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The Brave Report: Market Commentary for October 2018

Click here for the PDF version of this report: The Brave Report-October 2018

Well, that escalated quickly. For anyone waiting for a pullback, October finally delivered.  In what has historically been a very volatile month we saw some of the sharpest fluctuations we have seen in years with some of the major averages giving back almost all of their year to date gains and the NASDAQ having one of its worst months since the financial crisis.  The reasons behind the sharp selloff are still being dissected and as is often the case it wasn’t one single thing that caused the selling. However, as we have seen in some other brief selloffs this year, the selling happens quickly and is often exaggerated as traders rush to lock in profits and algorithms precipitate the movement in both directions.

While some pundits have been shouting that this is the beginning of the end of the bull market, others are rushing to call the bottom.  In these times, as an investor (and not a trader), it is important to block out the noise and put the focus back on fundamentals. This doesn’t mean the bottom is in yet, but if you were optimistic over the last few months and looking to put some new long-term capital to work, then black Friday sales have come early.

Market Overview

There was no real winner over the last month, just areas that lost less.  The Dow Industrials held up the best losing only 4.8%. This was followed by the S&P 500 at -6.3% and the NASDAQ lost the most at around -9.8%.  This represented one of the worst months the tech-heavy NASDAQ has had since the financial crisis.  It is not surprising that it would the biggest laggard as it has been the biggest outperformer over the past few years so when panic selling occurs it is normally the normally the high flying momentum names that get hit the most. These are normally the names that have seen their valuations get stretched and investors rush to try to lock in gains. The selloff, however, was market wide with very few places to hide.

On the fixed income side, we saw rates jump rapidly at the beginning of the month, only to settle back down a bit as the month went on. While the initial jump in rates may have contributed to the selloff, we did not see a rush to safety as equities started selling.  I see this as a sign that there is still upward pressure on rates and that investors may not be as fearful of this equity selloff as they have been in the past.

Market Selloff:  This recent market selloff was one of the swiftest we have seen in recent years, but, historically speaking, is pretty standard as market selloffs go.  The averages only briefly touched correction territory of down 10% from their highs and have seemed to find some stabilization over the last week.  I’m not saying the averages can’t go lower but the underlying fundamentals in the economy and corporate America are too strong to be ignored and should provide some level of support to at least mute too much further deterioration.

Since the selloff started, almost all financial news coverage has been insufferable with every pundit coming out of the woodwork with their opinion as to what happened and where we are going from here.  Depending on their background or investment stance they try to pin it on one thing or another. As with most market movement, it was not just one variable that led to this correction, but a series of uncertainties that told traders it was time to take a step back and reevaluate valuations until some of these uncertainties subside. Once the selling started, however, the current trading landscape takes over and we saw algorithmic sell programs and ETF selling accelerate the downward pressure. This new market dynamic speeds up and amplifies market movements. Because of this, selloffs and bounce-backs now happen much quicker and are often exaggerated. This trading dynamic is here to stay but what caused the initial selling in the first place?

  • Rates: At the beginning of the month we saw a rapid jump in rates as fears that the Fed would continue to aggressively raise rates were amplified by some comments by Fed Chairman, Jerome Powell. I think this was a major factor in some traders moving to the sidelines, however, it shouldn’t be a surprise to anyone that rates are moving up to more normal levels.  The pace of these moves is what investors should be watching now. While this may have been the initial spark to the selloff, if other market uncertainties were not present this spark would never have lit a fire as it did.
  • China Trade: This has been the elephant in the room for months now and the uncertainty around it is casting a large shadow over the markets.  Throughout the current earnings season, trade tensions have been mentioned over and over again. However, we have seen very little negative impact on actual corporate results.  The problem lies in future guidance.  With such an uncertain outcome it is difficult for companies to project how any tariffs will impact future results. This uncertainty often leads companies to announce more conservative guidance. With all the other uncertainties in the markets, it seems that traders are jumping on any bad news in these earnings reports and dragging stocks lower, adding fuel to the selling.
  • Midterm Elections: The administration has pinned most of the selling on uncertainty around the midterm elections, trying to pin any negative market news on the prospect of Democrats taking control of one or both houses of Congress. I do not put much credence in this assertion.  I do agree that there is a lot of uncertainty about the elections but historically a split congress is often a boon to the markets as there is some certainty that nothing will get done. I do think a blue wave taking both houses could have some potential negative impacts on the markets but with a Republican in the presidency, it would be very difficult for a democratic congress to accomplish anything for the next two years.
  • Earnings:  By most measures, earnings season was again very strong.  The concern that some traders and investors are jumping on is that we are at peak earnings meaning earnings growth will stall or decline over the next few years.  I agree the earnings growth we have seen this year, which was fueled in part by the tax cuts, will be tough to sustain but that doesn’t mean that corporate results can’t still be strong in historical terms.

Conclusion and Opportunities: There are obviously a number of other factors that probably helped contribute to the selloff but more than anything I think it was a perfect recipe for a quick correction. Valuations were getting a bit stretched, especially in some of the high flying momentum names.  A number of uncertainties were weighing on investors so all it took was one spark for investors to decide to take a little breather and reevaluate their risk exposure. They took some profits in names that had made them a lot of money and will now look to redeploy it when some of these uncertainties are lifted.

As a long-term investor, I look at this selloff as a great opportunity to invest in some quality names at a discounted price. As I mentioned earlier, very few areas were spared from this selloff, meaning traders were throwing the baby out with the bathwater. This caused a lot of very strong companies to be sold off, not based on their own results or growth prospects, but because everything was being sold. The opportunity now lies in identifying these names or sectors you have wanted to get into.  They are now at much more attractive valuations.  If you were bullish on them a few months ago then you should really like them now.

Strategy Commentary

Over the past month, I selectively cut some of my equity exposure as the market began to sell off.  In hindsight, I probably should have cut a little more in some places but the worst thing you can do during a sharp selloff is panic sell.  In the end, patience will pay off. I reduced our exposure to small caps as they tend to get punished more when the markets sell off.  I also reduced our exposure to consumer discretionary as this is another area that has been on fire for the last few years so will be one of the fastest to selloff as momentum changes. I will look to redeploy this cash as soon as we feel any panic is gone.  The goal is not to call the bottom but to find a lower entry point once things stabilize.

Domestically I am still maintaining my overweight to technology.  I probably should have cut some exposure early in the month but I do not think the fundamentals have changed much, if at all in the sector and it should be one of the winners if the market bounces back. Of all sectors, it has provided and should continue to provide some of the best opportunities for continued earnings and revenue growth. I am also still maintaining my overweight to healthcare.  The sector has performed relatively well in recent months and if we do not see a quick bounce back money should continue to find its way into this defensive sector.

I am still underweight almost all international markets.  That being said, we could see some amazing opportunities in some of the emerging markets that have sold off over the past 6 months. In particular, China is very intriguing. The trade war cloud is still hanging over everything china related but many high-quality names are down 20-50% from their highs earlier this year.  Should any progress be made on the trade front I expect many of these names to rebound quickly.  I am not advocating putting all your money to work here but there could be some amazing opportunities to start building back some international exposure.

I continue to be underweight almost all of the fixed income space.  With rates on the rise, we have seen pretty broad-based negative performance throughout the space.  I am maintaining higher cash allocations as a replacement for my fixed income allocations.