Weekly Update: An unforeseen event, typically one with extreme consequences

10-19-2018

That is the definition of a black swan, according to the New Oxford American Dictionary. October’s nearly 8% correction was relatively orderly with no shortage of plausible fundamental causes. We have heard a wide variety of explanations, many reflecting some degree of entirely natural “confirmation bias,” a behavioral finance bias that assigns blame to whatever risk factor one happens to be most worried about. This week, my travels took me back to Orlando and then off to Nashville. In Orlando, I again presented behavioral finance, describing numerous human biases that affect our investment returns. I told the group of advisors that, fully 10 years after the financial crisis, people are still looking for the next shoe to drop, even though there is much to cheer in the economy and market. Indeed, an advisor told me afterward that when he started in the business in 1972, a client insisted that “the Dow will never go above 1,000.” While the market has responded to last week’s oversold condition, breadth wasn’t all that impressive. This and the inability of investors to point to something tangible they can rally around as the “cause” of weakness suggest the weakness has not fully played itself out. European debt, trade tariffs, higher rates, Saudi Arabia, China’s slowdown—all are on the table but none has become the flash point. As Renaissance Macro puts it, human behavior craves a straw-man, a scapegoat, a common enemy. The devil known is better than the devil unknown. Until that devil presents itself as a common and agreed upon source of concern, it’s impossible for it to have been fully discounted. The irony is, the concern reaches its exhaustion at the point where and when everyone can identify with specificity what the problem is. It’s unlikely the market is in the clear until we get that.

Higher long-term real interest rates due to unwinding unconventional monetary policy have created small pullbacks throughout this cycle. Even though large-scale asset purchases of Treasury and agency securities have had little effect on economically sensitive equities, each inflection point in the unwind process has been associated with a transitory correction. Examples include 2013’s “taper tantrum,’’ 2014’s end to quantitative easing, 2016’s liftoff from zero interest rates and this year’s two corrections following sharp upward moves in long rates. Each represented a buying opportunity in stocks. Technically, when the VIX spikes as it did last week, equities have been up more than 90% of the time over the next six and 12 months, outside of recessions. Neither Goldman Sachs nor the New York Fed sees odds of one anytime soon, highlighting the penalty for prematurely exiting the market given that bull markets historically peak eight months ahead of recession. The Q3 earnings season started strong, with Thomson IBES predicting the final year-over-year (y/y) increase will be a very robust 22% but slower than Q2’s pace, fostering concern that earnings growth is peaking. But that’s not the worry some think it is, as about three-quarters of market peaks have come more than two years after peak earnings growth. The sell-off improved valuations, dropping the forward P/E to roughly its cyclical trough, and nothing in the economic data suggest the clouds on the horizon have darkened—Conference Board leading indicators have been on a tear and initial reports reflect robust autumn activity (more below). A protracted pullback is rare when annualized GDP growth is surpassing 3% for consecutive quarters, as is the current case. Another sign an equity market top is premature: the S&P 500 historically doesn’t peak until after the Fed finishes hiking, and Fed projections point to rate hikes through 2020.

The fourth quarter tends to be the strongest quarter of midterm election years, with the S&P rising 86% of the time for an average return of 6.4%. Notably, the biggest increases tend to come post-election. The bears may worry tariffs will overwhelm the benefits of tax reform, but game theory projects all sides will reach a workable solution, on this issue anyway. The big nut on China is all about intellectual property (IP), not tariffs. The concern all along has been that the China 2025 plan aims to create technology dominance, in part by using IP theft as a means to this end. This is why IP theft has come to the fore after years of complaints by U.S. and European companies and why Congress in August overwhelmingly passed the Export Control and Foreign Investment Risk Review Modernization Acts, putting teeth into anti-IP-theft efforts. If prosecuted vigorously, these acts could add years to the 2025 program. If the trade war is hurting China’s economy more than the U.S. economy as Trump believes, and with Trump gaining allies to support similar policies, China could be forced to eventually concede on technology, which is seen as the ultimate victory. In the Q&A following my Orlando presentation, I was asked what the next black swan will be. I argued that black swans can be positive or negative and suggested the next one may pleasantly surprise. I envision the next shoe to drop to be a glittering red one like Dorothy wore in "The Wizard of Oz.’’ Only it’s a Jimmy Choo.

Positives

  • Factories humming Industrial production posted its fifth gain in a row in September and, on a y/y basis, rose at its fastest pace since December 2010.
  • October manufacturing accelerating The New York Fed’s monthly survey of regional manufacturers found growth rising at a slightly faster pace this month, led by an uptick in new orders and shipments. The Philly Fed's companion survey of manufacturers in that area found similarly robust activity.
  • Consumers spending September headline retail sales moderated but core control sales (ex-restaurants, gas, autos and building supplies) that feed directly into GDP were strong. On a y/y trend basis, retail sales neared their fastest pace since April 2012, with the core rate almost at a 7-year high.

Negatives

  • Housing meanders September starts and permits slipped, continuing a pattern that has seen activity move little since peaking in January amid rising mortgage rates, a lack of buildable lots, higher material costs and a tight labor market. Existing sales also fell, although the data was skewed by Hurricane Florence. On the other hand, builder confidence climbed and 12-month average starts are still trending up, reaching their highest level since February 2008.
  • It’s not getting better overseas Unlike in the U.S., leading indicators are above their long-term averages in fewer than a third of countries, and fewer than a quarter have rising month-to-month momentum. The worst positioned appear to be in emerging markets, particularly Turkey and Indonesia, and in Europe. Conditions have been weaker overseas than in the U.S. for months, creating a headwind for U.S. markets.
  • More pressure for long-term rates The federal budget deficit hit a 6-year high in fiscal 2018, up 17% from a year ago to $779 billion. This represents 3.9% of GDP, the biggest share since 2013. The Treasury projects it will exceed $1 trillion in the new fiscal year, while the Congressional Budget Office sees it surpassing that mark in 2020 and holding above it through 2028.

What else

A blue wave or ripple? Comparing their standing in the weeks heading into each’s first midterm election, President Trump’s net approval rating is higher than President Obama’s was, according to Rasmussen Reports. Notably, Trump’s disapproval numbers have been falling, with those who “strongly disagree” with him below the “strongly disagree” levels for Obama at a similar juncture. There clearly has been a post-Kavanaugh bounce in Republican enthusiasm in Senate polling, but six races are still within the margin of error while the generic ballot indicates a 50/50 House. The equity market has not confirmed the surge in betting odds for a Republican sweep.

If it’s Tuesday, the market must be up Evercore ISI shares this oddity. Since 1980, the best day for S&P returns has been Tuesday. If Tuesday’s results are excluded, the S&P compound annual growth rate falls from 9.1% to 6.5%.

I got 10 in the last two days If you’re sick and tired of robocalls flooding your cell phone, there may be relief on the horizon. Attorneys general from 34 states (and the Hawaii Office of Consumer Protection) are calling on the Federal Communications Commission to create new rules that would allow telephone service providers to use new technology to detect and block illegal robocalls. Consumers got more than 30 billion illegal robocalls last year and the number is expected top 40 billion in 2018.