Published January 25, 2019
Stocks have rebounded sharply from the Christmas Eve nightmare though plenty of fog remains for investors. You will recall that the Nasdaq 100 (QQQ) fell 12% over seven trading sessions in mid-December as thin holiday trading combined with rampant fears conspired to drive stocks downward. That plunge culminated in a 2%+ fall on Christmas Eve. From that excessive low point, stocks have bounced back, though they remain in a clear downtrend as the chart below shows (the green 100-day average line has rolled over and is trending downward, capping all rallies so far).
Needless to say, market psychology has changed dramatically in four months from the all-time highs of September to the -20% depths of a possible bear market commencement.
Recall that the basic math of stock prices is corporate earnings and dividends divided by a discount factor. The discount factor is a combination of the cost of money (aka interest rates) and perceived risk. Risk is pure investor psychology. We get a glimpse into investor risk by looking at the VIX volatility index. Nothing weighs on investor psychology like market volatility. Volatility expresses and also feeds investor uncertainty/fear. An elevated sense of uncertainty is a hallmark of bear markets. In a bear market, we note that the VIX metric does not fall below the level of 15 (the horizontal line below). It stays elevated all the time as investors never completely relax. The fog ahead is too thick for that.
In our stock price formula, rising risk raises the denominator and reduces prices. With corporate earnings at all-time highs, earnings are clearly not the problem for the stock market. The issue investors face is a sudden and dramatic increase in the perceived risk of investing. What caused the perceived risk of investing to rise so much so fast?
Rewind back to early 2017. Stock prices were entering what would be a wonderful year with large gains worldwide. The catalyst for this rise in prices was an expectation that the global economy was encountering a rare period of synchronized growth (therefore rising earnings). That this growth was occurring in the midst of low interest rates created nirvana for investors – strong earnings with minimal risk. Investors poured money into stocks pushing the market indexes sharply higher. This action peaked in January 2018 with a one month gain of almost +9% as a fresh round of corporate tax cuts would push upcoming earnings even higher.
At that point, however, risks begin to re-emerge with the imposition of trade tariffs. The tariffs unsettled an ebullient stock market. As the trade spat escalated throughout 2018, stocks still paid relatively little attention – the surge in earnings outpacing any concerns. However, come September 2018, earnings were considered to be at their peak just as the Trump Administration announced a new round of tariffs targeting China. Investors looked into the future and saw lesser earnings growth with an increased risk of global economic uncertainty from a trade war between the world’s two largest economies. The math of a flatter numerator (earnings) with a rising denominator (risk) became clear; stocks fell.
This negative narrative gained further steam in December – typically one of the stock market’s stronger months. Investors began to fear that the Federal Reserve was ignoring the escalating risks on trade. Whether impacted by the tariffs hugely or not, the 2017 narrative of a synchronized global economic boom had come undone. The global economy, and China in particular, was slowing down. Would the Fed continue to aggressively push interest rates higher in the face of this slowing global economy? In December investors suspected they would as domestic U.S. economic data remained strong. Investors also became concerned that the slowdown globally would drag down the U.S. The U.S. had been in a long but slow post-crisis economic rally for going on a full decade. Many became very concerned a recession simply had to be around the corner – all the good news was out and used up. See below how the synchronized rise in global stocks ended once the tariffs began in February with international stocks stagnant. After September, global markets returned to moving in unison, but downward this time, with the U.S. somewhat “catching up” by falling faster in December.
Rolling into 2019 investors are looking for clues about future corporate earnings growth. Have the fears of a coming U.S. recession been overblown? The Federal Reserve, for its part, has seemingly backed off its interest rate hiking crusade, making more cautious comments about the future growth of the economy. To this point, earnings have been generally ok and not as dire as some predicted. As a result, we are seeing pockets of goodness in the stock market. But the overall angst has not gone away; it’s merely diminished for now. And the downtrend remains in place. As we write mid-week, a key and much-beaten down stock market sector – semiconductors – is perking up. But we see below that the lift (circled) might not have enough oomph to clear the red line resistance and turn the trend back upward.
Hopes for an end to the trade dispute between the world’s two largest economies hold the key for the bulls as earnings growth will inevitably slow from the juiced-up level of 2018 (due in part to relaxed tax rules). For now, risks remain elevated (VIX is above 15) and stocks remain in a downtrend.
Stock investors scored a victory of sorts this week as an attempt by the bears was thwarted. After four weeks of solid gains, the overbought stock market encountered some selling in Tuesday’s return from the Monday MLK holiday. A report of weak growth in China reminded investors of the slipping global economic growth story. Stocks fell -1.4% on the day. However, the selling stopped Tuesday with investors embracing earnings from Dow Industrial components IBM, Procter & Gamble (PG), and United Technologies (UTX). The S&P 500 found support at its 50-day moving average during the Wednesday session, encouraging for the bulls. Stocks closed +0.2%. Downbeat comments from European Central Bank chief Mario Draghi and U.S. Commerce Secretary Wilbur Ross kept investors cautious Thursday. However, that caution was more than offset in the Nasdaq as semiconductor stocks finally caught a heavy bid. Surprisingly good earnings from a trio of semiconductor firms pushed the Nasdaq up +0.7%. Interestingly, semiconductor heavyweight Intel (INTC) disappointed investors after the close Thursday with a weak outlook. However, investor response was limited to that company as buyers added a second day of buying to the influential semi group overall. A deal to end the government shutdown (temporarily?) further encouraged investors Friday, as did a report suggesting the Federal Reserve might be nearing an end to its program of ‘normalizing’ its balance sheet. That normalization effectively takes money out of the bond market thereby reducing liquidity. Stocks pushed higher by +0.9%.
After an early selloff to clear the overbought market condition, stocks spent the rest of the week holding firm. The S&P 500 (SPY) closed with a relatively flat -0.26% weekly move. The Nasdaq 100 (QQQ) held at -0.06%, as did the Russell 2000 (IWM) at -0.05%.
Warm wishes and until next week.