Watching the news on Wednesday or reading the papers Thursday morning you would have thought we were down big this week. But only the small-cap Russell 2000 index stands out with a loss of over -1%. The S&P was little changed, and even emerging equities hardly budged despite the turmoil in Brazil (more below). The EAFE stands out with a +1.3% weekly gain, bringing the YTD advance to +14.5%. The gain in the developed world came entirely from currency shifts. The euro added +2.5% for the week while the yen was up +1.9%.
Regardless of where the gain came from, overseas stocks are finally having a bit of a run. The chart below shows international stocks versus the S&P 500. When the line is falling the S&P is beating international. The line has been falling for quite some time!!! But the bounce we have had in relative performance (international beating U.S.) is pretty meaningful and those with a technical persuasion might consider this a breakout. Time will tell.
Politics Disrupts Tranquil Markets…
Every day seems to bring something new on the political front in the U.S. On Wednesday, we seemed to hit a point where political uncertainty unnerved the markets, at least for a day. Or at least the political news was taken as a reason to sell stocks.
We should put Wednesday’s selloff in perspective, though. It is important to acknowledge that the markets have been experiencing a very unusual period of calm the last few months. The chart below shows that this is the longest period without a greater than a 0.5% move in the S&P 500 since 1969.
As you expect, volatility is cyclical. Periods of low volatility are followed by periods of higher volatility. But just because volatility spikes higher does not mean it’s a sign of bad things to come. The table below from Pension Partners tells this story very well. It lists the largest one day spikes in volatility and what happens with both volatility and S&P returns over the next day, week, and month. Wednesday’s selloff generated the 7th largest spike in volatility in recent memory (it is coming off a very low base) – the VIX, a measure of volatility, spiked higher by 46.4%. On average, volatility has then trended lower and the S&P has bounced over the next month.
All this means is that one day wonders like Wednesday are, more often than not, noise. They don’t signify anything more than the old adage about why markets go down – ‘more sellers than buyers.’
…but Tranquility isn’t the norm
What you can say with more certainty is that corrections in the equity markets are a fact of life. Blogger Ben Carlson maintains the chart below that shows the worst peak-to-trough drawdowns for the S&P by calendar year.
As he notes:
“The average drawdown over this 67-year period was -13.5% while the median was an intra-year loss of -10.5%. There were double-digit drawdowns in more than half of all years while one out of every six saw a 20% or worse drawdown during the year.
The crazy thing is that although these drawdowns occur almost every year like clockwork stocks were still up over 11% per year since 1950. They were positive in 79% of all years. They were up double-digits roughly 60% of the time while they finished the calendar year up 15% or more in almost 50% of the time.
In effect, double digit losses were almost as prevalent as double digit gains even though the gains far outweighed the losses in the overall scorecard.
Stocks don’t have to crash every time they fall. In fact, the majority of the time when you’re invested in the stock market you’re going to be experiencing a drawdown for the simple fact that new all-time highs aren’t reached every single day and stocks are only up around 50% of all trading days.”
So, were stocks down on Wednesday because of Trump? Maybe. But if it wasn’t him, it would have been some other reason. There’s always a reason. And that reason is often times assigned only after the fact.
Brazil Attempts to Steal Trump’s Limelight
Political turmoil has once again engulfed Brazil following reports that President Michel Temer was involved in an alleged cover-up scheme involving the jailed former speaker of the lower house of Congress. The O Globo newspaper reported that a secret recording exists of Temer approving an illegal payment to Eduardo Cunha, who orchestrated the impeachment of Rousseff. The tape was submitted to the Supreme Court by two senior executives from meat-packing company JBS SA as part of a plea bargain deal, the newspaper said.
This latest political storm could potentially trigger another presidential impeachment. There are at least three scenarios that could lead to Temer’s removal.
1) Temer could resign
2) The Supreme Court could impeach him for obstruction of justice
3) The Superior Electoral Court could void his presidency if he is found guilty of illegal presidential campaign financing.
Of course, Brazil has been consumed with political problems the last few years. Once the darling of investors (it was up 121% in 2009 in dollar terms), Brazilian stocks seriously struggled from 2011 to 2015 due to a never ending political scandal that brought down a government. Over this period Brazilian stocks lost roughly 70% of their value. Then in 2016 stocks shot higher (+64%) once the political situation stabilized and Temer came to power. Through Wednesday of this week they were up another +17%. However, on Thursday stocks promptly lost -16% (in dollar terms) in one day.
This loss was partly due to falling stock prices which were down -8% for the week (chart below).
But U.S. investors in Brazil also take currency risk. The same day the stock market was down the Brazilian real lost almost 8% (see chart below – two far right columns).
And if this wasn’t painful enough, if you happened to own Direxion’s leveraged Brazil ETF, you’d be down -42% this week, even after a +18% rally on Friday.
This makes our market volatility this week look like child’s play.
History is Little Guide
Back to the political turmoil in Washington. We can’t add anything to the debate other than to illustrate what market history look like. And on this score, there isn’t much to go by. As BCA noted on Friday with the accompanying charts of the S&P 500:
“The U.S. has experienced three impeachment crises over the past 100 years: The Teapot Dome Scandal (April 1922 to October 1927),
Watergate (February 1973 to August 1974),
and President Clinton’s Lewinsky Affair (January 1998 to February 1999).
Only the Watergate crisis was accompanied by a bear market in stocks, and that was largely a function of the fact that the U.S. was going through one of the deepest recessions in the post-war era at the time.”
We should also point out that the correction during the Clinton era was due to the Asian financial crisis, not politics. And this gets to the heart of the issue. Markets over any length of time are driven by the economic backdrop. As Europe has shown over the last few years, political uncertainty is ultimately discounted by the markets. BCA argues that this time is no different. What matters for the markets beyond the week-to-week volatility is what happens with economic and earnings growth.
J.P. Morgan also took a look at the last three major political scandals to illustrate what is different this time. If you look at Watergate, Iran-Contra, and the Lewinsky situation, in each case the sitting President’s party did not control both house of Congress (see table below). So far Trump has both.
Only Regan had the support of the Senate. This is important because while it takes a simple majority in the House to start impeachment proceedings, it requires a two-thirds majority in the Senate. Of course, this can change, but it will take time.
J.P. Morgan noted the following on Friday:
“..the most meaningful indicator of shifting probabilities of Trump’s non-completion of his term would be shifts in his support from Republicans at large, both institutional and popular. (The chart below) shows that while Trump’s overall approval rating is unusually low for a President so early in his term, his support among Republican voters has remained resilient and above 80%. This will be important for markets to track going forward. And for this reason, special congressional elections, and especially how 2018 mid-term elections might shift the balance–in Congress also becomes that much more significant and critical for market perceptions of Trump term non-completion risks.”
So while the political backdrop will almost certainly influence the markets, gauging the size of the impact, or even the direction, is tough. History is little guide because each example evolved in a very different environment. And ultimately this is probably the lesson. The macro developments outside of politics will end up being the dominant sustained market driver over the next few months barring more dramatic revelations or a partial Republican revolt in Congress.
Have a good weekend.
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