Year-End Expectations: Will the Market and Economy Hit a Wall?
October is generally a high-risk month for the markets with an above average probability of negative market trends. Investors may look back on October of 2018 as the month that the markets hit the wall. Leading up to now, investors have been pushing stocks higher even as market risk has increased. Since Caterpillar’s Q1 comments about peak earnings, market pundits have been looking for the inflection point when earnings telegraph a weakening trend. While Q3 earnings reports continue to show strong growth likely to exceed 20%, revenue growth and corporate trend guidance are showing signs of fatigue.
So far the Q3 earnings season has not been kind to equities, with broad indexes falling 5-10%. For the past several months, market internals have become increasingly toxic with approximately two-thirds of the S&P 500 stocks falling into correction territory (-10%). Market leaders have led the charge lower in October with the FAANG stocks falling by as much as 15-20% from prior highs. Could this portend a shift to an increasing bias toward bear market conditions?
The month of October was pretty brutal for investors with 9 out of 11 sectors eschewing positive returns. Two traditionally defensive sectors produced positive returns: Utilities 1.95% and Consumer Staples 2.31%. Yet Consumer Discretionary (-11.27%), Energy (-11.26%), Industrials (-10.81%) and Materials (-9.47%) all led the market lower. So far, only four sectors remain in positive territory year-to-date with Information Technology up 11.02%, Health Care 8.83%, Consumer Discretionary 7.04%, and Utilities 4.72%.
To illustrate how the bull market trend has weakened, one can look to the 12 S&P 500 Factor-Based Equity Indices which all posted negative returns in October. When defensive factor indices for low volatility, value, and dividends post negative returns at the same time growth, quality, and momentum factor indexes fall, investors need to sit up and take notice. Typically investors rotate from growth and momentum to value and dividends unless they fear more significant losses are coming.
Despite an attempt to recover losses, U.S. equities gave up most of the gains achieved earlier in the year in October. And with midterm elections, Fed monetary tightening, and trade war risk still building we think investors should stop focusing on returns and instead take action to protect bull market gains and capital from further losses that may be in the offing. With earnings and revenue trends starting to show signs of weakness and the economically sensitive sectors (materials, industrials, and energy) also falling, it’s time to check their fully invested bet.
While low-cost indexing and buy and hold tend to work well in bull market trends, they also tend to be a disaster for investors in bear markets. Concentrated flows into low-cost indexes over the past five years has created a crowding effect that can poorly unravel as recession looms and bear market carnage wreaks havoc on tens of millions of baby boomers poised for retirement. One thing is patently clear: Boomers can’t afford another bear market with losses that tally 40%, 50%, or more. An obvious risk of the crowded trade into indexes is that investors will rush for the exits, as they did in 2008, creating a seller’s panic that causes prices to unwind faster with even deeper losses than normal.
Late-stage bull markets can seduce investors into thinking that risk has abated as markets rise in a last-gasp rally than turns out to be nothing more than a head fake. If investor sentiment does improve and we get a Santa Claus rally through year-end, investors could be gifted the opportunity to sell high, which is something they rarely do. Instead, they usually stay too long at the party exposing their capital to severe losses. I pray this time will be different.
For more on this topic, listen to Bull | Bear Radio #51: Will the Fed Crash Santa’s Sleigh?
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