The volatility in recent weeks in the equity market may be leaving investors uncomfortable. Combine that with mixed economic data and a bear market in crude oil and investors are left with many questions. We tried to offer answers to some of the frequently asked questions:
What has spurred the recent volatility? If we need to pinpoint reasons, we could highlight lower guidance from tech companies or regulation concerns surrounding social media. This hampered the momentum trade as the FAANG stocks (i.e. Facebook, Apple, Amazon, Netflix, and Google) have fallen in or near bear market territory. Other factors contributing to the weakness include; the bear market in crude oil that has sparked concerns about global growth. The rise in interest rates dragging on housing. Fears of the debt bubble bursting as high yield spreads climb to a two-year high. Concern that the Fed may be too aggressive and the ongoing trade fears as we approach the crucial G20 meeting this weekend.
Is the pullback signaling a recession? While the peak in economic growth likely occurred this year, it does not mean a contraction is imminent. Our base case remains that the next recession is likely at least 12 months away. Manufacturing is still expanding, the labor market is strong, the consumer has been resilient and business confidence is still near a record high.
Will volatility impact the Fed? We believe the Fed will hike rates at its December meeting. Inflation has reached the FOMC’s target for 2018 (2.0%) and their 2019 target (2.1%) looks plausible. However, we are not convinced that the Fed will raise rates 3-4 times in 2019 as some predict (and Fed dot plots show). We believe 2-3 is more likely.
What are technicals telling us? From a contrarian perspective, this 6% pullback did not cross into “oversold” territory (S&P 500 RSI below 30). It did get close (low of 35) but did not approach levels like were seen in the Sept/Oct pullback (RSI fell below 20). On Friday 11/15, the S&P 500 50-day moving average crossed below the 100-day and the Index has been below its 200-day for 22 out of the past 25 trading days, suggesting the potential for further weakness.
What is working, what is not? Those equities that were pushed higher for most of 2018 driven by momentum and complacency have fallen the most. Technology lost 11% in the Sept/Oct pullback and another 10% in this one. In addition, an iShares Momentum ETF is negative YTD after rising 16% prior to the Sept. pullback. Growth has suffered in both pullbacks while value has fallen less.
Verdence view on recent volatility. At this time, we feel comfortable with our current positioning (slight overweight equities with a bias towards international vs. U.S.) and would remind investors volatility is normal. Valuations do not look cheap enough to justify making changes to allocation currently. The forward S&P 500 P/E is trading on its historical average and we would like to see that fall solidly below before adding is compelling. There is also room for growth to fall further which has been impacting the broad market. If you look at the Russell 1000 Growth/Value it is still trading two standard deviations above its historical average. While we will evaluate periods of weakness, our base case has not changed. At this stage of the cycle, investors should focus on international vs. U.S., value vs. growth and active vs. passive investing.
Source: Data as of November 26, 2018.
Footnotes: Bloomberg Finance LP, Verdence Capital Advisors.