Trick or Treat
October, the month of Halloween and two of the most memorable stock market crashes, can be a scary time. Fear is often considered the most powerful and uncontrollable human emotion. When it ignites, the primal human survival instinct takes over and reason and logic go out the window. This year’s October was no exception, and investor fear levels are clearly on the rise once again.
Stock prices for the month of October fell 6.94%, bringing the year-to-date total return of the S&P 500 down to an unsatisfying 3.01%. For some context, February (-3.89%) and March (-2.69%) were also difficult months in which to own stocks. From January 26th to the April 2nd low, stock prices fell over 10%. The recent drop, from September 20th to the October 29th low, was 9.8%. Both were uncomfortable drops in price and can be labeled corrections. Seasoned investors often consider corrections a necessary evil when one chooses to commit financial assets to the stock market for the long run.
The market’s behavior in October was unusual. For example, of the 23 trading days in October, 16 saw negative returns. There were 5 days on which prices rose more than 1%, and 5 days when prices fell more than 1%. According to Bespoke Research, October 30 marked the end of a 28-day run for the S&P 500 without back-to-back days of positive returns; the preceding occurrence of this phenomenon dates back to World War II. Stocks have recently struggled mightily and lost ground. My concern is stock prices themselves are often considered the most telling indicator of future stock prices.
Of course, the stock market is made up of a vast array of companies occupying different sectors of the economy. Different stocks have characteristics that cause them to respond differently to the same events. For example, stocks that fared best during October were ones that had the highest dividend yields, the highest level of international revenues, and the poorest Wall Street analysts’ ratings. Consumer staples and utilities were the only two sectors with positive performance.
In my opinion, the increased agitation in stock prices may be an early signal of an earnings deceleration. This will likely be coincident with slowing economic growth and possibly even a recession. For example, expectations are for earnings growth of 10% in 2019. This is a reduction by 50% of the 20% growth we’ve experienced in 2018. By mid-2019, investors will fixate on earnings projections for 2020, and those figures will probably be impacted by several factors. For example, the trade war is causing higher costs for some US companies as a result of higher tariffs, longer lead times, and broken supply chains. In addition, hints of inflation and indications that wage pressure is building will likely lead the Federal Reserve to continue on its current course of restrictive monetary policy.
Consumer confidence (at the moment) remains extremely high, both historically and in absolute terms. This is a good thing, at least for now. The confidence levels reflect the fact that jobs are available and people with jobs are out spending money. There is still some punch in the proverbial punch bowl, and that could extend what has already been a prolonged economic run. Given that we live primarily in a service-oriented economy, the historical cycles of older industrial economic cycles do not necessarily work as a barometer. There may well be more room to run, but according to Bespoke Research, when consumer confidence has peaked historically, we tended to be at the early stages of a recession.
In my opinion, stocks are still the asset class of choice. The backdrop is the same as when the speed limit on the freeway drops from 75 to 55 and suddenly you feel like you’re crawling along; the freeway still beats the back roads for a long road trip. We will need to quickly become accustomed to the new rate of economic growth and the new market place and likely pivot to a more value-oriented stock selection approach. Expected returns from stocks may well be lower going forward than they have been since 2009. Our work is to choose the best stocks to own as the future characteristics of the market become clearer. I am happy to discuss this with you in greater detail if we have not spoken recently. Please feel free to reach out.
Bruce Hotaling, CFA