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'It's not supposed to be easy'

No one really knows the reason for Q4's falloff. What we do know is if this is just a soft patch, then there should be more upside for investors.
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This week, I did a scheduled quarterly conference call with an advisor group in Seattle. I was bullish in September. My host’s first question pulled no punches. “We read you all the time. We look forward to your comments. So what would you say to the fact that the market got crushed?” The sharp and unexpected decline has served as catnip for many behavioral biases, particularly confirmation bias. Everyone has their pet theory as to why financial conditions tightened and global growth slowed, spanning from algorithms to the Fed’s ongoing shrinking of its balance sheet. While almost nobody can prove how one mechanism drove the other, conviction has increased. Evercore ISI quotes Berkshire Hathaway Vice Chairman Charlie Munger: “It’s not supposed to be easy. Anyone who finds it easy is stupid.” People want simple answers to complicated problems and studies prove that when you can sound confident about a simple explanation, people will listen. Cognitive scientists refer to this as “processing fluency,” and it’s why we are likely full of more flawed ideas than we would like to believe. ISI says repetition makes this problem worse as “randomized controlled trials have shown that people are more likely to believe things to which they’ve been exposed repeatedly.” Sound familiar?

We’ve heard and read repeatedly that the sell-off made no sense given strong fundamentals (earnings, balance sheets, etc.) and attractive valuations (P/E multiples at 5-year lows). Market structure issues do. Empirical Research finds that the stocks of 75 companies with the best growth profiles reached a record 63% correlation in returns late last year. Repositioning by hedge funds is no doubt part of the story, with their favorites underperforming significantly, just as they did in 2008 and 2016. The correlation between factors (macro, company fundamentals, technicals, etc.) has reached an all-time high, implying a significant change in the structure of the market. An increase in correlation usually reflects a deterioration in macro data, as evident all over. However, what makes this different is that stock correlation is not so elevated. Bernstein sees this being particularly evident in high-momentum stocks as well as value and dividend stocks. Nearly every cyclical sector made its 2018 low on Christmas Eve, and while they have been rising since then, a true “V-shaped’’ recovery is very rare. Even after multiple up volume days (10 up to each 1 down), the market has historically gone on to make new lows 80% of the time.

With stocks’ sensitivities to oil, credit spreads and inflation at multi-decade highs, the start of the new year has been constructive, as credit spreads have narrowed, oil prices have broken into a bull again and inflation gauges continue to signal moderation—December headline CPI dipped below 2% year-over-year (y/y) on falling oil while y/y core CPI was unchanged. This improvement could help extend the rally and limit the depth of a drawdown/retest, buttressing the view the burgeoning bounce is part of a bottom, not a bear. After confusing the markets, the Fed is sounding supportive (more below). Over the past 90 years, big P/E multiple declines such as experienced last year have been followed by market rebounds in 15 of 20 episodes. Since 1984, there have been six corrections in previous economic expansions that averaged -19%, spot on with Q4’s decline. In each case, the S&P 500 rebounded 25% on average six months after the correction ended. Will we be so lucky this time? Probably, if it’s just a soft patch. Despite Q4's hard landing, above-average U.S. labor market data leaves the door open to a soft landing. No one ever said it would be easy.

Positives

  • Flexible Fed This week’s minutes from December meeting (more below) and comments yesterday from Fed Chair Powell signaled that the central bank likely will be on pause as long as financial markets remain turbulent and global growth is slowing. At an Economic Club of Washington, D.C., gathering Thursday, Powell repeatedly used the word “patient” to describe Fed intentions.
  • A job-seeker’s market is good for wages Despite declining for the second time in three months, November job openings and hires remained near historic highs, with openings exceeding the number of unemployed a ninth straight month. Also, the Conference Board Employment Trends Index rose a strong 5.4% y/y in December and the NFIB (more below) said small business job postings hit a record high.
  • Hopeful start for housing Lower mortgage rates helped mortgage activity spurt out of the gates in 2019, with purchase applications rising a seasonally adjusted 17% the first week of the year and applications for refinancing jumping 35%. The surge pushed y/y purchase applications back into positive territory.

Negatives

  • Services activity moderates The ISM gauge of non-manufacturing activity fell more than expected in December to a 5-month low but remained historically consistent with above-trend growth, with new orders rising at their fastest pace in six months.
  • Business optimism dims Conference Board CEO Confidence sank in Q4 to a 6-year low on trade issues, financial market volatility, rising debt costs and moderating global growth. Small business optimism also drifted lower in December but is still at a high level, reflecting the fact the NFIB tracks smaller domestically oriented firms while the CEO survey includes multinationals exposed to global trade and growth risks.
  • Global recession watch While various country-specific economic diffusion gauges have reached an inflection point that indicate a bottoming, a pickup in global growth may take some time. Just this week, China reported that producer prices actually declined while France said industrial production unexpectedly contracted.

What else

Soft patch watch Recognition in December's Fed minutes that excess reserves are falling largely because of expanding commercial, industrial and real estate loans is a very positive indicator for economic growth and both equity and bond market activity. Declining excess reserves also provide the Fed with more latitude in reducing its balance sheet, also potentially market friendly.

Inflation is not the problem Full employment and a tight labor market may have very little to do with inflation, SIS Research surmises. It sees the supply of money as the key factor. While a tight labor market and low unemployment do have cost-push implications for affected industries, that’s as likely as far as that argument goes since it only causes a redistribution of income from one sector to another. In the long run, when inflation is fully anticipated, low unemployment has had no effect on inflation.

Inflation is not the problem There’s been a striking increase in prime-age labor force participation for women, driving the overall rate up 170 basis points over the past three years to 82.3%, an 8½-year high. This added labor supply should help keep wage inflation lower for longer, extending the cycle. The labor force participation for people over 65 also is increasing, again because of women.

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DISCLOSURES

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Correlation expresses the strength of relationship between distribution of returns of one data series and its benchmark. The coefficient correlation is always between +1 (perfect positive correlation) and -1 (perfect negative correlation).

Price-earnings multiples (P/E) reflect the ratio of stock prices to per-share common earnings. The lower the number, the lower the price of stocks relative to earnings.

The Conference Board's monthly Employment Trends Index measures eight indicators that reflect labor market trends in the economy.

The Conference Board surveys CEOs at major companies quarterly to gauge their confidence about the economy.

The Institute of Supply Management (ISM) nonmanufacturing index is a composite, forward-looking index derived from a monthly survey of U.S. businesses.

The National Federation of Independent Business (NFIB) conducts surveys monthly to gauge how small businesses feel about the economy, their situation and their plans.

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