For the week ending September 27
This publication is provided by BMT Wealth Management.
Stocks stumble on political headlines, but likely remain resilient given subdued investor sentiment
U.S. stocks were down for the second week in a row as mixed trade headlines and impeachment concerns further slowed the market’s upward momentum. Encouragingly, even as stocks approached all-time highs earlier in the month, investors remained skeptical as evidenced by numerous survey-based measures as well as defensive fund flows. Too much optimism is typically a bad sign for future market performance, and investors are nowhere near exuberant. We believe the combination of politically driven volatility, cautious investor positioning, central bank accommodation, and still stable economic data creates a market environment in which both upside and downside may be limited as we approach 2020. Given that the S&P 500 has produced a year-to-date total return of nearly 20%, a rangebound market in the near-term is hardly a poor result.
We continue to believe the odds favor a continuation of the economic and market cycle, but we must also acknowledge the heightened chance of periodic volatility. In such an environment, investors should fight the urge to panic (for example, the fourth quarter of 2018), but also be diligent about ensuring portfolios are properly balanced and that asset allocations accurately reflect intended levels of risk.
Economy more important than impeachment. With potential impeachment proceedings dominating the headlines, we would focus more closely on trade negotiations and the upcoming presidential election. Based on both the Nixon and Clinton impeachments, the market will likely be more focused on things that directly impact the economy. Markets struggled during Nixon’s impeachment, but that was amid an ongoing bear market, large spikes in inflation, and dollar volatility as the Bretton Woods era ended. Similarly, the Clinton impeachment coincided with some short-term market stress, but stocks ended up 27% in 1998. Our view is that the risk of impeachment has risen, but there is unlikely enough support in the Senate to remove Trump from office.
As it relates to trade, Trump’s approval rating has been positively correlated with China trade de-escalation. This is important because a president’s approval rating is roughly the percentage vote that can be expected during a re-election. The President knows this, and it will likely influence trade negotiations as the election heats up. Finally, it was reported that the administration is considering the removal of Chinese listed companies from U.S. exchanges. Thus far, the mechanism by which this would occur is unclear, and although we believe implementation is unlikely, investors should understand potential implications. In this case, MSCI indexes have systemically increased the percentage exposure to China in recent years. The popular iShares EEM emerging markets ETF, for example, is now approximately 40% China. Even if investors don’t hold individual Chinese stocks, being comfortable with one’s overall exposure via other investment vehicles is important when assessing the overall risk of a portfolio to this particular event.
A lack of investor enthusiasm should provide support. Major market tops are most often associated with bullish positioning and optimistic investor sentiment. In other words, investors often get most optimistic at exactly the wrong time. The American Association of Individual Investor (AAII) survey measures the spread between bullish and bearish respondents. Preceding major market tops in 2000, 2007, as well as before significant sell-offs in 2011, 2015, and 2018, the AAII bull-bear spread was at or above the 90th percentile – with bulls outnumbering bears. Today, even near all-time market highs, the spread remains below the long-term historical average (Chart 1). Further demonstrating the current lack of investor enthusiasm, in August passive U.S. equity funds saw approximately $900.0 million in outflows while active U.S. equity funds had $18.9 billion in outflows. Further, Commodity Futures Trading Commission positioning –a good proxy for hedge funds – is still running net short. Subdued sentiment does not rule out additional corrections, but we do believe it limits the near-term downside.
Chart 1: Bears Outnumber Bulls: even near all-time highs, bullish sentiment is below average.
AAII Sentiment Survey, Bull-Bear Market Spread, Percent – United States
(6/29/1989 – 9/27/2019)
Source: FactSet, Inc.
Late-cycle, not end of cycle. For now, the U.S. consumer looks healthy and credit markets are not stressed. As evidence, U.S. initial unemployment claims remain extremely low, consumer confidence measures have eased but have not fallen sharply, and senior loan officer surveys have not exhibited the tightening in lending standards typically associated with recessions. Given this backdrop, it is difficult to assume an imminent economic contraction. Last week, the final reading for second quarter GDP came in at a solid 2.0%, and the University of Michigan Consumer Sentiment Index remained elevated, increasing from the previous month’s reading. In our view, while slower growth is probable in 2020, a recession is not. As the deepest and most protracted bear markets have historically been associated with recessions, we are not inclined to recommend an overly defensive posture in portfolios at this stage.
Follow the leader. So far in 2019, it has been growth and defensive areas of the market leading the way. Two weeks ago, we saw a brief rotation into value and more cyclical sectors, but that proved to be short-lived. We believe value investing will continue to provide a return premium for those able to take a long-term view, but growth plus defense is likely the proper playbook until we see clear evidence of an economic reacceleration. Indicators we track point to a potential bottoming in cyclical economic data in early 2020 (Chart 2), so we will continue to closely watch this data for clues of a more durable leadership rotation.
Chart 2: Looking for a Bottom in Manufacturing: as lower interest rates impact the economy with a lag, we should see a bottoming in things like manufacturing PMI early next year. This could coincide with a more sustainable shift in sector and style leadership.
Comparison of ISM Manufacturing PMI Index & Two-Year Change in 10-Year Treasury Yield
(6/29/1989 – 9/27/2019)
Source: FactSet, Inc.
Change in interest rates – green line – lagged 18 months