Published November 4, 2016
Last week’s market summary noted that stock investors were looking for earnings to light a fire under the bulls and deliver stocks to new high ground, a spot the Nasdaq Composite index had visited for one day early in that week. Since that new high for the Nasdaq, it’s been nothing but badness for stocks with the S&P 500 index logging a rare eight straight down days.
The reason given most often for the tumble was a sudden turn of polls in the U.S. Presidential election. Mid-last week, Hillary Clinton held a commanding 80% or so probability of being elected according to multiple sources. Upon the surprise announcement by the FBI that they had further emails perhaps related to Ms. Clinton’s case reopened uncertainty surrounding the election and put the stock market in a tizzy. Ms. Clinton’s probability of winning dropped over the course of a week from that 80% down as low as 65% before stabilizing. While investing based on elections is proven to be a horribly losing strategy, the sudden surge of uncertainty in the election unnerved investors who were previously not worrying about it. The stock market has shown a strong and clear preference for Ms. Clinton if only due to her long time in public service – e.g. she’s a known quantity and therefore more certain and less risky in the market’s view.
The volatility (fear) index spiked higher, reeling off a record nine consecutive days of increased fear as market participants bought insurance to buffer against a falling market. As investors fled risk, smaller company indexes like the micro-caps sold off hard and steady. See Chart 2 below an update of the chart we posted in August as this group broke higher in an attempt to manage a fresh uptrend – now failed.
Chart 2: Microcap (read: high risk) stocks stumble
While investors fled risky assets, one previously maligned sector held firm. Financial stocks, beneficiaries of higher interest rates and a steeper yield curve, showed little impact from the market’s woes, holding their August breakout. Chart 3 below is an update of the chart we presented in August – interestingly this chart was presented alongside the microcap breakout chart above, now showing the divergence in market sentiment.
Chart 3: Financial stocks hold firm
Additionally, emerging market stocks, while feeling pressure from an upwardly moving U.S. dollar, have also held above their breakout point – just barely thus far.
Chart 4: Emerging markets hoping for support
Stocks have been weak, or rather not-strong, since their breakout in July. The Nasdaq index had become the only index left standing near new highs as all the other indexes retreated. This past week the dam burst somewhat and all the stock indexes came tumbling down. If the move were only due to the election, then we will see a sharp recovery if Ms. Clinton prevails. However, it appears there is more to this pullback as earnings, though generally good, have not been enough to encourage investors. We would note that the transport index (symbol: IYT) logging a rare eight straight down days. sits near recent highs when earlier in the year it was a notable laggard. Economic growth looks to be steady and fine having just printed a +3% GDP. Wages in the most recent employment report are now solidly rising (+3%). Interest rate hikes look to be mostly understood and accepted by the market now with rates having made their adjustment higher in recent weeks. What if markets stabilize post-election after coming to realize that the economy just might be at a point where it no longer needs the Fed’s support? If the market comes to that conclusion, new highs will be achieved and all of the angst we’ve seen this week will have just been a long-awaited pullback. As always with the markets, the question is if this narrative takes hold, or some other surprises await.
What is a good indicator of a coming recession?
Investment folks often look at the spread between short-term and long-term interest rates. Normally, long-term rates should be higher to compensate investors for the longer time of the investment. Investors want more compensation in the form of higher interest rates as the longer time frame allows for more things that could happen to cause risks as well as longer impact of inflationary forces. This compensation between short and long-term investments is measured by the spread or difference in interest rates between short-term bonds, say 2-year bonds, and longer-term bonds, say 10-year bonds. Short-term rates will rise as the economy strengthens and particularly when the Fed is raising rates in an effort to slow the economy down. If this short-term rise in rates gets to a point where the short-term interest rate equals the long-term rate, then the spread has gone to zero. That zero spread or difference in rates often presages a recession. Chart 5 below shows that the spread in short-term and long-term rates, while narrowing lately, is still very far from zero (shown on the Chart 5 below as 1.00 or parity between the rates).
Chart 5: Spread in interest rates still substantial
2-yr/10-yr Treasury yield ratio provides a recession signal almost a year in advance of a recession.
Market Update
Another Merger Monday kicked off the week in stocks with a variety of companies tying the knot. Why now for this sharp spike in mergers? Interest rates have started rising making the cost of funding higher. Stock prices tend to rise in November/December making the cost of mergers higher. Those are just two of the financial inputs to such a decision, which may or may not have influenced any of these particular tie-ups. General Electric merged its oil and gas business with Baker Hughes, for one, while Centurylink and Level 3 combined in the communications/tech space. Speaking of oil and gas, it was falling oil prices that helped keep stocks off-kilter this week as OPEC failed to solidify a production agreement.
Stock indexes were flat Monday to close a losing month of October. November opened no better with a -0.7% slip as Pfizer reported poor earnings and a poll showing Donald Trump ahead unnerved markets who had recently been fully expecting a Clinton victory. Oil prices and election concerns continued into Wednesday taking another -0.6% off the market while ongoing weakness in biotech took a bigger bite out of the Nasdaq. Biotechs suffered another -3% Thursday on word of pricing investigations being launched by the Dept of Justice. That news combined with a tepid outlook from Facebook to keep pressure on the Nasdaq. Oil continued falling this time on disappointing inventory data. Thursday added an 8th consecutive losing session for the S&P with the index giving back -0.4% but leaving the index on its 200-day support level. That level proved beneficial through Friday morning as indexes bounced at the open and ramped up through midday on a solid monthly jobs report that featured strong growth in wages. But investors showed little interest in holding stocks through the weekend, presumably waiting until after the election before returning to the market in earnest. After being up about +0.5% stocks cratered in the final two hours to a -0.2% finish. It was the S&P’s 9th consecutive down day; its longest losing streak since 1980.
Warm wishes and until next week.