5 Nov 2018
The U.S. Market Has Entered a Volatile Phase
The last several weeks have brought a distinct change in U.S. market behavior and character; with elevated volatility, triple digit moves in the Dow back in vogue, and the NASDAQ and Russell 2000 (small caps) entering correction territory.
This shouldn’t be much of a surprise as interest rates have moved higher, financial conditions have tightened, worries about peak growth have increased, trade concerns have grown, midterm election rhetoric has escalated, global growth has slowed, and Fed uncertainty has risen. Put this more uncertain “season” on top of the worst month of the year historically for equity returns and you have the recipe for more volatility. But a potential positive offset is that we’re entering what has historically been a strong seasonal period for the markets. Novembers and Decembers of midterm election years have historically been quite strong. And in all years, going back to 1952, the three-month period beginning in November has been the best three months of the year. Of course past performance is no guarantee of future results but it can be comforting to have some historical tailwinds.
Additionally, the recent uptick in volatility has allowed investor sentiment—a contrarian indicator—to drop out of the excessive optimism zone according to the New Davis Research (NDR) Crowd Sentiment Poll (which aggregates seven distinct sentiment measures). This could provide more near-term support for stocks and set the stage for further relief rallies. That said, we remain cautious about equities and continue to recommend investors take no risk beyond their longer-term strategic U.S. equity allocations, and use volatility to rebalance as necessary. We have also expressed this caution with our bias toward large caps over small caps; and our sector recommendations, which have become more defensive in nature, offering a ballast within equity portfolios.
Earnings season has been decent as far as results go to this point but as we often say, “better or worse matters more than good or bad.” Earnings growth rates have been trending down this year, from 27% in the first quarter, to 25% in the second quarter, to an expected 24% in the third quarter and an expected 19% in the fourth quarter (according to Thomson Reuters). But growth then takes a meaningful dip in 2019; largely thanks to simple “math:” Once we move into 2019, earnings will be compared in year-over-year growth rate terms with the tax-cut juiced earnings of this year. Expectations are for 8-9% earnings growth for next year’s first half (Thomson Reuters). And although current earnings remain strong and the “beat rate” remains healthy at more than 80%, investors’ reaction to results has been fairly severe. According to Bespoke Investment Group, for the third quarter earnings season through October 24, the one-day decline for earnings misses averaged nearly -5%; but perhaps more telling is that even earnings beats saw an average decline (albeit a slight one). Additionally, tariff concerns are increasingly being mentioned in corporate conference calls according to data from FactSet, which could impact companies’ willingness to spend on capital expenditures as well as dent profitability. As an aside, the latest Federal Reserve’s Beige Book report on the economy had a rash of references to pessimistic corporate commentary associated with tariffs’ impact on business. And the major area of concern, the Unites States’ dispute with China, shows few signs of thawing, with both administrations appearing to dig in their heels.
Open season on the Fed?
The rise in interest rates, and resulting heighted volatility in equities, has resulted in elevated uncertainty as to whether the Fed can smoothly navigate the monetary policy normalization process without a “mistake.” The Fed’s continued hawkish tilt, as seen in the recently-released Federal Open Market Committee (FOMC) minutes, has raised concerns about the Fed moving too quickly or too far—especially given still-subdued inflation. The core consumer price index (CPI) is up a modest 2.2% over the year ago period, but that is above the Fed’s 2% target. And although wage growth has been slow in coming this cycle, it has picked up pace more recently.
There are broader inflationary signs simmering below the surface. Tariffs, as mentioned above, are typically inflationary: as U.S. companies face rising tariff costs associated with imports, they often pass those “taxes” on to consumers. And the labor market continues to tighten, with the number of available jobs recently outpacing the number of available workers by more than 900k. It’s likely that companies are going to have to increase wages in order to lure workers away from other employers—also inflationary if it should start to take hold.
We continue to believe that the Fed has little desire to slow down economic growth and will continue to be cautious, but if inflation takes hold it will behoove the Fed to keep tapping on the brakes; arguing for a more cautious stance by investors.
October has again been a scary month for investors, even though past performance does not indicate future results, history shows that stocks tend to face a seasonal tailwind heading into the end of the year. There will likely be more volatility but at least overly optimistic investor sentiment has eased, U.S. economic growth remains solid, and the midterm elections will soon be over, all of which could trigger at least a relief rally off the recent lows. But gains both here and globally are likely limited by myriad late-cycle pressures. Remain disciplined, consider diversification and rebalancing, and consider establishing a more tactically defensive positioning.
Investment involves risk. Past performance is no indication of future results, and values fluctuate. International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market, economic or political conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Diversification and rebalancing a portfolio cannot assure a profit or protect against a loss in any given market environment. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events may be created that may affect your tax liability.
Past performance is no guarantee of future results. Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.
Ned Davis Research (NDR) Sentiment Poll shows perspective on a composite sentiment indicator designed to highlight short- to intermediate-term swings in investor psychology.
The Consumer Price Index (CPI) Ex Food & Energy released by the US Department of Labor Statistics is a measure of price movements by the comparison between the retail prices of a representative shopping basket of goods and services. Those volatile products such as food and energy are excluded in order to capture an accurate calculation.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.
About the author:
Liz Ann Sonder, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
Jeffrey Kleintop, Senior Vice President and Chief Global Investment Strategist
Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research