FOOLS RUSH IN WHERE ANGELS FEAR TO TREAD
- Moderate returns for U.S. equity markets in Q3
- Whenever the market seemed poised to breakout the Fed talked it down
- Historically quiet quarter from a volatility point of view
Fool me once, shame on you. Fool me twice, shame on me. Fool me three or more times and now you’re imitating Janet Yellen and her brigade of Fed governors during Q3 of 2016.
The third quarter began on the heels of a mini-rally brought on by the fact that the financial world didn’t come to an end as predicted when the Brits voted to “go” in the “Brexit” referendum. And it closed on a mini sell-off when somebody leaked that the U.S. government was going to levy a $14 billion fine on undercapitalized Deutsche Bank, allowing market participants’ imaginations (memories?) to run wild picturing a replay of the final dark days of the once-proud Lehman Brothers Investment Bank.
The U.S. equity markets advanced a little more than a percent each of the three months of Q3
Reality turned out to be not so dramatic. Sandwiched between these two mini price movements were three months of watching paint dry.
One of the reasons its growth was so muted was the interference of its central bankers where it seemed that every time the market looked ready to break out, either Yellen or one of her minions would step to the mike to “jawbone” the thing down. It was like they had all shorted the market to finance their office Christmas party.
First there were Yellen’s comments shortly after Brexit that she was “relaxed” about the ramifications of Great Britain exiting the E.U., remarking that the case for a rate hike was “getting stronger” thereby throwing ice water on the building bonfire. Then there she was in late August, lounging around an upscale resort in Jackson Hole, Wyoming, with a cadre of fellow central bankers remarking that the case for a rate hike had “strengthened”. Down went the markets.
In early September, it was Ms. Yellen’s minion, Boston Federal Reserve President, making similar comments from that well-recognized financial hub, Quincy, MA. Again, any nascent stock rally was smothered in its crib.
And, finally, it was the Fed’s Open Market Committee Meeting (FOMC) on September 20-21 that served as the backdrop for the Fed Chairman to reinforce her favorite message.
The funny thing was that – just like all the previous times – no sooner had the proclamation left her lips, then there arrived a piece of hard data that proved how bogus her statement had been.
In this case it was the August non-farm payrolls that limped in at 151,000 when 180,000 new jobs were expected to be reported; immediately, anybody who could count knew there’d be no rate hike this time around.
The lack of volatility throughout the summer proved that the “Boy Who Cried Wolf” effect was fully in play
August saw 38 days in a row where the broad market index, the S&P 500, didn’t move more than 1% in either direction – a record going back to the summer of 2014. Even more telling, for 17 straight days in August the benchmark didn’t vacillate ¾ of 1% in either direction – that was a market record going back to 1970. August traded in a range of 1.54%, the tightest month in 21 years.
This only proves that during the summer post-Brexit, just as in the case of the boy who ended up as wolf-food, the villagers were no longer believing the message.
Even in September when Mr. Rosengren and she were doing their damnedest to spook the market, the best they could do was to push the “fear index” (the implied volatility index called the VIX) up to its historical mean of about 20. Even then it couldn’t stay there very long before reverting to the more quiet levels seen all summer.
As much as the equity markets barely moved during the period, it doesn’t mean nothing happened sector-wise. Under the surface, in fact, quite a sizable sector rotation was taking place – from the stalwart, defensive, “risk off” sectors like Utilities (-5.9% for Q3), and Consumer Staples (-2.6%) which had been the solid anchors for the portfolio during the first risk-filled weeks of the New Year, to the more economically-sensitive, “risk on” sectors like Technology (+12.9% during Q3), Industrials (+4.1%), and Materials (+2.9%).
Like an orphan-sector rejected by its sponsor, Fed Chairwoman Yellen, Financials were a story unto themselves
All that talk about rate hikes coming from the senior central banker in the land brought an early positive spotlight to the Financials Sector, the one area most levered for success in a higher interest-rate environment. Yet when actual rate hikes never materialized, stock players dropped the sector like a bad habit as exemplified by its -1.4% return for the month of September. Some of the damage was caused by the high profile blistering that big name brands like Wells Fargo and Deutsche Bank took during the period.
Considered “ground zero” for the 2008 economic and stock market meltdown, Financials are the one sector that has yet to recover to its all-time high prior to that event. While Technology is more than 100% higher and Consumer Discretionary and Consumer Staples are approaching the 150% milestone, drab and dreary Financials are still 20% under their market peak of October 2007.
Many observers blame new regulations in the brokerage and banking industries as a consequence of the events of 2008 as the ultimate cause for this lag.
Now along comes a “classification event” to shed a little light on the subject. The governing board of the Global Industry Classification System (GICS) that determines how stocks, their industries and sectors should be classified has decided that the Real Estate Investment Trusts (REITs) should be their own sector. (Prior to this they were classified as a number of “industries” representing an “industry group”, a subset of the Financials Sector. These things are determined by a number of factors including correlations across constituents.)
During the third quarter the REIT stock holdings were jettisoned from the Financials sector forming their own stand-alone sector; this action only further highlighted what has gone on in Financials over the last few years.
Net of Energy, where the slashing of oil prices has wrought havoc on the sector since 2014, Financials have been the worst performing sector over the last three years. With the exodus of the REIT securities it becomes increasingly clear how much the successful REIT stocks have been hiding the real damage of the “pure play” financials, especially in the banking and insurance industries.
The aggregated Financials sector reported roughly an +8% return over the last two years, and Real Estate weighed approximately 20% of the sector. With the REITs stripped out, the remaining Financials have returned +3-4% over the last two years; meanwhile, the REIT sector has returned approximately +26% over that same period.
The good news going forward is that the “new” Financials sector trades only 13.1 times earnings vs. the “old” sector’s multiple of 14.2 times. Some industry components of the new sector trade at even greater discounts – namely banks and integrated financials which trade at 10 and 13 times earnings respectively. Conversely, the new REIT sector now trades roughly 30 times forward earnings. Officially, for the third quarter the Financials Sector returned +4.6% while REITs lost -2.1%.
At its essence, the equity markets can be boiled down to two elements: what a company makes – its earnings – and how a company is valued – its multiple (or P/E – priced earnings ratio.) After eight and a half years since the bull market in equities began in March 2009, stock prices are generally trading at high multiples any way you measure it (18.5 times forward projected earnings or 19.5 times trailing.) These multiples are arguably sustainable for as long as a) interest rates remain low offering nowhere else for investors to go especially for yield and b) earnings in 2017 are going to be better.
The latter tidbit may ultimately determine the success or failure of domestic equity markets over the near term
Largely driven lower by the fallout from a year plus of lower oil prices, the U.S. has been in what has been dubbed an “earnings recession” for over six quarters. Now that oil has bounced nearly 80% from its bottom, relative to earnings for the Energy Sector – and by extension the rest of the market – analysts are rapidly becoming more optimistic.
Whether the actual numbers keep up with the lofty expectations will determine whether October and beyond will be happy months or if the VIX will surge to new levels indicating that all is not right in Bedrock.
In keeping with the “risk on” theme for equities in Q3, Small Cap out performed Large Cap and Growth outperformed Value. Internationally, developed companies (as represented by the MSCI EAFE Index) outperformed our S&P 500, +6.4% to +3.9%. The more risky Emerging Markets had a strong quarterly performance returning +9% for the period (nearly +40% annualized). Year-to-date the MSCI Emerging Markets Index is up +16%; the MSCI EAFE is up +1.7% and the S&P 500 has advanced +7.8%.
During the summer doldrums, the S&P 500 closed within 1% of its all-time high for 44 days in a row, the most since 48 in a row in 1995. One of the interesting facets of this fact is how you would never know it talking to money managers both institutional and retail. They, like most investors, are feeling the acrophobia that comes with all time highs – accompanied by all time high valuations. This dichotomy – where investors need to be in the market even though they want to be out of it – is what unemotional, rules-based, risk-managed asset management was built for. The good news is that algorithms never get a fear of heights.
This quarterly market recap is offered for informational purposes only as a review of current and historic economic and market events; no discussions or comments herein are in any way intended to be forward-looking or predictive and nothing should be interpreted that way. Although all data, information, inferences, and conclusions found within it are based on information derived from reliable sources, in no way can ARS or anyone else warranty its accuracy in any way. Also, in no way does this blog offer investment advice and nothing within it should be taken as such. At no time should this document be considered an endorsement for any investment product, methodology, philosophy, or index and always remember that indexes are not investable and most investment returns include fees whereas most indexes do not.