Market Meltdown – How we got here and the path out
By David Nelson, CFA
Wednesday at the NYSE started off like any other. A quiet overnight trading session in S&P futures revealed little about a rush to the exits only hours away. About 8AM on the heels of negative commentary from LVMH one of Europe’s leading luxury goods makers, action started to increase and by 12PM it was clear the day wasn’t going to end well.
S&P Futures 5 day 10 minute chart
As Hurricane Michael hit the Florida Panhandle Wall Street was facing its own perfect storm. The interest rate dynamic had been playing out for weeks with the 10 year yield breaching the highest levels since 2011. A week earlier the Fed hiked another 25 basis points as Fed Chairman Jerome Powell forced many back to their models ratcheting up the number of hikes we can expect next year. Finally the unwind of the very popular growth trade saw many Wall Street favorites including the FANGs abandoned as investor’s crowded into safety trades like General Mills (GIS) and Kellogg’s (K).
The selling continued Thursday with all of the usual suspects hit hardest. That evening I had the opportunity to join a panel with Fox Business anchor Charles Payne to weigh in on the action. Doing a post mortem is a lot easier than forecasting what lies ahead.
Certainly programmed trading played a roll. Today fund allocation shifts that a decade ago would have taken week’s takes only hours in today’s algo driven computerized trading world. Popular financial website ZeroHedge published an article mentioning research out of Nomura suggesting CTA funds were forced to dramatically reduce equity exposure. Selling was coming in $60 Billion waves with little sensitivity to price.
VIX (Volatility of Fear Index) 5 year weekly chart
October started off with the VIX or fear index below 12 not surprising on the heels of a pretty good quarter. Even on the day of the big decline it started off at just 16. On Thursday’s show I brought up the point that declines like this don’t even pause until the VIX is north of 25. The good news was that Thursday we breached that level and while there were several attempts to wipe out the day’s gains, Friday eased the pain of the week with a 1.42% return.
Bottoms are a process
S&P 500 1 year chart
It’s natural for investors to ask have we seen the bottom: I think most professionals would agree that whatever happens over the next week the bottom is a process with likely retests over the next few months.
Let’s examine this from both the fundamental and technical side. I thought Technical Analyst Carter Worth’s explanations on what happened and likely trading ranges deserve a second look so why re-invent the wheel. Carter points out that while we recently broke out to new highs fewer and fewer stocks were participating. The S&P Equal weighted index never hit a new high indicating it was only some of the larger mega-cap stocks holding us up. Stocks will likely trade in a range as those who bought higher will weigh on the tape, selling as prices approach breakeven.
S&P 500 Valuation Compare
The good news at least for now is that current fundamentals for the economy and stocks are strong. No question there are challenges including an all-out trade war with China not to mention a Fed that seems hell bent on maintaining the present pace of normalization. I’ll echo Bond Guru Jeff Gundlach’s comments that the Fed’s biggest mistake was not starting the process sooner. I believe the pace today is trying to make up for lost time unnecessary in my view given inflation is at target. I still have faith in Mr. Powell believing that he understands the importance of the market dynamic and the wealth effect, pausing if that dynamic is in jeopardy.
iShares Emerging Markets (EEM) 2 years
Outside the United States, markets are a snapshot of economies struggling to deal with a range of issues. Emerging markets are likely feeling the pain of rising U.S. interest rates. With dollar denominated debt a concern it’s not surprising that many Emerging Market ETFs (EEM) are near 52 week lows. China, which the World Trade Organization mistakenly classifies as an emerging economy makes up over 32% of the index. Even developed markets are exhibiting signs of stress. Italy for one continues to butt heads with Belgium over their budget. It’s reflected in the market with their sovereign debt Credit Default Swaps having blown out earlier in the year.
All in, it’s important for these markets to show signs of at least stabilization if the U.S. is to continue on a path to a sustainable 3% + GDP. I’ve said the following ad nauseam; “with 40% of S&P 500 revenue off shore, these countries are our customers.” If they continue to struggle, eventually it hits the top and bottom line of U.S. multi-nationals. Look for any stabilization in EM as a good sign for stocks here in the U.S.
All eyes are on the upcoming meeting between President Trump and President Xi at the G20 later next month. Tensions are high and as Director of the White House Economic Council Larry Kudlow has said; talks with China to date “have been unsatisfactory.” The theft of intellectual property seems to be a key point and one China does not want to concede. As I’ve said in previous posts, Xi will drag his feet until the mid-terms hoping for a flip in the House or Senate to gain a better vantage point.
In the mean time we’ve kicked off earnings season with many of the major banks reporting. I thought JPMorgan’s (JPM) quarter was outstanding but even their stock ended up down in a very strong tape. A highlight was net interest margins +2.51% above most forecasts. I’m speculating here but I suspect there is mounting fear for a sector that has enjoyed much in the way of regulatory reform. With the balance of power potentially shifting in Washington, any unwind would be met with disappointment.
*At the time of this article some funds managed by David Nelson were long GIS, K and EEM