Flavor of the Weak: Notable End to Some Key Winning Streaks
September was a sad month, but not just for the stock market. Before I get to the business at hand, I want to pay tribute to my friend Tobias Levkovich, who sadly passed away on Friday after succumbing to injuries sustained after he was hit by a car in early September. I first met Tobias, who was Citigroup’s long-time Chief Equity Strategist, nearly two decades ago. He took on the role at Citi at about the same time as I took on my current role as Schwab’s Chief Strategist. I’ve been a great admirer of his work since then; but also his humanity, humility and humor. Tobias made me, and many of us, better strategists and will be missed by us all. Rest in peace my friend.
Onward and downward?
September closed with a whimper (from folks hoping the seven-month stretch of positive performance months for the S&P 500 would make it to eight). The month also held true to the history of September being the worst month for performance on average since the index’s inception in 1928. There were no shortage of risks conspiring to bring the market down a notch; including ongoing debt ceiling negotiations, fiscal policy uncertainty, monetary policy uncertainty (including over whether Jerome Powell will keep his position as Fed head), global supply chain bottlenecks, slowing economic and earnings growth projections, and ongoing inflation fears.
From the S&P 500’s all-time high on September 2, the drawdown through the final day of the month was -5.1%; ending a streak of 211 trading days without at least a 5% pullback—the longest since January 2018. As shown below, nearly every historically-lengthy streak without at least a 5% pullback occurred during secular bull markets (with the exception of 2004); although more than 40% ultimately turned into at least a 10% correction.
For all the chatter about “the market” having been resilient this year; that really just refers to the “benchmark” S&P 500 at the index closing level. The churn and weakness under the surface has been more significant. As of last week’s close, more than 90% of the S&P 500’s constituents have had at least a 10% correction from their highs. For the NASDAQ, it’s just under 90%; while for the Russell 2000, it’s a loftier 98% (meaning nearly every small cap stock in that index has suffered at least a 10% correction from their highs this year).
Significant breadth deterioration has been brewing for some time under the surface of the major indexes. As we’ve been highlighting since early summer, there has been a fairly steady deterioration in the percentage of stocks trading above their 200-day moving averages—including within the S&P 500, NASDAQ and Russell 2000 (first chart below). Throughout September though, there was notably more deterioration within the previously-resilient S&P 500 than either the NASDAQ or Russell 2000—especially in terms of the percentage of stocks trading above their shorter-term 50-day moving averages (second chart below).
We have also been highlighting the rapidity with which sectors have been moving in and out of favor this year, which has led to significant divergences in terms of sector-level breadth readings. As shown below, in terms of each sector’s stocks and the percentage trading above their 50-day moving averages (blue bars), there is no starker a divergence than Energy with 100% of its names above, and Utilities with 0% of its names above. Even when looking at longer-term 200-day moving averages (yellow bars), there is a stark difference between Energy’s 95% and REITs’ 94% members trading above, and Consumer Staples’ 47% trading above (second chart below).
Breadth by Sector
“Everything rally” bids adieu
Another milestone was reached as September was in its final days. The so-called “everything rally” came to an end after 290 trading days. As shown below, courtesy of our friends at Arbor Data Science, the average rolling one-year Sharpe ratio across major asset classes fell to below 1-to-1 for the first time since July 2020. As a reminder, the Sharpe ratio, developed by Nobel laureate William F. Sharpe, is the average return earned in excess of the risk-free rate per unit of volatility or total risk.
Commodities remain the lone major asset class continuing to extend an already-extreme bullish run. Since the low in March 2020, the Bloomberg Commodity Index is up 70%. This is in keeping with inflation, which continues to run hot; and has been a volatility-driver for the equity market. As shown below, although a bit off the boil, Citi’s Inflation Surprise Index (measuring how inflation data is coming in relative to expectations) remains in the stratosphere. As detailed in the accompanying table, historical returns for the stock market tend to be lower when inflation surprises are higher. Also shown though is the historical tendency for small cap stocks to perform significantly better in those high inflation surprise zones.
Inflation Surprises Easing?
In contrast to inflation having been surprising on the upside, economic data has been surprising on the downside; albeit with a slight uptick recently as shown below. As with the Inflation Surprise Index above, Citi’s Economic Surprise Index is not a measure of the level of economic data readings; but a measure of how the data is coming in relative to expectations. Courtesy of some recent and notable economic data “misses,” including consumer confidence/sentiment and payroll growth, the index remains in negative territory. As detailed in the accompanying table, historical returns for the stock market tended to be lower when economic surprises are lower.
Economic Surprises Bottoming?
Also losing steam has been the widely-watched Atlanta Fed GDPNow forecast tracked, shown below. Since the initial forecast for the third quarter of more than 6% back in July, the retreat has been fairly brutal and the forecast now sits at 2.3%—in part due to the estimate for personal consumption having been cut from 2.2% to 1.4%. As shown in the chart, the estimate is now well below the Blue Chip consensus, which oddly has accelerated in the past few weeks.
Another area of concern is around the labor market. Although job openings still exceed the number of unemployed by a hefty amount, payroll growth for August was weaker than expected. Some recent data out of the St. Louis Fed and Homebase is suggesting that there have been little-to-no job gains since August. The number of people working at small businesses fell for eight consecutive weeks during the period ending September 12 (based on a sample of ~50k businesses). A rub is that the data is not seasonally adjusted; nonetheless, the St. Louis Fed has been relying on the survey, which did correctly suggest the weaker August payroll report.
The recent trends of hotter inflation data coupled with weaker economic data are bringing back stinging memories of the 1970s era of “stagflation.” We do not put ourselves in that camp given there are presently more differences than similarities between then and now. Not only was monetary policy slow to respond to the ignition of 1970s’ wage-price spiral style of inflation; those same policymakers had overly-optimistic assumptions about the economy’s supply capacity. The government’s attempt at wage, price, and credit controls to combat inflation in the 1970s did little more than cause severe distortions. Demographics and the power of trade unions were also tailwinds at the back of inflation in the 1970s. Finally, today’s productivity is head-and-shoulders above the structural productivity weakness of the 1970s.
Regardless of the forces likely keeping stagflation at bay longer-term, we may be shifting to a higher plane for inflation in the medium term—especially if the pandemic continues to exacerbate already-severe supply chain bottlenecks. This inflation dynamic and changing perceptions about its trajectory looking ahead helps to explain the significant retreat in the correlation between Treasury bond yields and stock prices.
Relationship trouble brewing between stocks and bonds?
As shown below, for nearly the entire span between the mid-1960s and mid-to-late 1990s, the rolling 200-day correlation between bond yields and stock prices was negative. As a refresher, bond yields and bond prices move inversely. As such, when the correlation between bond yields and stock prices is negative, that means the correlation between bond prices and stock prices is positive (they move together). For much of the period since the late-1990s—and all of the time since the Global Financial Crisis—the correlation between bond yields and stock prices has been positive. But it did just recently dip into negative territory—a sustained period below the zero line might be a warning that a secular shift is underway.
Stocks Now Negatively Correlated to Bond Yields
The correlation between yields and stock prices bears watching. The multi-decade period of negative correlations spanned from the Bretton Woods era of the dollar’s ties to gold through the financial crises of 1997 and 1998 (including the Asian currency crisis and the collapse of Long-Term Capital Management). That was followed by the equity market melt-up and subsequent collapse, which ushered in the replacement of inflation fear with deflation fear. It was an environment when bond yields could rise; but because they were generally rising alongside economic growth and/or expectations—without commensurate rising inflation risks—it was also a healthy environment (generally) for equities.
The inflation we’ve been experiencing may still be transitory, even if the definition of that term is longer than many thought a few months ago. The relationship between bond yields and stock prices may hold a key to figuring out just how long this transitory “phase” is likely to persist.
One of the key reasons why pullbacks have been less prominent this year has been the dip buyers that have stepped in during each bout of weakness—particularly among retail traders/investors. Last Tuesday—the largest selloff for big tech since May—retail bought $1.9 billion worth of equities in tech/growth heavyweights. It was among the five largest net buying days since the pandemic began, according to Vanda Research. The recent trend has been for retail to buy during larger bouts of weakness—they’ve been mostly sitting out on days when the market has moved sideways. Per Vanda, that suggests that retail is not particularly thrilled about stocks right now; with only a temptation to buy dips if a “substantial” discount develops.
We are all keenly focused on the evolution of the post-pandemic economic and inflation landscape. The recent move up in inflation, and down in growth forecasts, has been driven by the combination of supply and demand shocks and dislocations. There are more questions—including about fiscal and monetary policy—than there are answers; and risk has undoubtedly risen for investors. It would not surprise me to see continued bouts of volatility and corrective phases. To date this year, the S&P 500 index itself has stayed out of correction territory; even if the churn and weakness under the surface has been notably weaker. We can’t rule out that the index plays some “catch down” to the weaker trends under the surface.
Importantly though, to be a successful investor doesn’t require you (or me) to perfectly time volatility or corrections. As I often say, it’s not what you know (about the future) that matters, it’s what you do along the way. Heed the risk/reward benefits of diversification within and across asset classes. For stock pickers, focus on quality-based factors, including strength in earnings revisions, cash flow yields and balance sheets. I continue to believe factor-based investing will serve investors better than trying to pick consistent winners among sectors or standard style indexes.
In particular, take advantage of volatility—including sector swings—by periodically rebalancing portfolios. Rebalancing is such a beautiful discipline as it “forces” investors to do what we know we’re supposed to, which is buy (add) low and sell (trim) high. Remember, neither “get in” nor “get out” is an investing strategy—that’s simply gambling on moments in time, when investing should always be a disciplined process over time.
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