Weekly Update: If you're stressed about a correction, visit Wisconsin

10-12-2018

Off to friendly Wisconsin this week. We started in Madison with a client event where my comments about record optimism, jobs and confidence were received with polite silence, followed by their listing of big worries: the unwinding of the Fed’s balance sheet, money-printing powering the market, tax cut just a sugar high. “Aren’t you worried about a black swan?” Our advisor host asked if investors in other parts of the country also want to discuss politics, “because it’s a hot button here.” Yes, ad nauseam. We had an excellent conversation with an advisor in Milwaukee about behavioral finance and the fact that it is next to impossible to predict a black swan. Remember Elaine Garzarelli? (She made the bear call a week prior to the Oct. 12, 1987 “Black Monday” crash.) Meredith Whitney? (She warned of major bank problems just prior to the onset of the global financial crisis.) Both stumbled with subsequent dire predictions. We had dinner in beautiful “Lake Country.” Wisconsin has more lakes than Minnesota, the self-described “Land of 10,000 Lakes’’ state, yet it promotes itself as a dairy state even though California’s dairy industry is bigger. I asked the group if their clients are nervous. “There is blind optimism. Our clients tell us to ‘let it run’,” I was told. At least, that was as of Wednesday.

A lot of pundits have been blaming the sell-off on the Fed. What’s new there? Chicago Fed President Charles Evans did say this week that the central bank plans a pause after reaching 3% on its target rate around mid-2019, but that’s in line with market expectations. Some say it was Wednesday’s higher PPI reading, but Thursday’s CPI went the opposite way (see below). Others contend the trade war is catching up to the U.S., as suggested by recent guidance and preannouncements for the coming earnings season (more below). But didn’t we just nail down more favorable agreements with Canada and Mexico and aren’t President Trump and China President Xi Jinping set to meet next month on this very topic? Many, of course, blamed the spike in bond yields, but all that did was cause the yield curve to steepen. Weren’t we worried about a flattening yield curve just a few weeks ago? And isn’t a 10-year yield of 3.25%-3.50% historically consistent with 3%+ economic growth, a positive for earnings? The fact is, nothing new has happened fundamentally to change the path of the economy or the backdrop for U.S. financial markets. This suggests something of a more technical nature may be going on. Wednesday’s selling had characteristics of a climactic flush—the percentage of stocks trading at a 20-day low spiked through 50%, NYSE breadth was 11 to 1 decliners vs. advancers, about half of S&P 500 constituents posted a 2 standard-deviation move, volume sharply expanded and the volatility curve (spot VIX vs. 3-month VIX) inverted. As of this writing, the market was flirting with its 200-day moving average of 2,765. This level was undercut in January and again in late March, but it proved to be temporary and reasonable support that eventually set the stage for summer’s advance. A sustained period below the 200-day would be discomforting, but we’re not there yet. Dudack Research suspects the potential closing of three substantial hedge funds may have contributed to the illiquidity, with individual stocks further pressured by buyback constraints due to the coming earnings reporting season.

All things considered, Strategas Research posits the market is within the ballpark of a tradeable low, particularly given the seasonal tailwind that begins to emerge by late October. Historically, 3% daily S&P declines in uptrends have proved to be buyable events over the last 75 years, with forward returns coming in above historical averages one, three and six months forward. The decline has pushed the forward P/E multiple on the S&P below 16 to a level that’s acted as a reliable floor for equities since Brexit. In researching the past three post-recession rate-hiking cycles (1984-1988, 1995-1998, and 2004-2005), JP Morgan uncovered what it calls 16 “late-cycle potholes”—relatively short-lived but sharp pullbacks averaging from 5.36% to 13.06%. Before Friday’s strong opening, the S&P was 7% below its September peak. Our meeting in Fond du Lac—the first of my three final stops in Wisconsin yesterday, the others being Green Bay and Brookfield—was so pleasant, you’d forget Wednesday’s market rout. Rather, we had a lengthy discussion about beer and cheese curds. Incidentally, string cheese was invented just 20 minutes outside of the city. Never knew that it squeaks when you eat it warm off the line. I suggested the correction has more to do with normal pre-election corrections, technical factors and tariff-related earnings worries. An advisor disagreed, claiming there is too much money in exchange-traded funds (ETFs), and sales of such on Wednesday caused the market to fall hard in a “blink.” (Fundstrat reports the combined inverse ETF+VIX volumes reached 6% of all NYSE trading on Thursday—think about that—6%!! This matched the February reading, arguably another sign of a bottom.) And then we continued our beer discussion.

Positives

  • Small businesses enthusiastic A monthly survey of members by the National Federation of Independent Business said optimism slipped in September off August’s record but continued to be very high—matching the second highest reading on record. Inventory, capital expenditure and hiring plans all moderated but remained robust.
  • Strong consumer sales up and down the income scale A Redbook survey of chain stores said September sales rose 5.9% year-over-year (y/y), the most since at least 2005, with sales growth strengthening the final week of the month and jumping even more the first week of October. A separate International Council of Shopping Centers survey of chain stores reported similar trends, just not quite as robust. The weekly Bloomberg Consumer Comfort Index did fall by the most since May 2014, but held near a 17-year high, while the preliminary Michigan consumer sentiment take on October also dipped but remained solidly optimistic.
  • Do we or do we not have an inflation problem? September’s headline PPI rebounded after slipping in August, with the year-over-year (y/y) core rate rising to 2.5%. But outside of a big jump in transport services, prices were relatively benign. September’s CPI posted its smallest increase in six months, in part because of a sharp drop in used-car prices, with the y/y headline rate increasing at its slowest pace since February and the y/y core rate holding steady at 2.2%. Ex-petroleum prices, import inflation moderated, with the y/y rate declining to 3.5%.

Negatives

  • Here’s my vote for why we’re correcting Earnings optimism has been acting as a firewall protecting stocks, but warnings from PPG, Fastenal and others and concerns that tariffs may harm tech this week seemed to sour the mood on the eve of the third-quarter reporting season. The sample size is still too small to draw any firm conclusions, but JP Morgan notes consensus 2019 forward earnings-per-share of around $178 has been lending solid valuation support to the S&P.
  • The labor market is tight A record-matching 38% of firms surveyed by the National Federation of Independent Business reported current job openings that they cannot fill, with more than half of all respondents saying they are encountering recruiting difficulties. A record 37% said they had to raise worker compensation to find and keep employees. Although its Employment Trends Index slipped in September for the first time in four months, the Conference Board expects continuing strong labor demand will push the jobless rate to 3.5% or lower in 2019.
  • Do we or do we not have an inflation problem? Based on the Atlanta Fed’s latest measure, inflation expectations among businesses rose to 2.3% y/y in October, matching April of this year as the highest for this series since it was initiated in 2011. In many ways, the Fed pays closer to attention to inflation expectations than it does inflation.

What else

Will there be a Fed ‘put?’ A 10% pullback might get the Fed’s attention—another bad day like the last two could do it—but Evercore ISI believes it would take something closer to 15-20% falloff to potentially lead policymakers to change their rate-hike path.

Deficits in the context of a record large economy When the 12-month rolling federal deficit hit $900 billion in August, many said the U.S. was on the path to $1 trillion deficits for years to come. Then came September’s surplus (not unusual for the month), lowering fiscal 2018’s deficit to $782 billion. That’s still large but represents an arguably manageable 3.9% of GDP, and an increase of just three-tenths of a point the past 12 months despite a tax cut of nearly seven-tenths of a point of GDP.

Wisconsinites are proud of this A USA Today article entitled “The Drunkest Cities in the U.S.” said 10 of the top 20 were in Wisconsin, with the state accounting for the top 4! “Why,’’ I asked the advisors there. “We don’t do anything without drinking!” They credited their German background. Yes, I said, but we have Germantown in Pittsburgh, and we drink Yuengling. “Yuengling? Come on!” was their reply.

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