Where now for indices?

After the sudden drop in equities, what does the current data picture tell us, and what does history suggest might happen next?

US trader
Source: Bloomberg

‘If you can keep your head when all about you are losing theirs, then you clearly haven’t understood the magnitude of the problem.’ With apologies to Rudyard Kipling for the mangling of that quote, it is time to look at indices after the carnage of 10 October.

It is typical of investors that they spend weeks praying for a sell-off, a dip that they can buy into with confidence, and then when one arrives it seems like the end of the world. Caution prevails, the dip turns into a rally and the latest chance to hop on the bull market train is lost. Yes, this one might be the big one. One day, it will be, but so far there are precious few signs suggesting that this is the next correction, or market crash.

Since my crystal ball is currently being repaired, we can only look at the data and previous examples and see what might happen next. For the moment, barring some dramatic development, this is not the beginning of something much worse, and if it is then the cause has yet to be determined.

It is important to remember that the average intra-year drawdown for the S&P 500 is around 12% (since 1980). Sell-offs happen, the third quarter (Q3) of 2018 was a quiet three months. But until proved otherwise, this is still a dip, not the next 2008. Risk management remains key, but the bull market is intact.

Economic data

US data remains overwhelmingly supportive of the current bull market. The yield curve has yet to invert, and even when it does, it will be at least eight months before a recession starts, with an average lag of 19 months between inversion and recession:

Unemployment claims continue to fall, and have hit 49-year lows. These will rise at least seven months before a recession, so there is no cause for concern here:

The one point of worry is the housing market. New home sales peaked ten months ago, and on average 11 months passes before the next recession begins. So we do have one cause for concern:

Hourly wage growth remains positive, demand is still rising too - with real personal consumption growing 3% year-on-year (YoY) in August - and inflation is still under control.

The economic picture remains encouraging, with only housing flashing a possible amber light.

Yields

Treasury yields have become a hot topic for traders over recent months, with the rise in yields often going in hand with economic strength, and recent gains in US data points providing further upside for treasuries as markets feel less inclined to buy safe-haven assets. Interestingly we can also see yields rise in the opposite environment, where markets have very little confidence that the government will be able to make the repayments, as with the case in Greece. It is clear that the rise in Italian yields is associated with economic fear, while the US case is associated with economic strength.

In either case, rising yields can be a big issue for economies with substantial current account deficits, where governments spend more than they take in. This is due to the fact that for economies that hold huge debt obligations, the cost of servicing those debts will rise as yields increase. Greece, Italy, and the US are all such cases. With Italian fiscal expansion being the hot topic, there are few signs that the Italians will lessen their debt profile and instead are likely to have to take on even more debt, paying ever higher rates.

This brings us around to one of the main worries behind the US-led sell-off that has happened overnight, where the rise is borne out of strength rather than weakness. Rising yields make treasuries more attractive to investors as a place to put their money, coming out of a period where traders saw stocks as the only place to make consistent inflation-busting returns. We can see that regardless of the Nasdaq, US markets have not looked particularly expensive, despite their substantial gains.

Instead, we are seeing markets begin to worry that rising yields will shift money out of the stock market, while also ramping up the costs to a government which already pays a huge amount to service their debt. With central banks often seeing treasury yields as a means to gauge economic strength, we regularly also see tighter monetary policy as yields rise. This highlights why we are seeing worries emerge around the US economy, yet it is also worth noting that the difference between the US and Italy is that the former is able to print its own money at will, thus negating any fears of a potential default on their debts.

Corporate outlook

We are moving into Q3 earnings season, giving investors the chance to ‘look under the hood’ of the US economy. Currently, Q3 is expected to see earnings rise 17.7% and revenues increase by 7.7%. In Q2, quarterly earnings per share (EPS) rose 27%, hitting an new all-time high:

Meanwhile, operating margins for the S&P 500 rose 11.5% in Q2, to a new record high:

The index has been driven higher by earnings, not buybacks. Since Q2 2016, the S&P 500 has risen by 30%, while earnings are up 41%. The index is lagging the growth in earnings, which is a positive sign. The constant whining about buybacks and their effect on the rally is a red herring.

Breadth

Looking at breadth, we are now in a ‘washout’ phase. Everyone is bearish, as a glance at Twitter and the financial news will show. It’s amazing how sentiment follows price. While we can look at any number of indices, we’ll stick with the S&P 500 as a benchmark. Where it goes, others are likely to follow.

In the regular breadth updates we produce, we usually look at two measures. First, the percentage of stocks above their 20-day simple moving average (SMA). This is a contrarian signal. When breadth is strong, upside is limited. Conversely weak breadth, such as we are seeing now, is usually a buying opportunity. As the first chart shows, breadth is now at its weakest level since March. It can go lower, as January showed, but short positions will need to be short-term and relatively nimble. The risk-reward from these levels is probably skewed to the upside in the longer term.

Or we can look at the percentage of stocks at 20-day lows. This has shot higher, to five standard deviations above the mean. There have only been seven such instances of weak breadth in the past five years. After 60 days, the average return for the S&P 500 was 4.8%. Here too, risk-reward probably favours the buyers rather than the sellers.

Options expiry

Next Friday (19 October) is options expiry day. The Wednesday of the preceding week (ie yesterday) is what’s known as ‘Weird Wollie Wednesday’, named after Dan Wolanchuk, who noticed a particular phenomenon. This day usually sees the market close in the opposite direction of expiration day. So, following the rules, yesterday’s big down day may well mean that Friday 19 October will see a big up close for expiration day.

Seasonality

We are firmly into the strong Q4 period for markets. The final three months of the year usually sees a strong rally (please note, this does not mean they cannot go down before rebounding). The chart below reminds us of what usually happens:

This being a mid-terms year, slightly different seasonality applies, as the below indicates:

In both, however, the year usually ends well. It is important to note that the above includes 2001 and 2008, so if these rather exceptional years were excluded then the Q4 performance would be even more favourable.

Globally, markets do well in Q4. The MSCI World Index traditionally does well in the last three months of the year:

This is an average, and there are always exceptions. But most corrections do not turn into huge sell-offs. This one may be different, and time will tell. But seasonality is on the side of the bulls.

Previous examples

Finally, we look at previous instances where markets sold off as dramatically as yesterday. Firstly, the S&P 500 is now on course for a three-week losing streak, after recording an all-time weekly closing high a month ago.

There have been 20 such incidents since 1970. Of these, the S&P 500 closed higher three weeks later in 16 of 20 occurrences, and 12 weeks later in 18 out of 20.

Another way of viewing it is that we have seen 15 daily falls of 3% with a close above the 200-day SMA for the index since 1970. The median return 20 trading days later is 1.6%, with an average of 1.59% (minimum equaling —7.26% and maximum equaling 7.96%).

As breadth and seasonality above suggest, risk-reward is probably now biased to the upside.

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