Weekly Update

The Storm Below the Market’s Surface

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Published October 8, 2021

Markets have clearly been gripped by uncertainty over the past month as interest rates have risen while concerns about government funding and China have called into question the trajectory of the economic recovery. Below is a portion of an excellent overview from Schwab’s Liz Ann Sonders on the noisy information facing investors these days.

“September closed with a whimper, if you look to folks hoping the S&P 500 would make it to eight straight winning months. The month also held true to its history of 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%. That ended a streak of 211 trading days without at least a 5% pullback—the longest since January 2018. As shown below, nearly every lengthy streak without a 5% (or greater) pullback occurred during secular bull markets (2004 being the lone exception. More than 40% of those declines ultimately turned into at least a 10% correction.

There has been plenty of chatter about “the market” having been resilient this year. But that just refers to the S&P 500 at the index closing level. Under the surface, the churn and weakness has been much 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).

Longest streaks without 5% correction in S&P 500
Source: Charles Schwab, ©Copyright 2021 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at http://www.ndr.com/copyright.html. For data vendor disclaimers refer to http://www.ndr.com/vendorinfo/, as of 10/1/2021. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.

Significant breadth deterioration has been brewing for some time under the surface of the major indexes. There has been a fairly steady deterioration in the percentage of stocks trading above their long-term 200-day moving average trendlines—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 medium-term 50-day moving averages (second chart below).

Bad Breadth

Deterioration in the percentage of stocks trading above their long-term 200-day moving average trendlines

Deterioration in the percentage of stocks trading above their long-term 500-day moving average trendlines
Source: Charles Schwab, Bloomberg, as of 10/1/2021. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.

Stagflation redux?

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. 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 (stocks rise as interest rates go up). But that relationship just recently dipped into negative territory for the first time in almost 15 years. A sustained period below the zero line might be a warning that a major shift is underway.

Stocks Now Negatively Correlated to Bond Yields

Stocks Now Negatively Correlated to Bond Yields
Source: Charles Schwab, Bloomberg, as of 10/1/2021. Correlation is a statistical measure of how two investments have historically moved in relation to each other, and ranges from -1 to +1. A correlation of 1 indicates a perfect positive correlation, while a correlation of -1 indicates a perfect negative correlation. A correlation of zero means the assets are not correlated. Past performance is no guarantee of future results.

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.

In sum

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.”

Here at TimingCube, our take-away from the above is that having a model-driven long/short strategy such as ours is the best solution for this type of choppy, uncertain environment.

Market Update

Stocks kicked off the week with heavy losses as rising interest rates continued to damage leading tech/consumer stocks. The Nasdaq 100 (QQQ) slid -2% in Monday’s trade. The index recouped half of that loss Tuesday as investors still are generally buying dips in stock prices. Energy prices rose again, which, when combined with hikes in wages and tight housing supplies, are fomenting more pronounced inflation fears. Sellers emerged to drive stocks down early Wednesday before an afternoon rally brought indexes back to a positive +0.4% close. The heightened volatility comes as investors await the beginning of earnings season and companies offer insight into the extent of supply shortages. Further adding to the uncertainty has been the usual back-and-forth around the debt ceiling in Congress. Thursday gave investors marginally happy news on this front as the nation’s legislative body agreed to a temporary resolution. The news sent stocks upward by +1% Thursday. Friday delivered the monthly jobs report. The report was a disappointment with the increase in jobs fully half of what was expected. Nevertheless, the report was viewed as being within the range acceptable for the Fed to begin reducing bond purchases. Interest rates ticked higher once again as a result. The rise in rates pressured growth stocks which headed down throughout the day.

Stocks rose on the week though their overall downtrend remained in place. The S&P 500 (SPY) ticked up +0.79% while the Nasdaq 100 (QQQ) was essentially flat at a +0.26% change. Smallcaps (IWM) slipped -0.18%. Also of note, the rising U.S. dollar has pinched international stocks, which added a fifth consecutive weekly fall this week.

Warm wishes and until next week.