By Paul Nolte.
With the various “skirmishes” around the world, it feels as though “we’re on the eve of destruction”. While the song was written nearly 50 years ago, it seems rather poignant today. Others scroll back 100 years to the series of events that pushed Europe and eventually the US into World War I. Whether it is Russia looking to regain some of their former states,
China rumbling in the east or the usual fighting in the Middle East, the lyrics are ringing truer today than maybe even back in 1965. The markets and the economies of the world have changed so much over the years, yet investors are held
hostage to each day’s events, impetuously buying or selling on each bit of news. Within a two week period, the SP500
has declined nearly 4%. But to hear the various pundits, the next major decline is now here and y’all better sell now. The
truth is market’s decline 5% at least once during the course of a year.
It has been two years since the last occurrence, so we are certainly due for one. But that doesn’t mean that impending doom will come to the stock market. For that we’ll need to see economic weakness, not record earnings, nor persistent growth in the labor market.
The underlying economy is growing, albeit at a slower than desired rate, but growing. Happy days are not quite here again, but neither is the eve of destruction.
The Wall Street adage that markets rise using the escalator but fall using the elevator is rather apt this year. There have
been three long periods of gains punctuated by rather short/sharp declines in the markets over the past eight months. In
each instance, the declines were eventually erased by the subsequent market advance. In each of the declines, investors
turned very quickly negative on stocks as measured by various sentiment readings. Such is the case today. The Individual
Investor Association survey has matched its most negative readings of the past year. Each of the prior instances was
within a week or two of the eventual price bottom in the SP500. A sharp turn in sentiment is also seen in various
professional surveys as well. Is this time different? There are many more stocks in decline phases than any time this year.
Volume has generally increased on market down days, which is not a very good sign. Bonds, the scourge of equity
investors, are also beginning to show better overall performance relative to stocks. So while we are not ready to back up
the truck and buy stocks, we view the recent decline as long-term healthy for the ongoing bull market.
Bond returns this year are fairly close to stocks so far this year. Similar to stocks, bonds have been pointed to as a bubble
and face big losses as the Fed stops their bond buying program in the fall. But the Fed remains in a box. The economy is
growing and rates should be boosted to avoid potential inflation down the road. However, if they raise rates too
much/quickly, then the still relatively fragile economy could sink into a recession. A
fter which the Fed will have to cut ratesagain to get it going. The only hole in this argument is that the economy is stronger than many believe and can withstand gradually higher rates. Our bet continues to be that rates remain between 2 and 4% as they have for the past six years.
The decline of the past two weeks has put the market back to roughly where it was mid-June. What is more instructive is
to see how the industry groups have performed over that two month period. Industrial stocks, which we highlighted two
weeks ago, are by far the worst performing group. It can be argued that poor industrial performance is a sign that
investors don’t believe economic growth will persist. If that were true, we would see other groups like basic materials and consumer related issues doing poorly.
However, joining industrials on the “bad” list is utilities, the bastion of safety when the world is falling apart. They are also a play on interest rates and have not done well as rates have declined over the past month. It is this dichotomy within the market that points to a corrective phase rather than investors shifting toward defensive stocks to cushion a huge market decline.
Energy stocks did make the “bad” list, however they were near the top last week, indicating investors were no completely abandoning this top sector just yet. The fighting seemingly around the world has made markets nervous and much more volatile over the last few weeks.
A correction of 5%+ is certainly overdue and very likely, however it is not enough to abandon quality stocks and hope to properly time a reentry into the market. The bond market has softened the blow of the equity decline. Given the very low
current yields it would not be surprising to see them a bit higher between now and year end.
