The Brave Report: Market Commentary for November 2018

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

Santa Claus is coming to town…. Maybe. The markets have been on quite the roller coaster over the past two months as investors and traders have debated where the market goes next.  On one side, the underlying fundamentals of the economy seem quite strong and corporate results continue to outperform. On the other side, a number of risks still persist.  The trade war with China, Fed tightening and the potential of an inverted yield curve continue to hang over the markets. Beyond that, we just seem to have a lot of speculation of what the economy will do over the next few years. There is a worry that earnings have peaked and there is the widely debated prospect of slowing growth over the next two years but at this point, these are both merely speculation. If some of these uncertainties can continue to be clarified or minimized we could see a small rally into the New Year, albeit a choppy one. However, if these uncertainties persist we could see buyers just sit on the sidelines until there is some resolution and this could lead to some profit taking into year end.

Market Overview

Over the past month, all the major averages squeaked out gains. The Dow and the S&P both posted gains around 1.8% while the NASDAQ rose only slightly.  Even though all the averages saw some gains, these gains were not without some volatility.  The NASDAQ swung throughout the month from up over two percent to down over seven before rallying back to the flat line after Thanksgiving.  These sharp swings seem to be the pattern since the beginning of October. Traders are selling off on any bad news or prospect of bad news while the bounces are happening just as rapidly. This often happens as investors are uncertain about the next direction of the market and don’t want to be on the wrong side of the next move.

On the fixed income side, we have seen rates pull back over the past month.  After reaching a high yield of 3.24 early in the month the rate on the 10-year has fallen back to around the 3% level.  The drop in the 10-year is not necessarily the big news on the fixed income side but we have seen a continued flattening of the curve, especially in the middle of the curve.  By the time this report gets published I would not be surprised if we see some inversion somewhere along the curve. In recent history, this has been a sign of an impending recession as we have seen the curve invert prior to the past 7 recessions, although there is often a lag between inversion and recession.

There are a number of risks and uncertainties that have been hanging over the markets for quite some time. As I have mentioned in some previous reports, the longer these uncertainties persist the greater their potential impact on the markets as more and more investors just decide to move to the sidelines and wait for resolution. Additionally, the more difficult it becomes for companies to make longer-term capital allocation decisions.

China: Trade relations with China have been the big elephant in the room for quite some time now and I have discussed it at length in previous reports. This past weekend we saw the two administrations kick the can down the road as they extended the deadline for new tariffs to take effect.  While this should provide a short-term reprieve, until we get some specifics around the truce agreement or start to see some real progress in the longer term negotiations, I see this as more of a band-aid than a cure.  As we have seen, a single tweet or news leak can quickly erode any perception of progress. With that being said, from the beginning, I have contended that the actual financial impact of the trade conflict will be negligible on most companies but when it is combined with these other uncertainties buyers are more comfortable on the sidelines.

Fed Tightening:  The market selling in October was catalyzed by some strong comments by Fed chair Jerome Powell, indicating that rates are a long way from neutral.  In more recent comments, however, he walked those comments back a bit, saying we are closer to neutral.  That brings us to the upcoming December rate decision. There is a pretty wide consensus that he will raise rates in December. The uncertainty and risk lie in the projection and pace around future rate hikes.  Most investors and traders are looking for the Fed to soften their language and go back to the Janet Yellen era language that future hikes will be data dependent rather than continue the strong stance that we are far from neutral. We rarely get concrete answers during Fed meetings.  The hope is for the Fed to give us tea leaves that read better than the comments in October.

Yield Curve Inversion: The potential for the yield curve to invert has risen rapidly this year as growth forecasts for the next few years have dropped and inversion is now becoming much more of a concern. The reason for the concern is that the last 7 recessions, dating back to the 1970s, have been preceded by an inverted yield curve based on the spread between the 10-year and 2-year treasury. The accuracy of curve inversion as a leading indicator is still widely debated and just because we see some slight inversion in certain areas on the curve does not mean a recession is coming. However, with the wall of worry the market seems to be trying to climb, the chance that inversion is an accurate indicator is enough to impact markets.

There are a few important things to point out about this potential leading indicator.  Prior to 1970, this was not a very accurate indicator as we saw a number of recessions without inversion and a number of inversions without a recession. Going back even further, prior to WWII, the yield curve was almost always inverted. We are obviously a much more mature government and economy now but it is worth pointing out.

Additionally, looking back at the recessions since 1970, we are in a much different rate environment than we were for most of that time period. For instance, when the curve inverted in 1981 the rate on the 1-year treasury was almost 17%.  Currently, rates are at their lowest point, across the board, compared to any other inversion during this timeframe. So while we may some inversion along the yield curve, we are in a much more stable rate environment than during many of these other recessions.

Lastly, an inverted yield curve rarely signifies an immediate recession. There is normally more than a year between when the yield curve inverts and the start of a recession so even if we do see the yield curve invert it does not mean the world is ending. If inversion happens, expect the pundits on CNBC so start portending the end of the world as they want to be the one that predicted the next recession.  I would also not be surprised to see some increased volatility in the markets as we seem to be in an environment where traders and investors are selling first and doing their due diligence later.  Add to that the automated news-driven algorithmic traders and just the mention of inversion can send the markets lower on the short term. If this does happen, the patient investor will be rewarded as these panic pullbacks are often short-lived and provide great buying opportunities.

Valuations: With all of these uncertainties in the markets it is also important to point out that a lot of damage has already been done. As of the lows on November 20th. The market was sitting slightly in correction territory, with all major averages down over 10% from their highs. At these levels, this just represents a garden variety pullback. And for the whole year, the Dow and S&P were only down slightly on the year, with the NASDAQ still in positive territory. However, if you dig deeper and look at changes in valuations, the performance this year has been much worse.  Market valuations, based on the price to earnings ratio of the next 12 months of earnings has had one of its worst yearly declines since the statistic started being tracked in 1991. So far valuations are down 17% year to date.  To put this into perspective, during the financial crisis in 2008 valuations dropped 18%.  So while the pullback in stock prices has not been that severe, when you factor in the current and projected earnings growth the markets have lagged substantially.

If you look at a stock price as the discounted value of future cash flows than stocks are 17% cheaper than they were at the start of the year, even though the stock prices are right around the flat line. This does not mean stocks have hit their bottom, especially factoring in all the risks I have discussed, but if you are a long-term investor valuations are now much more attractive than they have been in a while.

Strategy Commentary

Over the past month, I cut some equity exposure while adding in other areas. With the wild weekly swings, we have been seeing, making any large-scale changes to a portfolio is not recommended. My current equity exposure now sits slightly underweight but depending on any upcoming positive news on the trade front and from the Fed I will look to add back to positions.

Domestically, I trimmed some of my technology exposure.  This has been a huge winner for me for the past few years and with the volatility, we have seen some of my preset stop-losses kicked in so we took some profits.  On the longer term, I am still very bullish on the sector and think it provides the greatest prospects for future growth.  But in the current environment, these higher beta, momentum names tend to get sold off first and more drastically with any pullback. Once we see some stabilization I will probably add back to the sector. To be clear, I am not underweight technology, just moved to a more neutral stance.  I am still overweight healthcare as I think until some of these market risks abate this defensive exposure is appropriate.

I am still underweight most international markets but have started to add selectively to some emerging markets names. The pullback in China starter months before our own and was much sharper. We have started to see a little strength from the region, especially in some of the higher quality names.  I am not anywhere close to overweight but will continue to add to these opportunities, especially if there is some resolution on the trade front

Even with the stabilization in the fixed income complex, I am still underweight almost all fixed income exposure.  If the Fed begins to signal a slower pace of rate hikes I may start to add to some positions. But, with the prospect of inversion, most of this exposure would be on the short end of the curve.

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