Will She or Won’t She….
Good riddance to the third quarter, the worst in four years and only the fourth negative quarter in the last sixteen. It is little wonder that investors are getting nervous that another big decline is just around the corner. As usual there was plenty of confusing data and information last week. The poor employment report and durable goods orders that confirmed the global weak economic data from China and Europe. However, some Fed officials, in an effort to be more transparent, indicated that a rate increase was still very likely before year-end. Others indicated that the US economy is too weak to raise rates just yet. European and Japan central banks both reiterated their desire to keep rates low and provide other measures to their respective markets to keep the liquidity spigots open. Confused yet? So were the financial markets, as they dropped hard on Monday, spent much of the week recovering. They reacted to the poor employment report by dropping over 1% before finishing up over 1% and higher on the week. Economic data doesn’t seem to matter much and neither will the earnings season that begins next week, it is all about the Fed and trying to understand just what they are thinking and likely to do next. Even within the Fed, there does not seem to be consensus. The blind is leading the blind.
There are plenty of worries about October as it has been the month of crashes in 1929 and 1987. But what is missed has been a generally good environment over the past 20 years during October. In fact, October is the third best month of the calendar year, outside of November and April since 1995 and rising 70% of the time. This also follows a historically poor period during August/September. Combined with a very bearish stance by investors, the tinder is very dry for a hot year-end run for stocks. Looking at the three major sentiment indices, their “bullish” stance is the lowest since the 2009 lows. If history was always a perfect indicator of the future, investing would be easy. There are some negative issues that restrain the very bullish stance. First is that the markets remain expensive by historical standards. A “normal” multiple of earnings is roughly 15 times and the most recent earnings of the SP500 is $100, putting a “normal” price for the market at 1500 vs. 1950 today. Many companies have been working hard over the past three years borrowing money to buy back stock, pushing up their earnings per share. The $100 earnings on the SP500 have been inflated by those buybacks. But with interest rates likely stuck around zero for the remainder of the year and 10 year treasury rates at 2%, investors are left to buy stocks in order to try to garner a return.
The poor economic reports this week have given investors the green light to buy bonds as they feel as though the Fed can’t possibly raise rates. This is in spite of the fact that Chairwoman Yellen and others over the past two weeks have given speeches indicating rates are likely to rise before year end. The lack of wage growth in the jobs report and still very weak commodity sector point to a near zero inflation rate for the “foreseeable future” and hence why the Fed is struggling to increase rates. The possibility exists that the US economy is stuck in low gear, similar to the past 15 years in Japan. They have been unable to increase rates and have had a variety of “quantitative easing” episodes that have served to boost stock prices but not economic results. Until the commodity complex begins to show price strength and wages begin to grow faster than 2%, interest rates are likely to remain stuck near zero.
The daily volatility has served to keep investors alternately excited or depressed, depending upon the direction of the markets. The past two month decline has changed some of the leadership beneath the market. The former “can’t miss” sector has been healthcare. They have stumbled over the past month as biotech has fallen over 20% and now rank in the middle of the industry group pack. Leadership has been taken over by consumer related stocks and utilities that usually hold up well during periods of market corrections. When looking at the major asset classes, the only one above its long-term averages are bonds. Until the various asset classes are able to rally and get above those long-term averages, rallies should be looked at with some suspicion.
The markets are entering the best part of the calendar year from a historical perspective. The still very volatile daily swings are likely to continue for the next few weeks, hopefully with a positive tilt. The equity markets are looking for excuses to rally, however the global economic backdrop could keep investors defensive. Bonds have beaten stocks this year and may stay ahead if economic data remains poor the remainder of the year.
The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.