Markets have been heavy, so let’s start with a light but brief story before digging through some of the important issues as we start the week…
In 1973 the editors of British magazine New Music Express put Keith Richards at the top of their annual “rock stars most likely to die within the year” list. He remained at the top of this stack for the next decade. It was a logical guess, given Keith’s hard driving lifestyle. After a decade, however, NME had to face the inevitable: Keith Richards is immortal.
Plenty of market observers have the 2009 – present bull market on a similar deathwatch, but that story (courtesy of a 2010 New Yorker article) is a good reminder that the seemingly obvious doesn’t always come to pass.
With that, three things to know as we kick off what will certainly be another volatile week in US and global equities:
#1. Last week’s 3.9% selloff for the S&P 500 notwithstanding, corporate earnings reports were actually much better than the prior week. In fact, Q3 earnings season is now actually ahead of the 5-year average “beat” percentage. The numbers (source: FactSet):
- Through October 19th (when just 17% of the S&P 500 had reported earnings), the average company had beaten their Q3 earnings expectations by 3.9%. The mean year-on-year earnings growth rate was 19.5%.
- Through last Friday (with 48% of companies reporting), the average S&P company has beaten expectations by 6.5%, above both the prior week and the 5-year average of 4.6%. Average earnings growth now stands at 22.5%, which represents a notable acceleration from last week.
- Last week’s financial reports also showed better revenue growth than the prior week. The numbers: 7.6% year-on-year growth versus 7.4% last week.
So why did stocks sell off if everything is so good? Worries about the Fed, yes. But despite the better beat percentages, analysts actually cut their Q4 2018 estimates. Last week, they were looking for 16.5% year-on-year growth. Now that number is 16.1%. Wall Street is also reluctant to boost their 2019 numbers, which remained unchanged this week despite the better tone of earnings reports.
Bottom line: Q4 numbers may continue to come down this week even if last week’s better beat rates continue, an unwelcomed development. This is something we did not see mentioned anywhere, but it neatly explains why the pullback has a fundamental as well as macro explanation.
#2. The market’s game of “I double dare you” with the Federal Reserve continues. The latest odds on rate increases (source: CME):
- Fed Funds Futures show a 30% chance the Fed skips the widely expected December 2018 rate increase. A week ago the odds were 16%.
- If the Fed does go in December, futures now make the odds of a March 2019 increase at just 40%, down from 50% a week ago.
Bottom line: while Fed Funds Futures may be repricing rates, the 2-year Treasury market isn’t really buying it yet. Yields of 2.81% are the same as at the start of October. That’s important, since this is the most visible measure of riskless opportunity cost for equity investors. We’ll need to see 2-year Treasury rates come down further to see equity prices stabilize, in our opinion.
#3. Trends in US equity sector correlations explains a large part of why the CBOE VIX Index remains lower than feels “right” given recent volatility. The numbers and some background:
- Back during the February – April 2018 volatility spike, the average S&P 500 sector was 0.80 – 0.80 correlated in terms of daily price action to the S&P 500 as a whole. (We use 30 day trailing correlations for this measure.)
- Over the last 30 days, the average S&P 500 sector is 0.72 correlated to the index, even with the recent volatility. That is 14% lower than the vol shock earlier this year. Why the difference? Utilities, Consumer Staples and Real Estate are decoupling – something they did not do from February – April.
Bottom line: to our thinking it is a spike in sector correlations that signals an investable bottom for US stocks, and this is an underappreciated input into the behavior of the VIX “fear” Index. Watching correlations worked during the February – April selloff and accurately tracked the 2-month bottoming process. The current 0.72 reading is not yet back to the +0.80 readings that signifies the start of an investable low. In Churchill-ian terms, we’re more at the end of the beginning than the beginning of the end.
Summing up: everything here points to more US/global equity volatility and the real chance for further losses this week. Cuts to Q4 earnings expectations and correlations tell that story well enough. A sticky 2-year Treasury yield only reinforces it. Like Keith Richards, these aren’t likely enough to kill stocks outright. But they are enough where the bearish deathwatch will continue.
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