Buss Capital Management, LLC
THE MARKET MONTH THAT WAS
THE MARKET MONTH THAT WAS
By Carol Buss
You hear such generalities when listening to the news these days, and so much is glossed over to fit the perspective or agenda of the commentator, that I thought I would present a more detailed report about the past month.
Financial news is in a woeful state these days: generalities abound, sensationalism reigns, and too many are eager to advance their agendas than accurately describe the state of the market. Every day there is a new story line and a fresh angle, while a wealth of important details is regrettably glossed over. This report represents my attempt to be specific -- hopefully you will not mind weeding through the facts and figures and will find it informative and useful.
During the month of August, 2019 the Dow, S&P 500 and Nasdaq indexes only fell 1.72%, 1.82%, and 2.6%% respectively, given the spectacularly erratic behavior of the market averages on a daily basis. For some perspective, the average return for the S&P 500 in August from 1950 to 2019 has been pretty much flat, down -.24%. Last month’s decline was due in large part to worries about the escalation of the trade war with China, inversion of the 2Yr. and 10Yr. Treasury bond yields, and the incessant talk of an imminent recession.
It seemed that every day brought a different set of worries or optimism, based on whatever headline or tweet was dominating the news cycle. I’m sure that the constant fear-mongering has rattled many of you, so it is important to consider the factors contributing to the increased volatility:
August included the biggest drop in the Dow of the year on August 14th, 800 points. The 2-year and 10-year yield inversion that first occurred on that day has not occurred since 2006, and the worry is that it portends a recession. It is important to remember however, that the average lag time between such an inversion and a recession occurring is about 22 months. In addition, there is no certainty that a recession will occur based on such an inversion. Also, it is more worrisome if it stays inverted for weeks. So far, since then, the 2 and 10 Yr have been going in and out of inversion. On the last trading day of the month, 8/30/19, the 2 Yr. yielded 1.51% and 10 Yr. 1.499%, still inverted. The news isn’t always foreboding either. Historically in the year following the 10-year/2-year inversion, U.S. equities have yielded positive returns.
There is the worry that the lack of a trade deal with China will cause a spike in inflation. This may happen.
So far, this has not been realized, although a company who chooses to absorb the price increases instead of passing them along to the consumer will impact their bottom line, and therefore their stock price.
The uncertainty over the lack of a trade deal with China has caused corporations to cut back on investment spending. This has resulted in a slowdown in economic activity in the U.S. and globally, although the U.S. economy and consumer spending is still strong. A slowing of economic activity doesn’t always last, and doesn’t automatically mean a recession is on its way.
There is a worry that the incessant drumbeat of an upcoming recession will actually cause a recession. This is quite valid, as the perception that one will occur can cause the U.S. consumer to retreat. This is already happening among the affluent who have recently cut back on luxury purchases. Politically, it is in the best interest of this administration’s opponents to talk the country into recession. They realize that with a strong economy in place, it would be very difficult to defeat President Trump. Keep in mind that most recessions are not just financial events, but political events. It is important to note that recessions rarely occur when they are this forecasted, and usually follow a period of euphoria, which is not present today.
The strong dollar is a negative for the global economy. The world’s debt is held in dollars, and the slower the Fed is to cut rates, the stronger the dollar gets.
While it is dangerous to say this time is different, there is a reason other than problems within the U.S. that is causing the bond bubble and an inverted yield curve. Negative interest rates in other parts of the world have increased global demand for U.S. Treasuries, pushing prices up and yields down.
While most individual investors would prefer a smooth, upward trending line for the U.S. stock market indices, the stock market has only recently cooperated in 2017. Feel like your stomach is always churning, but your stock portfolio is going nowhere? You are not alone, and you are feeling that way for good reason.
Since the beginning of 2018, volatility has increased, but with little to no upward movement. For those holding individual stocks, the volatility has been even more pronounced. Each earnings season often produces an outsized movement in the price of individual stocks, typically due to earnings or revenue or outlook, or divergence from analyst expectations. The market has been struggling ever since President Trump initiated the trade war with China on January 23, 2018. Since then the S&P 500 has been under the January 23, 2018 close of 2839.13 75% of the time. As of Friday’s August 30, 2019 close of 2926.46, the S & P 500 is only up 3.08% for the past 19 months – pretty frustrating.
However, patience is still in order here. Don’t be tempted to do something, just because you are frustrated with the lack of progress in your portfolio. If you have a longer time horizon, the important thing is not to let your emotions get the best of you and overreact to these sudden, downside movements, without a fundamental reason to sell. To be successful in the stock market long-term requires that you stay on a steady course, and not succumb to knee-jerk reactions that affect day-to-day stock prices, even if you feel insecure. To invest in the stock market requires a steady mind and thorough analysis, not investing based on wild prognostication and simplistic cause and effect relationships.
This market is like a coiled spring, with many stocks with growing revenues and earnings getting cheaper, especially during this past month. Many are down from their highs of 2018 by double digits, even as the overall averages have hit new highs recently, in July. It has not been a market that lifts all boats, but a less than ideal market, with many headwinds and crosswinds. Passive indexing investment strategies have been the rage in the past few years, which makes the more popular large-capitalization names in those indices more and more expensive, while leaving many small-capitalization and growth stocks to drift lower. This makes for a bifurcated market.
I would even posit that this popular passive indexing craze is a bubble. Thus, there are a great number of undervalued issues out there, waiting for investors to recognize their potential, some with very attractive dividend yields. Fundamentals have not dominated. Instead, market averages have been jerked around by every tweet, every headline in a reactionary manner, without thorough analysis. Market sentiment is poor, which is why there is a flight to bonds. Computer algorithms, programmed by humans to sell in a lemming-like manner, is a big factor. Also contributing to the choppiness are similar institutional traders’ options strategies that involve short-term trading.
While it often remarked at how expensive stocks are, they are not wildly overvalued by various valuation measures, particularly in a low interest rate, low inflation rate environment:
Return on Equity is an important indicator of a stock’s performance. In the first quarter of this year the S&P’s Return on Equity was 18.9%, the highest level since 1998.
Using the Real Earnings Yield Model, the quarterly spread between the S&P 500 earnings yield and the CPI rate has averaged 3.3% since 1952. During the 1st quarter, 2019, this was 3.5%, about average.
Using the Buffett ratio, the Market Capitalization of All U.S. Equities divided by Nominal GDP: During the 1st quarter, 2019, that number was 1.85, only a bit below its record high at the end of the previous bull market at the end of 1990’s, which would be concerning. However, Buffett has cast dispersion on his own model, saying that this value metric doesn’t reflect that the inflation and interest rates are at record lows, so he is ignoring it. On the contrary, in May, Buffett remarked that stocks are a huge bargain if interest rates remain at these low rates, and rates have fallen further since his May remark.
The “misery index” is the sum of the unemployment rate and the CPI inflation rate. Currently, this number is 6%, a very low number. Thus, the forward price/earnings ratio of the S&P 500, 16.1, slightly higher than the historical average of 15, may be justified.
Under the Fed Stock Valuation Model, from 1979 – 2001, the S&P earnings yield (1/forward P/E) and the yield on the 10 Yr. treasury bond were close. That spread has been declining ever since. On August 30, 2019, the S&P forward earnings yield of about 6.2% far exceeds the 1.499% yield on the 10 Yr. bond. Either stocks are a screaming buy or bonds are grossly overvalued, or both.
Many S&P 500 stocks are below their 52 wk highs by double digits. In fact, on Monday, August 26, 2019, the number of stocks hitting new 52-week lows versus 52-wk highs on the NYSE was double and more than triple on the Nasdaq. You don’t see those numbers in an overheated market with stretched valuations.
Last week the S&P 500 dividend yield exceeded the yield on the 30 Yr. Treasury bond for the first time since 1958, which was good news for stockholders. That reversed by the end of the week, and on the last trading day of the month, the dividend yield slipped 6 basis points to 1.92%, vs the 30 Yr. treasury yield of 1.963%,
but still indicating that stocks are very cheap compared to bonds.
Thanks for reading – hopefully you have enough to make up your own mind about the fate of the market.
Well that is all I have for this month, dear readers. I hope I have been able to talk some of you back from the cliff and take a swim. Be sure to check back again next month for another thrilling edition of The Market Month That Was, and remember, knowledge is the wisest investment of all.