Calibrate Wealth: Current Market Analysis
by Zach Marsh on Oct 26, 2018
What do We Make of this Market?
First, the bad news. At the close of today’s trading session, the S&P 500 was down over 8.75% for the month of October. For historical perspective, it is the 15th worst month since 1950. It also makes this the worst month for the large cap index since February 2009. Of the 15 worst months since 1950, 13 of them occurred during recessions or pre-existing bear market conditions. October 1987 and August 1998 are the other 2 months in the list to occur outside of recession or bear market conditions. So, to say this has been a bad month for the market is a bit of an understatement. It also forces us to ask some difficult questions. First question: is the economic picture not as rosy as advertised? And second question: is there some lurking financial crisis percolating beneath the surface?
Looking at the first question, we typically only know post hoc if we are in a recession, but it seems safe to assume that given the current employment situation and recent GDP data we are not in a recession, nor are we on the verge of one. That isn’t to say that, should this sell-off in the stock market continue, we won’t be dragged into one. As the tech bubble began to burst in late 2000, the US economy was not in a recession. But the fallout from the wealth destruction from falling stock valuations, the economy eventually slipped into recession. So, while we are not currently in a recession it is not out of the realm of possibility to think we may be much closer than current conditions suggest.
The answer to the second question may be even more difficult to currently assess. In August 1998, in the middle of a booming economy and stock market, a rogue wave of sorts occurred that thrust the markets into chaos. A Russian default triggered a contagion effect centered on a highly leveraged, powerful hedge fund, Long Term Capital Management. In what would be prelude to a much larger crisis 10 years later, the financial industry was nearly brought to its knees, before the banks got together and bailed out the firm. Perhaps we are currently experiencing the beginnings of something more dangerous, but as of yet it seems difficult to know.
The other instance was the market crash of October 1987. That crash was triggered by rising interest rates and elevated stock market valuations. Our current sell-off began under similar circumstances. Interest rates have been on the rise all year, but the pace of the rise began to accelerate in late August. This acceleration began to spook the market on October 2nd. While rates were moving higher at a much faster rate in 1987, interest rate increases can be relative. Since the end of the Great Financial Crisis in 2009, financial markets have become extremely reliant upon easy borrowing conditions. Companies have used low borrowing costs to issue corporate bonds to purchase back shares of their own company’s stock. This has had a dramatic impact on share prices. Additionally, with no other viable alternative for investing, individuals and funds across the board have sought returns through investment in stocks. A return of higher yielding bonds has begun to siphon off investment in stocks and into safer alternatives in the bond market.
For now, I believe that we are in a situation of a mass de-risking of investment allocation. The more important question is how long this will last. The answer to this question relies upon relative valuations of stocks and bonds. It is hard to argue that stocks, even after a 10% correction, are not highly elevated. But is a 3.1% 10-year bond yield high enough to sustain a longer-term pattern of investing re-allocation. This is especially pertinent considering that, should this continue, bond yields will fall below 3% in a matter of a couple months. However, this does ignore the possibility that many could flee the stock market and go to cash. One characteristic of the market is that selling can beget more selling causing small, temporary corrections to turn into full-fledged bear markets.
When we look back at months which witnessed drawdowns in excess of 8%, the average two-month return following the 8% decline was only 2%. John Maynard Keynes said, “Don’t try to wade across a river with an average depth of 4 feet.” Averages can mask the variance of results. When the drawdowns occur at the end of a bear market, like February 2009, proceeding two months typically have high returns. When they occur at the beginning of a bear market, the returns are quite the opposite. Should this be another 1998 situation, a steep drawdown in the middle of a continuing bull market, the proceeding two months could be robust. This current bull market by all measures is the longest on record and consequently we should not discount that this decline in the market could be deeper and longer than recent corrections.
I started this article with the bad news, now for the good news. In the near-term current market conditions appear extremely oversold. Today the S&P 500 tested the lows from Wednesday and bounced strongly. That temporary relief rally was again sold into, pushing the market back down, but north of the previous lows, before once again rallying back. This type of price action would lead me to believe that we are due for a more sustained relief rally. Frequently these rallies can be violent in nature, with many recouping between 50% and 70% of the previous decline. How the market reacts following this relief rally will, in my opinion, determine whether we are in the beginning of a bear market or a just a pause in the longest running bull market on record.
Year-to-Date Returns of Various Assets
S&P 500 -2.23%
MSCI Developed Int’l -13.2%
MSCI Emerging Markets -19%
US 10 Year Treasury -2.76%