October Washout Serves Up Compelling Buying Opportunity At Lower Forward Valuations

The escalating trade standoff with China, an increasingly hawkish Federal Reserve, and the impending mid-term elections finally took a toll on investor psyche, creating a rush to the exits in October as concern rises about the sustainability of the ultra-strong corporate earnings given China’s key role in global supply chains. Even some sell-side analysts have seen fit to slightly trim Q4’s strong earnings estimates. Nonetheless, the month ended with an encouraging rally from deeply oversold technical conditions. Overall, Sabrient’s model continues to suggest that little has changed with the positive fundamental outlook characterized by solid global economic growth, strong US corporate earnings, modest inflation, low real interest rates (despite incremental rate hikes), a stable global banking system, and historic fiscal stimulus in the US (especially corporate tax cuts and deregulation) that is only starting to have an impact on all-important capital spending. Also worth mentioning are the Consumer Confidence Index, which rose to its highest level in 18 years, and the Small Business Optimism Index, which continues with the longest streak of sustained optimism in its 45-year history.

Although the S&P 500 managed to plod its way upward during the summer and hit new highs well into September, a dramatic risk-off defensive rotation commenced in mid-June reflecting cautious investor sentiment, which disproportionately impacted Sabrient’s cyclicals-heavy portfolios. But this was not a healthy rotation. In fact, I wrote during the summer that the market wouldn’t be able to move much higher without renewed breadth and leadership from cyclicals. But instead of a risk-on rotation to recharge bullish conviction, we got a big market sell-off in October. Notably, such a pullback is normal in mid-term election years, but what is also normal is a strongly positive market move over the course of the 12 months following the mid-terms.

Last week’s fledgling recovery rally from severely oversold technical conditions showed promising risk-on action – and some relative performance catch-up in Sabrient’s portfolios. Thus, while the aggregate earnings outlooks for companies in the cyclical sectors and smaller caps have held steady or in many cases improved, shares prices have fallen dramatically, making the forward P/Es in these market segments much more attractive, while forward P/Es in the defensive sectors have become quite pricey.

Getting the uncertainty of the mid-term elections behind us should be good for investor sentiment. So, I think the correction lows are in – barring a massive “blue wave” in which Democrats take over both houses of Congress or a total breakdown in the China trade talks. Also, companies are coming out of their reporting-season blackout windows so that they can resume their massive share buybacks, further goosing stock prices. All told, I anticipate a risk-on rotation spurring a year-end rally that should treat our portfolios well.

In this periodic update, I provide a market commentary, offer my technical analysis of the S&P 500, review Sabrient’s latest fundamentals-based SectorCast rankings of the ten US business sectors, and serve up some actionable ETF trading ideas. In summary, our sector rankings remain bullish, while the sector rotation model has been forced into a defensive posture due to the recent correction.

Market Commentary:

For the month of October, the SPDR S&P 500 ETF (SPY) registered a loss of -7% while the SPDR S&P SmallCap 600 ETF (SLY) fell more than -10%, and total peak-to-trough drawdowns from the recent all-time highs were about -10% for the S&P 500 (from September 20) and -13% for the Nasdaq Composite (from August 29). Notably, defensive sectors Consumer Staples and Utilities were both up about 2% in October, and low-volatility and dividend-oriented funds generally outperformed. Moreover, momentum and high-beta strategies that have driven this market for so long were the worst performers, down -10% and -13%, respectively, while international markets (both developed and emerging) also took heavy losses, in a broad risk-off rotation. Even long/short equity strategies lost an estimated -8% during the month, making one wonder how a contrarian can make money these days.

The CBOE Volatility Index (VIX) only spiked as high as 29 intraday during the October correction (compared with an intraday high of 50 in February) before closing the month at 21.23. It closed Friday trading at 19.51. When you consider the magnitude of the October selloff, it’s interesting that the same level of panic didn’t manifest.

Friday’s big peak-to-trough intraday drawdown was driven partly by Apple’s disappointing holiday sales outlook, but no doubt there also was some trader position-squaring and investor de-risking going on ahead of the mid-term elections. However, let’s not forget that the 12 months following mid-term elections tend to be quite bullish. According to the Wells Fargo Investment Institute, looking back to 1962 (14 midterm cycles), the S&P 500 sees an average -19% pullback heading into the elections followed by an average +31% gain in the 12 months after. Notably, 100% of those 14 12-month timeframes generated positive returns and only 3 were negative from election day until year-end.

June 11 brought about an abrupt shift from risk-on to risk-off investor sentiment, after the trade war with China escalated, as illustrated in the tables below. 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 the mega-cap Technology names like Apple (AAPL) and Microsoft (MSFT) that dominate the cap-weighted market indexes. Despite this defensive rotation, the major cap-weighted market indexes continued to hit new highs into late-September (before the October correction).

(Click on image to enlarge)

Sector performance comparison 2018

For example, you can see that prior to June 11, Technology sector and Semiconductors industry (a component of the broad Tech sector) were performing very similar, up +12.8% and +12.7%, respectively. But after June 11, the broad Technology sector held up pretty well, down only -4.8% at the depths of the selloff on October 24, while the highly-cyclical Semiconductors industry sold off much harder, down -16.9% between 6/11 and 10/24, before both recovered some ground by month-end. I wrote during the summer that the market assuredly would not continue to hit new highs on the backs of defensive sectors and that a rotation back into cyclicals would be necessary, with participation from small-mid caps and improved breadth demonstrated by falling sector correlations. But instead of such a risk-on rotation to recharge bullish conviction, we got a full-blown washout.

Furthermore, year-to-date, Growth (SPYG) and Momentum (SPMO) are still greatly outperforming Value (SPYV), while Low-volatility (SPLV) is performing in-line with the broad S&P 500 (SPY). But since the defensive rotation commenced on June 11, the relative performance among SPY, SPYV, and SPYG have converged together with roughly equal performance, while SPMO has trailed and SPLV has greatly outperformed.

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

Disclaimer: This newsletter is published solely for informational purposes and is not to be construed as advice or a ...

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