The Tematica team has been doing a lot of head shaking lately with the markets doing things that either don’t make much fundamental sense or violate well-established correlations. While we all clearly enjoy seeing the markets go up, we prefer to see confirmation that the upward moves are on steady ground. From falling volumes to the rise in both the dollar and oil prices, we are seeing some cracks in the proverbial wall of worry that equities climb and this keeps us in a cautious mood as we get ready for the holidays. In light of the upcoming Black Friday, I also offer a few suggestions at the end for those folks on your gift list that are just impossible.
Earlier this week I was reading The Wall Street Journal and my eyes rested on two articles that really speak to the tone of the markets: “U.S. Stock Indices post Records” sat shoulder-to-shoulder with “Bonds Extend Gains as Investors Rethink Risks.”
I must admit I’m utterly fascinated by the editor’s choice. We can add in the fact that yields on junk bonds in Europe are lower than U.S. Treasury bonds, because hey, Italy is surely a better bet than the U.S., (insert eye roll).
But wait, there’s more. As of Wednesday’s market close the SPDR Bloomberg Barclays High Yield Bond ETF (JNK) had closed down six days in a row, nearing a 7th month low, falling below both its 50-day and 200-day moving averages. (The aforementioned WSJ article was talking about investment grade shares as opposed to high yield which tends to trade more like stocks.) The iShares High Yield Corporate Bond ETF (HYG) also dropped below its 200-day. At the same time, the S&P 500 closed up for five of the past six days, closing at all-time highs. By Thursday’s close, the warnings signs that high-yield had been flashing were heeded with the S&P 500 dropping 0.4%.
You’ve been reading here and at other Tematica publications as well as hearing on our Cocktail Investing Podcast for months about the striking absence of any volatility this year, as the chart below so clearly illustrates, with a whopping 74% of all trading days in which the VIX closed below 10 occurring in 2017.
A wobbly trading day in Japan yesterday coupled with some less-than-stellar earnings reports, urged volatility to stick its toe out onto the trading stage, rising nearly 25% by mid-day. But that 2017 shyness returned and the day closed with the CBOE S&P 500 Volatility Index (VXX) up just over 8%. As of today’s market close, this has now been the longest streak in history for the S&P 500 to go without experiencing a 3% or more pullback. The second longest period occurred in the mid-1990s when Cyclically Adjusted PE ratios for the S&P 500 were less than 25 versus today’s over 31.
Market fundamentals are flashing warnings signs with the market cap weighted S&P 500 and the Dow Jones Industrial Average materially outpacing the equal market cap weighted S&P 500. Leadership in equity indices is becoming more and more concentrated. Moreover, as the major indices have been making new record after new record close, volumes have been declining, which means those price gains are coming from fewer and fewer transactions. These falling volumes are related to equity portfolio manager’s sitting on near record low cash balances, with the average a mere 2.8%, while margin debt has been rising at a 12% annual pace recently. Confidence is also near record highs with the Investor Intelligence bull reading at 64.4%, just 0.6% away from the Fall of 1987 all-time peak.
With just one bear for every five bulls there is serious herd mentality.
That being said, one of the things we are also seeing in the markets is an exceptionally low level of correlation, which is at least to some degree responsible for the low levels of volatility. If the various stocks in the S&P 500 are less correlated than normal, which means they move more independently from one another than has been typical in the past, volatility will naturally be reduced. While we have concerns with the fundamentals of the overall indices, our investment strategy is focused on specific companies, not the overall market and many individual companies are benefiting from our investing themes such as Disruptive Technology company and Tematica Investing Select List resident Universal Display (OLED), up over 200% over the past year. Low correlation means that individual stock selection is all the more important.
Yes, but employment is doing great and tax reform is going to really ignite the economy! Mmmm, not so fast!
Let’s look at this week’s Job Openings and Labor Turnover Survey from the Bureau of Labor Statistics. Overall job openings fell 50,000 in August then rose just 3,000 in September leaving them down 47,000 from the July peak. If we cut out government jobs, private sector openings fell 21,000 in September after a 41,000 decline in August. More importantly, hires fell 147,000 in September after falling 101,000 in August and are now down in three of the past four months. Again, removing government jobs, private sector new hires fell 157,000 in September after falling 96,000 in August and are also down in three of the past four months with the September level of hires the lowest in 5 months. My personal favorite canary in the coal mine, employment in trucking, has seen no growth in the past seven months. It’s early going here, but this has my attention.
As for that tax reform, Thursday’s release of the Senate Republicans’ plan would push the reduction of the corporate tax rate from 35 percent to 20 percent into 2019. Yes, that was 2019, not 2018. Small cap stocks, which would benefit more from an immediate domestic tax cut since they are more likely to generate the majority of their revenue domestically, have reflected the waning confidence in getting anything passed this year, with the Russell 2000 falling 2.3% over the past month as of Thursday’s close versus the S&P 500 which gained 1.4%.
The market’s all out leader this year has been technology, with the S&P 500 tech sector up over 38% in 2017. The tech sector, which reflects our Connected Society, Disruptive Technologies, and Asset-Lite Business Models investing themes is particularly sensitive to the dollar since so many companies have significant revenue coming from overseas. For much of 2017 the dollar was falling against all major currencies, but over the past few weeks that has trend has decisively reversed. Markets put another rate hike in December at about a 90% probability with another by mid-2018 at 60%, which will only push the dollar higher. Good news for those products we import, not so good for overseas sales. Keep in mind as well that given the dollar is the global reserve currency, whenever it has strengthened significantly in the past, it’s been tough on a lot of the world.
On top of the risks associated with a rising dollar, oil prices have hit their highest levels since 2015, which while great for the oil suppliers, is essentially a tax on the economy as gas prices have climbed 17% year over year. It will cost more to make and transport stuff and to get to work or to the in-laws over the holidays. That means less money in one’s pocket for the important things like this, because, let’s face it, who doesn’t fantasize about a $450 protractor and this because safety is always important and ought to be fancy.