profitability, and record levels of consumer confidence and small business optimism as being “as good as it gets,” i.e., just a fleeting final gasp in a late-stage economy, rather than the start of a long-awaited boom cycle fueled by unprecedented fiscal stimulus and a still-supportive (albeit not dovish) Federal Reserve. As a result, forward P/E on the S&P 500 is down a whopping -19% this year, which is huge – especially considering this year’s stellar earnings reports and solid forward guidance.

But has anything really changed substantially with regard to expectations for corporate earnings and interest rates (the two most important factors) to so severely impact valuations? Not that I can see. And Sabrient’s quantitative rankings imply that the economy and forward guidance remain quite strong, such that the market is simply responding to the proverbial Wall of Worry by offering up a nice buying opportunity, particularly in beaten down cyclical sectors and in solid dividend payers – although there might be some more pain first. Over the past 10 years of rising stock prices since the Financial Crisis, there have been eight corrections of roughly -10% (including nearly -20% in 2011), and this year’s correction has led to the fourth major drawdown for Sabrient’s Baker’s Dozen annual top picks list (1Q2009, mid-2011, 2H2015, and now). But selling at each of those previous times would have been the wrong thing to do, and this time seems no different.

Market Commentary:

Starting on June 11 when the trade war with China escalated, a risk-off rotation set in, as capital moved out of small caps, emerging markets, international developed markets, and cyclical sectors (like Materials, Steel, Homebuilding, Energy, Industrials, Financials, and Semiconductors) and into US large-cap defensive sectors like Utilities, Healthcare, Telecom, and Consumer Staples, as well as (at least for a while) the mega-cap Technology names like Apple (AAPL), Amazon (AMZN), and Microsoft (MSFT) that dominate the cap-weighted market indexes. The accompanying table illustrates this pre- and post-June 11 behavior, through the end of November.

Sector performance comparison

No doubt, there has been plenty of macro uncertainty to weigh on investor sentiment. First and foremost, of course, the two biggest have been: 1) the escalating trade war between the world’s two largest economies, and 2) the Federal Reserve seemingly hell-bent on raising rates and pulling liquidity out of the financial system without acknowledging the interdependent and highly-leveraged global economy – until recently, that is. In addition, there has been the mid-term elections, populist movements worldwide (including France’s violent Yellow Vest protests), the Mueller investigation, threats of impeachment, failing Brexit negotiations, Italy’s tenuous debt situation, deteriorating emerging market economies, China’s attempt at deleveraging as growth slows, an imminent battle in Congress over raising the debt ceiling and building “the wall,” and so on. All of this has served to increase investor concern about the sustainability of economic strength and where we are in economic cycle.

But lately, the negative headlines have been hitting the tape fast and furious. Within a few days of the Trump/Xi dinner, an announcement came out about the arrest of the CFO of Chinese conglomerate Huawei for violating sanctions against Iran. As for Trump (and his trusty sidekick Twitter), his latest negotiation approach is to proudly proclaim to be a “Tariff Man” – even while promising his willingness to sign any reasonable trade deal presented to him – as a veiled threat against a reeling Chinese economy that is struggling to maintain economic growth while deleveraging its massive debt (including its out-of-control “shadow banking” system) that has fueled its amazing growth rate. As for Powell, although he has talked in the past as if he is only concerned with US economic data in determining monetary policy, the reality is that the whole world feels the impact of rising US rates and a strengthening dollar, and this pain ultimately finds its way back home in an interdependent and highly-leveraged global economy – and he finally seems to be acknowledging such. The US economy indeed is “solid,” in his words, but not without risks on which wary investors have chosen to focus. Increasingly, commentators and investors are fearing the worst – an erosion in business confidence manifesting in reduced capital spending plans, a global recession commencing in 2019, and a bear market in stocks.

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Disclosure: The author has no positions in stocks or ETFs mentioned.

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Nicky Paterson 3 months ago Member's comment

Panic is out.