Putting the Selloff in Context
The equity markets tried to bounce this week but it all fizzled out by Friday. For the week the S&P was flat while small-cap equities had a fractional loss. The developed overseas markets held up reasonably well, but emerging took another hit. The index was off -1.5% and China slid over -2% for the week.
To put things in perspective, since the equity market high on 9/20/18, the main indexes are down as follows:
S&P 500 -5.6%
Russell 2000 -10.2%
Emerging Mkts -7.8%
Richard Bernstein Advisors crunched the number earlier in the week to put this correction into perspective. To quote their most recent piece:
“Last week’s drop in the S&P 500 marks the 27th 5%+ pullback of this bull market and the third of 2018. We do not take these market moves lightly, but it is also important to put them into context — both relative to history and relative to the fundamentals. 5%+ pullbacks have historically occurred three times per year going back to 1928. Of those, less than 20% turned into 15% corrections and roughly 10% turned into full-blown bear markets.”
The size of the move isn’t that unusual then, but the speed probably is. It seems as if the corrections over the last few years materialize in the space of a few days, rather than over a period of weeks.
Bond yields continued to push higher this week and intermediate-term Treasury bonds lost -0.2% while long-term bonds dipped -0.7%. What has been interesting the last few weeks has been the resistance against lower yields despite the equity market correction. Since the market high on 9/20/18 the main bond indexes have performed as follows:
Long-term Treasuries (TLT) -2.7%
Intermediate-term Treasuries (IEF) -0.7%
Short-term Treasuries (SHY) +0.0%
Bank Loans (BKLN) +0.1%
High-Yield (HYG) -1.1%
Emerging debt (PCY) -1.4%
Traditional bonds have not given you much of a hedge during this last sell off. This is unusual, at least historically.
Housing Slows But Leading Indicators Rise
The economic releases were light this week. A couple of key reports are worth pointing out.
Existing Home Sales
These came in weak for September after a stagnant August. Total existing-home sales, which are completed transactions that include single-family homes, townhomes, condominiums and co-ops, fell 3.4%. Sales are now down 4.1% from a year ago.
Interestingly, total housing inventory managed to shrink ever so slightly from 1.91 million in August to 1.88 million in September, and inventories are basically unchanged from last year. This is a change from the last few years when inventories have been steadily contracting (blue line below).
The absolute number of homes for sale remains relatively low. The red line above shows the months of supply on the market. It has ticked up to 4.4 months but is still hovering around the lows seen in 2003 to 2005. As we have talked about previously, housing is turning into a headwind, but not a major one. In a sense this is a long overdue slowing.
Leading Economic Indicators
A slowdown in housing isn’t a recession risk, at least not yet. Other factors in the economy are more than offsetting the headwind. A way to see this is in the leading economic indicators (LEI) report. The latest release shows the LEI for September increasing to 111.8 from 111.2 in August, as you can see below.
The shaded columns are recessions, and it is pretty clear the LEI turns lower before recessions. The lag can vary – anywhere from a couple months to over 12 months, but the LEI consistently turns lower before a recession.
Italy Brings Back Memories
While not an economic report, the situation in Italy continues to percolate. The European Union and Italy are going back and forth on Italy’s proposed budget. Italy’s new government wants to spend more than the EU rules appear to allow, and this is undermining confidence in Italian assets and European banks.
The yield spread between Italy’s benchmark paper and the equivalent German Bund, which shows the premium investors demand to hold the riskier debt, reached levels not seen since 2013. The absolute level of the Italian 10-year is approaching 3.5%.
To be honest, even this rate seems excessively low. Given the choice between buying a U.S. Treasury at 3.20% or an Italian 10-year at 3.48%, I think I know which I’d prefer!!
The Fed’s Buzz Kill
The rally in the equity market fizzled out this week after the Fed minutes came out. The minutes were from the September meeting where the Fed hiked rates by a quarter point. Key points included:
1) The view of the economy was upbeat. Growth was characterized as “strong,” with a few participants viewing recent data as stronger than expected.
2) It was mentioned that labor shortages and trade policy uncertainty were leading to foregone investment and production opportunities.
3) The Fed’s staff thinks growth will remain above potential in 2018-2020 before slowing in 2021.
4) The Fed thinks inflation will remain at the 2% target for the foreseeable future. Some of the participants noted a worry that inflation could overshoot on the high side.
5) The comment that the market really fixated on was the outlook from some of the participants that that fed funds rate would ultimately become “modestly restrictive” or “temporarily” rise above their estimates of neutral. This raised the specter again of the Fed being more aggressive next year than the 2 to 3 hikes priced into the market today.
When Are Corrections just Corrections, and When Are They Something More?
Given the correction of the last few weeks, Bank Credit Analyst released a timely study of previous major selloffs. They looked at the 1929 crash as well as declines in 1987, 1998, 2000, and 2008. They then broke these into two sets – selloffs that were simply temporary (1987 and 1998) and selloffs that turned into something much worse. To quote BCA:
“The evolution of the economy distinguishes the two sets of episodes. The 1929, 2000, and 2008 sell-offs foreshadowed significant declines in economic activity and corporate earnings. In contrast, neither the stock market crash in 1987 nor the one in 1998 presaged any imminent economic doom. The latter two episodes were among those ‘false positives’ that had led Paul Samuelson to quip decades earlier that ‘the stock market had predicted nine out of the last five recessions.’”
The chart below overlays the S&P 500 on a measure of corporate earnings. It is clear that major declines were accompanied by large falls in earnings. Conversely, 1987 and 1998 proved just temporary (albeit painful) because they happened in the context of rising earnings.
So the natural question now, especially if we get a few more weeks of selling and we breach the 10% correction threshold for the S&P, is where are earnings headed? Goldman published their earnings estimates this week for the next couple years. As you can see below, they estimate earnings of $159 this year followed by 7% and 5% growth in 2019 and 2020.
Without question there are plenty of things to worry about. Slowing global growth, rising interest rates, trade protectionism, Italy’s budget, and the upcoming mid-terms all rank high on the list. But the good news is that there are no signs of an imminent recession (and associated earnings decline) that, at least historically, are prerequisites for a major bear market.
Have a good weekend.
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