INSIGHTS

On October 17, 2018

The Gilded Age of Disposable Declarations of Despair

The reasons for the sudden and recent selloff in equities and the accelerated nature of it were a bit opaque and left investors, media and money managers melding the antagonists and protagonists together in the ongoing bullish narrative. Here is a brief list of some of the culprits, and potentially why this explanation may not fully explain it.

• The Federal Reserve hiking interest rates has now crossed the threshold to where they are tilting us toward recession in the next six to nine months. This is a stretch for the timing of its imminent in occurring in that this is the most anemic rate hike pace in the last six cycles, going back to the early 1970s. They have also been transparent and open regarding their pace. So, the sudden epiphany that the Fed’s action has crossed a threshold seems erroneous. Eventually, as is in any Fed rate hike cycle, the recession will occur and ongoing increases in rates do have an impact, but this is only one of the multitude of events that needs to occur for a recession or market correction to take hold.


• Corporate earnings are seeing increased negative guidance going forward and the market cannot trade at such a high valuation based on earnings pressure. While we have seen a bit more negative guidance, this is coming off some tremendous increases in earnings where the comparisons will be difficult to match. So far this quarter, the number one citation for earnings pressure was the rise in the U.S. dollar, followed by rising material costs and wage pressure. Only one company said the Fed’s hike in rates was the reason for negative ghasuidance. Expected earnings expectations for the S&P 500 for the next 12 months, according to Bloomberg, is 172.44 per share resulting in a 16x forward earnings. Though market metrics are not cheap as evidenced by the long bull market and economic expansion, based on past bull markets the current one appears to have more legs. However, profit margins are very robust and continue to look favorable going forward.
  

  

  
  

  

  
  


• Midterm elections, and incessant media coverage, has investors spooked about a major political event in which increased vitriol hinders any progress legislatively or more extreme events such as impeachment after the election results are tallied. This one is a bit more difficult to refute only in the fact that the level of emotion driving the vitriol has a louder megaphone than in the past due to social media. It does appear that a sense of fatigue is rapidly approaching as the headlines often don’t come to fruition. It appears we are in the gilded age of disposable declarations of despair. BlackRock developed an interesting perspective in attempting to define the uncertainty and its drain on the MSCI World equity performance.
  

  

  
  


• If the previous pessimistic prognostication does not come to fruition, just wait as it’s about to get even worse than that, in our opinion. It’s the classic fable from Aesop about “the boy who cried wolf.” Eventually the wolf does come, as it has over time and time again, however, until then it feeds on our negative bias wired from the evolutionary need to survive. Historically, research shows equity returns often have stout returns immediately prior and following elections as research from Deutsche Bank shows below.

• Consumers have topped out and are feeling the strains of higher rates on their debt increase over the last decade. This may be the most misused narrative based on the longer context of the consumer. In my last commentary, Focus on the Fundamentals, we showed two important metrics that show the consumer is in as good of shape this late in the cycle than previously seen. This affirms the narrative that The Great Recession was a once-in-a-generation event and caused a shift in generational attitudes. Eventually the consumer will top out and sentiment numbers will begin to represent the slowdown that will ultimately occur, but the amount of assets to debt and household financial obligation ratio still show a healthy household.


• “The yield curve is flat and will invert,” or “the curve is steepening and causing strains by accelerating the Fed’s forward policy.” Can we make up our mind on this one? The yield curve flattened and will ultimately invert, however, when it does you still have an average of 12-15 months prior to corrections and recessions. This time the signal, when it happens, could be far more premature based on the massive quantitative easing embarked by the Federal Reserve. The curve has steepened recently and historically the steeper curve relays more economic prosperity, not economic collapse. For best historical comparisons, consider the yield curve in the 1990s to the recession in 2001 when it flattened and steepened several times in the last four years of the expansion. The European Central Bank (ECB) as well as the Bank of Japan impact our yield curve by their massive purchases as well by changing the benchmark for “risk-free rates of return” in comparison. Perhaps the most out-of-whack metric is the disparity between the U.S. 10-year Treasury and the German 10-year Bund. The following chart from Bloomberg details the historic spread when the Treasury is at its widest spread compared to the German Bund – 2.6 standard deviations wide. The importance of this spread dynamic reveals the risk tolerance of institutional buyers, the shift in quantitative easing to tightening domestically relative to the ECB being on a two-plus-year delay and the cost of hedging currency for international holders of Treasuries increasing to a point where there are little positive currency-hedged returns for holding higher yielding Treasuries.

Attempts to find a conclusive justification for the recent selloff leaves many unfulfilled and perhaps more confused than before. The more demonstrative the rationale for the selloff by prognosticators often is not to take the entire variable into the equation. Later-stage-cycle investing often raises the tone and extremes in prognostications which can help mitigate massive bubbles, but the timing of such calls often leaves those who heed it as frustrated.

So, why do so many embark on market calls and timing? The back testing of selling at tops and picking up at bottoms amplifies historical returns substantially. However, there are no examples of one person making these perfect calls consistently. As our CEO/CIO Scott Colyer says, “The hall of fame for market timers doesn’t have any members.”

There has been tremendous research done by so many firms over the years about the dangers of market timing. Once you realize that market extremes are littered with optimistic headlines at tops and pessimistic propelling titles at bottoms, one gets the sense that being counterintuitive to the market herd pays off in the long run. In the last 35 years, there have been six periods in which the S&P 500 had substantial declines: 1987, 1990, 1998, 2000, 2007 and 2015.

Source: AAM

Since 1983, there have been roughly 9,000 trading days. Picking the six days of market tops gives one 0.00067% odds of being correct, or roughly 1/1500. Imagine a roulette wheel with 1,500 slots rather than the traditional 38; instead of being the standard 32 inches wide, it would be 105 feet wide assuming the same size ball and slots for each potential outcome. Picking the top, however, is only half the battle and I would argue, the easier of the two conditions for the perfect market timer. You must not only sell at the market top, but also buy at the bottom. In my decades of being involved in the market, buying at the bottom in a landscape of the direst headlines and continuing of the recent market moves is far more difficult to pick. To illustrate this, do an online headline search for the days preceding the market bottom and you will find a magnitude greater of negative headlines relative to positive. The biggest difficulty isn’t only the environment you face in buying back in, but also the psychological impact of being predisposed to a bias that has had recent confirmation due to market downturns being sharp and panic ridden. It seems once you get married to a negative narrative, it is often easy to get divorced from reason. For those wanting the math of picking a top perfectly and bottom perfectly, your likelihood of success would be 0.00005%.

An argument could be made that one could improve their odds when looking at tops in the later stages of a cycle. This, however, has been exhaustively researched by many firms who point to missing just 10 days of tops and what this does to your overall returns. The current market may have a bit more pressure in the near term as the trend toward more negative headlines does not look to abate anytime soon.

We have found that a better alternative to market timing is dialing up and down allocations to a wide array of investments from equities, debt, cash, commodities and alternative investment denominated currencies. Dialing up and down the various allocations and having the patience to let the philosophy play out won’t remove volatility, but we feel it helps balance the overall purpose of investment in balancing risk and reward in the long term.

CRN: 2018-1011-6941 R