Kerr Financial Group
Jeffrey J. Kerr, CFA
September 16, 2016 - DJIA = 18,212 - S&P 500 = 2,147 - Nasdaq = 5,249
"It's Been a Hard Days Night" 1
Just as everyone was getting comfortable quoting stock market statistics at their favorite watering hole about the narrow trading range (43 trading days without a 1% move), the Dow hits an air pocket and drops 395 points last Friday. It's not clear that stocks have transitioned to a different pattern but the volatility continued this week. Prices rebounded on Monday (up 239) but gave that up on Tuesday (down 258).
The possibility of higher interest rates and further geo-political tension gave investors reasons to sell. Boston Fed President, Eric Rosengren, offered that gradual interest rate increases will prevent the economy from overheating. There is a Fed interest rate decision on September 21 st so the timing of this statement got investors' attention. Also, he is considered a dove among Fed officials so this was out of character. This happened after North Korea conducted another test of a nuclear bomb and, taken together, Wall Street choose to "sell".
The calendar may partially explain this volatility. Had these taken place in July or August, stocks may not have reacted so dramatically. But as we know, September (and October) have historically been tumultuous months so news can have larger impacts than expected.
"Vacation - All I Ever Wanted. Vacation - All I Ever Needed" 2
Amazingly, September is the only month with negative monthly average returns for past 100, 50, and 20 year timeframes. This suggests a repeating adjustment of investor sentiment. Anatole Kaletsky of GaveKal Research proposes an explanation for this September trend. "During the summer holidays, when trading is light, people tend to defer big decisions. The return to work concentrates minds, and the result is often a drastic market re-pricing to reflect events that were not sufficiently recognised or analysed (sic) during the summer months." 3
As we know, there have been plenty of noteworthy developments over the past several months so it's possible that the markets may not have fully considered their importance. For example, the 'Brexit' vote was in June. While the global markets initially fell hard, they quickly recovered and may have overlooked the longer term fallout of Great Britain's withdrawal from the EU.
More than 25% of the OECD government bonds trade with a negative yield and this percentage is rising. Negative interest rates are not part of a normal economic system. Maybe the markets are more 'sufficiently' becoming aware of this and re-pricing assets accordingly.
The U.S. presidential election is another variable with an unknown outcome. The campaigns have repeatedly resembled a "Three Stooges" episode and it's unclear if the markets have properly considered a Clinton or Trump administration. This is similar to how the markets have become complacent regarding BREXIT. It's easy to see these things taking unexpected twists and turns over the upcoming weeks, but are the markets prepared?
As the markets re-think the above issues, the U.S. economy may be slowing. The August employment report was disappointing and the latest ISM Purchasing Managers Index report came in at 49.4 which was lower than expected and lower than July's 52.6 mark. Readings below 50 are often associated with recessions.
Before last Friday's drop, the S&P 500 had climbed almost 20% since the February lows. 20% moves in a six-month stretch are pretty rare and usually coincide with strong growth. Unfortunately, as we know, GDP is only expanding at around a 2% rate and corporate profits have been stagnant. In fact, analysts have been reducing their bottom line estimates. The result is unattractive stock market valuations and investors are starting to notice.
While everyone is scouring every word from Fed officials trying to determine when the next interest rate increase will take place, the market is not waiting. The 10-year Treasury note's yield closed at 1.54% on September 7 th. Two days later (last Friday) yields spiked to 1.67%. and touched 1.75% on Tuesday. Obviously, higher borrowing costs are an economic headwind, but they also reduce the current value of future earnings and cash flows. This doesn't help our 'challenged' valuations and provides another reason to question the summer rally.
Market trading has changed in recent years. Trading has become dominated by computer programs, algorithms and passive strategies. These are reactive to developments as opposed to the process of discounting future expectations with the goal of finding undervalued opportunities. These trend following black boxes will likely increase price volatility in both directions.
Last Friday's decline left the S&P 500 below its 50-day moving average and vulnerable to test the 200-day moving average which resides over 3.5% below current levels. If the averages can stabilize and then recover the 50-day, it would be a bullish sign. However, we would expect some further selling as the uncertainties facing the global economy are properly priced in. In the meantime, that hated asset class, cash, might become more popular than just at happy hour.
- John Lennon, Paul McCartney
- Gary Knight, Connie Francis, Hank Hunter
- GaveKal Research, September 12, 2016
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.