Time to add to equities as the lows are likely in
We remain bullish on equities through year-end and next, keeping our S&P 500 targets at a respective 3,100 and 3,500 for 2018 and 2019, as the causes for this correction seem short-term in nature while longer-term forces driving our bull-market call remain intact. In fact, secular bulls typically undergo these “flushing out’’ exercises to shake out the “weak hands” (see sidebar), making for a healthier market. Indeed, we welcomed—and had been expecting—the pullback for some time, and are using it to recommend that our clients add to their equity positions.
Now let’s look at three key issues that we think drove this sell-off and why it will probably prove to be overdone:
As those who follow me know, I've been a pretty steady bull on the markets since 2010 and have consistently laid out the case for the Secular Bull. Vis-a-vis this current violent pullback, I'd add this thought. Ultimately what fuels a secular bull market is the predominance of "Weak Hands" who are quick to sell on any short-term bad news; this flushes the market and sets the stage for the next advance. On our technical indicators, this bull has seen six "Weak-Hands" moments along the way up from the March 2009 lows: The U.S. debt crisis (May 2010); Grexit (2011's second half); the oil patch collapse (fall 2014); the China recession (summer 2015 through early 2016); Brexit (mid-2016); and the "Bond bear market begins" (early 2018). Today appears to be another one of these moments, driven again by the bulk of the market players reacting to relatively short term news flows. Among the current market participants that are structurally bearish/short-term news focused, we'd include: hedge funds, increasingly run as collections of small pools of effectively day traders with very short term profit & loss statements closely watched by their lead manager; risk parity funds, whose mandate effectively is to not lose money in the short term; exchange-traded fund (ETF) investors, who are there partly for the allure of being able to trade their portfolio intra-day; the secular bears who in 2008 nearly got the global economic collapse they've long predicted, only to have the Fed snatch it from them, and who are quick to jump out of their camouflaged bear caves the moment the market rolls over with their tired "Elliot Wave" and other theories; the 50% of the country that doesn't like President Trump and seemingly is hoping for the economy and the markets to underperform, jumping on the selling bandwagon when we get corrections such as last week's; and finally the "bears in bull clothing" who are willing to admit there are many short-term positives but feel the only debate about the next recession is whether it will happen in 2019 or 2020--either way, why stick around if the short-term news is getting worse? These episodic flushes of weak hands, which can vary from a few weeks to a few months, inevitably restore the balance of buyers and sellers that the market needs to advance on the good news as it comes.
- The trade war and earnings angst The correction started with concerns about the trade wars and cyclical earnings on the back of several preannouncements/downgrades in the Industrials sector, including PPG Industries and Delphi Technologies. While some companies no doubt are experiencing some cost pressures due to tariffs, we view this effect as short-term in nature and continue to expect trade progress in the months ahead. Canada and Mexico are behind us, Japan and the Europe are next. This pattern, along with a little heralded but important clause in at least the Canada/Mexico deal that give the U.S. a voice in any China trade deal with a U.S. partner, will give President Trump maximum leverage over China, which in its own self-interest is likely to come to some compromise with Trump before the coming winter snows melt.
- The Fed and interest rates Worries that the rise of the 10-year Treasury yield to above 3.20% and the impact rising yields generally may have on the economy via housing and autos added to the market downdraft. The worry is that this will only get worse as the Fed continues to hike despite the hit to rate-sensitive sectors of the economy—or maybe because of this impact. In an off-site meeting with several of my industry colleagues two weekends ago, someone stated the bear case simply as, “The Fed is going to keep hiking until it sends the economy into a recession.” Many knowing nods in the room told me this is roughly the consensus. Our view is different. We continue to see inflation pressures on the economy as only modest, and see the Fed as likely to pause once it gets its target rate to 2.75% or maybe 3.0%, just two or three hikes away. With the searing experience of 2008 still in the central bankers’ heads and little sign of apparent economic overheating, the bears are wrong to assert that the Fed is likely to commit a major policy error. If anything, the latest policy-setting minutes reinforced the view that Fed policymakers will be very diligent and data dependent. I think we all can agree they are at least as smart on this as the rest of us.
- The midterm elections A third cause for market angst were concerns of a post-Kavanaugh “Blue Wave,” with Democrats taking both houses of Congress and potentially the presidency in 2020. Regardless of the divergent views of the President’s tweets, this matters to the market because of the threat that the market friendly policies of the Trump administration could very well be dismantled should Capitol Hill and the White House both turn blue. Our read of voter enthusiasm post-Kavanaugh, based on a district-by-district review rather than national averages, suggests a Blue Wave is unlikely and at worst the market will face a Republican Senate and a bare Democratic majority in the House. If we’re right, the elimination of this policy reversal risk in three weeks could be a powerful catalyst leading into year-end.
We don’t know when the present washout of the weak hands will be over, but our sense is that last week may have been climactic. By Thursday afternoon, we were seeing oversold readings on virtually all the indicators we watch. For example, by Thursday night, 75% of S&P names were trading at their 20-day lows, a gruesome 44% of the broader S&P 1500 had endured a 20% correction, and even larger 85% were down at least 10%, so called “correction territory.” With fundamentals for the economy, earnings and valuations still solid in our view, we used this opportunity to add back two of the three points we sold out of our equity allocations early last summer in our PRISM® stock-bond model, taking that model back to 70% maximum equity overweight and our overall equity allocation to 95% of maximum weight. If we get a further decline, we are likely to add more. Although we like almost the entire market here, our moves last week added to our growth allocations in large- and small-cap stocks, where we view the near-term opportunity to be the best. But large-cap value still remains our largest overweight in the model.