October 2018 is living up to its reputation as being the scariest month of the year for investors. After coasting into late summer with a sense of optimistic complacency, the tables turned rapidly on investors as US markets followed their foreign peers downward. The popular indices such as the Dow Industrials and the S&P 500, which had been boasting decent gains for the year, have now seen those gains evaporate in the course of about a month. For the record, over the last four weeks the Dow has declined 6.3%, the S&P 500 has fallen 8.4%, and the Nasdaq Composite and Russell 2000 small cap indices have dropped 10.3% and 12.2% respectively. Not even high-quality bonds have been able to resist the onslaught, with long-term government bonds falling about 1.8% over the month. The lone bright spots have been utilities and gold, but with only small fractional gains they have not been enough to offset the broad market’s decline.
We are in a “bearish” market, if not a “bear” market. A bear market has been characterized by the media as a fall of 20% from the price high, but this is an arbitrary number. A bear market is when most stocks are in downtrends, and that is certainly the case at the moment, as the facade of a handful of strong stocks which masked underlying weakness has now given way. Even the mighty Amazon.com has dropped 20% from its high, putting it into the ever growing herd of bearish stocks. So while we may not have met the popular definition of a bear market, we are in a bearish market, and we must play by “bear market rules.”
Predictably, Wall Street pundits have been falling over themselves to explain “why” the rosy scenarios these same analysts were painting just recently could so quickly turn into a picture of gloom. The three most common explanations being trotted out are the idea of peak earnings, rising interest rates, and a global economic slowdown.
The peak earnings theory says that the strong earnings growth US companies have enjoyed over the past 18 months is now peaking. The salutary effects of extremely low financing costs (thanks to the Federal Reserve’s quantitative easing policy of 2008-2016) and the drop in corporate income tax rates have turbocharged earnings growth for US companies. But the effects of these two stimuli are now fading, reducing the rate of change of earnings growth.
The flip side to this explanation is that earnings expectations have been too high. As we wrote in the June 2018 Market Outlook, investors have been paying way too high a valuation for growth stocks, and these valuation levels were unsustainable. While the current downtrend is bringing the high flyers back to more reasonable valuation levels, it will be some time before they can be called cheap.
Rising interest rates seem to be the most common culprit in assigning blame for October’s decline. The strength of the economy, rising inflation, and the Fed’s slow but steady hikes in the Fed Funds rate has raised interest rates across all maturities. This is now being felt in the two key industries that rely on financing for sales: housing and autos. Slowdowns in these sectors are clearly being felt, sending a ripple effect throughout the economy, and dampening growth expectations.
Curiously, the Fed’s reversal of their money-printing policy, now called “quantitative tightening” (QT), has hardly been mentioned by Wall Street’s analytical elite. While interest rates have gone up substantially from their recent, artificially repressed lows, they are still remarkably low by historical standards (the 30-year Treasury Bond yields 3.3% today, compared to 5.2% in June 2007). What is different is that the Fed’s quantitative tightening is taking about $50 billion a month of liquidity out of the financial markets. We believe it is the reduction in liquidity that is finally starting to bite the financial markets, not the effect of higher interest rates on consumer spending. As if to underscore this point, the most recent GDP report showed the economy grew at a robust 3.5% pace in the third quarter, yet stocks fell almost 2% that day (October 26th). Given that the Fed is committed to “normalizing” its balance sheet, we can expect QT to be a drag on the financial markets for the foreseeable future.
Finally, the developing trade war is starting to have its effects on global trade. Unsurprisingly, tariffs have not enriched the US at the expense of our trading partners, but have had the effect of making everyone poorer. As any good businessman knows, one’s customers must be doing well for the business to do well. A well regarded product or service can see sales falter if customers are feeling poorer due to layoffs, inflation, or other setbacks. As foreign economies are slowing, many US companies are slowing as well, with many citing tariffs as at least a partial explanation of their own sales struggles. How far this will slow the virtuous cycle of spending and consumption we have enjoyed is anybody’s guess, but the increasingly dour future outlooks voiced by US companies is certainly emboldening the bears on Wall Street.
Explanations of why this is happening are less important than recognizing that in this environment, bear market rules apply. This has numerous implications for investors, including the assessment of whether a buying opportunity is at hand.
The first thing investors must assess is whether the basic trend of stocks is up or down. This is the first bear market rule to understand, and two key indicators that answer this question are the NYSE Bullish %, and the NYSE Advance/Decline line.
The NYSE Bullish % measures the percentage of stocks on buy signals using the point-and-figure (p&f) charting method. In bull markets, this measure will rise, as the percentage of stocks giving p&f buy signals increase. A bull market, after all, is defined by most stocks going up in price. Today, the NYSE Bullish % is 34% and falling. At 34%, it is saying that 76% of issues on the NYSE are on p&f sells (i.e. down trends), and that means the broad direction of the market is down.
The NYSE Advance/Decline (A/D) line is communicating a similar message. The weekly A/D line, plotted in p&f format, has been trending down, and gave a sell signal for the week ending October 26th. It is simply measuring whether the majority of stocks are going up or down in price. At this time, the answer is “down,” confirming the message of the NYSE Bullish %.
Second, is it a “correction” or an actual bear market? A correction can be viewed as a pullback in price, but where the major upward trend stays intact. A bear market, on the other hand, is when the major trend turns downward.
The way to determine the answer to this bear market rule is to look at the behavior of stocks on any rallies from their lows. In a correction, stocks will tend to fall to about the levels of their previous lows, then begin a climb to a new high price. Stocks in longer-term declines, however, will have feeble rallies from their lows and generally fail to get to new highs. This pattern is called a “failure swing” among trend analysts, and can be readily seen in charts of one to two years duration. Simply put, if the chart of your security looks like an ascending staircase (i.e. higher highs, and higher lows) it is in a bullish trend. However, if the chart looks like a descending staircase (lower highs, and lower lows), chances are good it is in a major downtrend. Today, there are many stocks with a descending staircase pattern, implying that the bearish trend may last longer than many are now expecting.
Once the major trend has been determined, investors must make the distinction between “overbought” and “oversold” conditions. These are momentum type concepts that measure the short-term direction in which stocks are moving. Rallies will give rise to overbought conditions, where rising momentum is high, but should be expected to slow. Think of a tennis ball whacked high into the air: at first, it has a lot of momentum as it arcs higher, but then eventually gravity takes hold and causes the ball to fall back to earth. Conversely, if you threw that ball into a pool, it would dive under the surface until buoyancy took over and cause it to rise. The peak of the upward or downward arcs are analogous to the overbought or oversold state of the markets. But the conditions in markets are created not by physics, but by the emotional state of investors.
The point of all of this is that an oversold condition, as we have at this moment, is not a buying opportunity by itself. The third bear market rule is that in major downtrends, investors will tend to sell into rallies rather than buy the dips. Thus, securities that look like they’re back in an uptrend as they bounce up from oversold conditions will suddenly stop and reverse back down, to continue their down trends. As the chart of General Electric makes painfully clear, there can be many selloffs and rallies in the context of a larger decline, so we must understand what the major trend is. This would be quite the reverse of behavior that investors have exhibited in recent years, when buying the dips had become an almost Pavlovian reflex reaction to any price decline.
The final rule for coping with bear markets is to recognize that the leaders of the previous bull market will likely give way to a new crop of new leaders in the market. Thus, the market darlings of the last few years, technology, social media, and biotech stocks, are likely to be weak reeds to lean on during this bearish period. This bear market rule says to look for changes in leadership for clues as to where to invest your money. An ideal tool to answer this question is the “relative strength” chart, which measures how a security is doing relative to “the market” (e.g. the S&P 500). These charts are also plotted on a p&f format to make the buy and sell signals clear and unambiguous.
What we are seeing today is relative strength sell signals in Facebook, Amazon, Netflix, and a host of other popular tech and biotech stocks. Positive relative strength buys have recently been given by Procter and Gamble, Kroger (grocery), Kellogg (cereal), and numerous utilities (e.g. Xcel Energy), and real estate investment trusts (REITs). Admittedly, these kinds of stable, unglamorous companies are the expected beneficiaries of the flight to safety we are currently experiencing. But in a longer term decline, the relative outperformance of these types of stocks will persist for many quarters to come, repeating the pattern which we saw in the declines of 2000-03 and 2007-08.
From a broader perspective, growth stocks are ceding their leadership to value stocks. Several months ago, we cited the comparison of the Vanguard Growth Index Fund (VIGIX) to the Vanguard Value Index Fund (VIVIX), using relative strength charts for each. At the time, Growth was the clear leader, but now the leadership has changed as Vanguard Value has given a buy signal on its relative strength chart, while Vanguard Growth has given a sell. These are useful guideposts to use to recognize when and where broad leadership changes are occurring, and when it may be time to shift portfolio allocations from growth to value oriented stocks.
Where is the silver lining in this bearish environment? First of all, it is a well known axiom on Wall Street that the strongest stocks of the bull market are the last to go down. So to see the market leaders such as Amazon and Home Depot now declining indicates that we are closer to the end of the selling than the beginning, at least in the near term.
Sentiment, which has been overly bullish, has turned on a dime and is now moving to quite pessimistic readings. This is a positive from a contrarian point of view. For instance, the CNN “Fear and Greed Index” reached a low of 6 (out of 100) in the week ending October 26th, which reflects the panicky mentality that has overtaken the markets. In way we are seeing a mirror image of the euphoria that pervaded markets early in 2018. Back in January, just after the tax cuts were passed, investors bid up stock prices without regard to price, creating a sort of parabolic, nearly vertical up move in the indexes. That didn’t last long. Today, we are seeing a parabolic down move in stocks, with a similar disregard for prices. Investors seem to want to get out at any cost, and that usually presents opportunities for investors.
Warren Buffett once said that as an investor, it is wise to be “Fearful when others are greedy and greedy when others are fearful.” While we can’t say we are at a major bottom, we can see that fear is the predominant emotion among investors right now. Our view is to lean against the crowd and take a more bullish view of the markets at this time. The markets will take some time to repair the many bearish trends of the moment, but armed with the tools described above, we hope to identify the leaders of the next upward cycle.
Once again, a timely, well thought out and clearly presented assessment of current trends in the market.
Your friend and colleague,
Excellent article and enjoyed hearing your thinking regarding conclusions–including the visuals.