After months of ambiguity, the direction of markets is clear.
How bad this economic and markets cycle will be remains to be seen, but the start is not encouraging.
Long-term investors should monitor closely and carefully to pick up the pieces after the crash.
As the year draws to a close, volatility is not demonstrating any intent of abating. Volatility is still significant but the direction is now clear. In October, the Nasdaq tumbled 9%, it’s biggest monthly drop since November 2008. The broader S&P 500 lost nearly 7% in October, its worst month since September 2011. After a limited rebound in November, December is proving to be even worse. The S&P 500 is down 12% this month, putting it on track for its worst December since the Great Depression in 1931 and the worst month since February 2009, and leaving the benchmark 9% lower for the year - the worst since 2008 - and 18% off it’s record reached this year.
Given the ferocity of the sell-off, it is hardly surprising that the share of stocks now down by a fifth or more in 2018 — at about 30% — is at its highest level this year since 2008. The Nasdaq is down by 22% from it’s peak in October, as well as the small-cap Russell 2000 index.
All stock index indicators are flashing red, suggesting a bearish mood may prevail a while longer. Even after recent falls investors are keen to get downside protection by snapping up put options. The CBOE equity put/call ratio has jumped to its highest level in two years. The Vix index, an option-based gauge of investor stress, is 65% above its five-year average.
Fears that the trade war will exacerbate a global slowdown are weighing on sentiment. The boost from Donald Trump’s tax reforms is fading. US corporate earnings are expected to have risen 24% this year. They are forecast to grow a third of that in 2019. Analysts are minded to nudge the figure lower still. Also, it is no coincidence that markets are sliding as central banks retreat from their ultra-loose policies. Bonds have become relatively more attractive. The US banking sector is in a bear market.
What about the fundamentals?
All of which is great news for longer-term investors. Under such febrile conditions fundamental analysts can struggle to be heard. The S&P 500’s forward price earnings multiple is less than 16, already below its long term average.
Many stocks are reaching attractive value levels, especially in the beaten Nasdaq. IBM has lost 35% from it’s peak this year, and is now trading at a meagre 6x market cap to operating cash flow, while sporting a dividend yield of 5.5%. Microsoft lost a mere 15% from it’s peak and is trading at a reasonable 17.7x. Alphabet lost 35% and is on 17.5%. Facebook, with the data sharing concerns throughout the year, lost a hefty 45% and is now at 14x. Apple, with the concern over peak iPhone, lost 35%, and is now at less than 10x. Amazon is the one that can probably afford to lose more; despite a 33% drop in it’s share price, it is still trading at 35x.
And while bricks and mortar retail, banking and housing sectors joined technology’s falls, some other sectors however remained relatively unmoved; fast moving consumer goods, utilities and telecoms have not budged much, and are in now relatively higher valuations than the much faster-growing technology sector. Perhaps investors and traders see these sectors as providers of stability in the storm, but utilities and telecoms are highly leveraged and have anaemic growth and tight profit margins, making them more vulnerable than the cash-rich, fast growing technology giants.
And the economic indicators?
The New York Fed’s Empire State business index tumbled to its lowest level for 19 months in December, while confidence among US homebuilders deteriorated this month to its worst since 2015. Given the 2008 crisis was driven by housing, unhappy house builders is not a good sign. Housing stocks are having their worst year since 2008, and some see even more distress
Global growth worries also kept oil prices under pressure, with Brent crude losing 40% in a matter of 3 months. The losses came in spite of hopes that the market was rebalancing following agreed output cuts by Opec and its allies.
An interesting parameter to watch is that the unemployment rate in the US is at near-record low of 3.6%. In a sign of the labour market’s strength, US employers have more job openings than there are unemployed Americans, the first time such a scenario has materialised in at least 17 years. The tight gap between low unemployment and a high level of job openings looks scarily similar to that reached in 2007. It could be a sign of excessive expansion.
A key gauge of US business investment unexpectedly fell in November, while orders for long-lasting goods manufactured domestically rose by less than expected, signalling the economy may be losing momentum at the end of the year. Non-defense capital goods orders excluding aircraft — considered a proxy for investment in big-ticket items — unexpectedly fell 0.6% in November from the previous month, when the figure climbed 0.5%, according to the Commerce Department. That marked the third drop in the last four months. Economists had estimated a 0.2% increase, according to a Reuters survey.
Meanwhile, demand for durable goods — items meant to last at least three years, such as washing machines and cars — rose 0.8% in November from the previous month to $250.8 billion. That was slower than the 1.6% increase that economists had predicted and followed a 4.3% drop in October. Orders for durable goods in November were driven largely by demand for military aircraft. The drop comes amid fears that the US-China trade war is hurting manufacturing and the US economy is slowing down, following weak regional manufacturing surveys from the US mid-Atlantic and north-east regions.
While more extensive number reading is needed to gauge where we stand and where we are heading, stars are starting to be aligned in the direction of an economic slowdown and an accompanying bear market. These conditions can create long-awaited opportunities for long-term value investors to pick stocks on the cheap. But investors have to tread extremely carefully and wisely while walking through the minefields, in order to reach the gold mine without losing an arm and a leg.
Disclosure: I am/we are long GOOGL, FB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.