Bedrock’s Newsletter for Friday 12th of October, 2018
12 October 2018


 Friday, 12th of October 2018

Hurricane season is clearly not over… As a natural one slams into the Florida panhandle, another, man-made storm slams into Wall Street (and then everywhere else). Whilst we have some understanding as to hurricane formation and timing, we really pain to explain the man-made ones which often show their strength in the month of October…


Big drops in the stock market like we saw this week, with the S&P 500 Index plunging as much as 5.90% over the course of Wednesday and Thursday, naturally spark a lot of angst. Is this the start of a bear market? Is this a repeat of 1987? (Yes, there are those comparisons going around.) Buy the dip or sell the bounce? Are stocks cheap or are they still expensive? Spoiler alert: you can find credible measures to support whatever bias you may have. Cutting through all the noise, the thing to know is that such sell-offs, while painful, are normal and that it pays to hang on. After the S&P 500 plunged 4.10% on Feb. 5, DataTrek Research crunched the numbers and found that declines of 4% or more on a single day have happened 41 times in 59 years. That’s an average of about 0.7 times a year. So, while Wednesday’s drop of 3.29% and Thursday’s 2.06% drawdown each fell a bit short of the bogey, taken together they are enough to say it has happened twice this year — and we can take a look at what usually follows. According to DataTrek, although the S&P 500 is generally flat in the month following a big plunge, over the next year it has been up an average 20.1%. The point here is that the stock market is extremely resilient. Yes, currently there seems to be an abundance of headwinds facing equities, from trade wars and rising interest rates to $1 trillion budget deficits, but there are always plenty of obstacles facing equities.


The bull market in stocks that began in March 2009 is now the second-longest on record. About the only thing that ends a bull market is a recession, and economists aren’t forecasting one of those until 2020.


This week’s first two auctions of coupon-bearing notes by the U.S. Treasury Department were kind of a dud. Demand for the three- and 10-year notes were below the average of recent auctions based on the number of bids investors submitted relative to the amount offered. That’s despite yields being at the highest in 11 years. Suffice it say that there was not a lot of optimism heading into Thursday’s sale of $15 billion in 30-year bonds. Rather unexpectedly, it was a hit. Investors submitted bids for 2.41 times the amount offered, the most for that maturity since January. That helped push yields lower for the third straight day, the longest such streak since August. To be sure, this is unlikely to mark a turning point for the bond market. For one, there’s more talk among traders about the U.S. government’s bulging debt and budget deficit, which is becoming more expensive to service as the Federal Reserve continues to shrink its balance sheet. Treasury Department data show the U.S spent a record $523 billion on interest expense in fiscal 2018 ended Sept. 30, up from $458.5 billion in fiscal 2017. As recently as fiscal 2015, the amount spent was just $402.4 billion!


There is a confusing misalignment amongst the principal financial markets- some are saying that the week-long rout in equities is normal, as we are now at the turning point in bond yields. It is “normal” that equities get re-priced down as bond yields rise (our theme of last week), but when we look at the bond markets, we see that yields actually dropped this week with the US 10-year Treasury now at 3.17%. Oh, but some will say that we should look rather at the short-term rates, but then, the FX trading world which looks at short-rate differentials is dumping the US Dollar again, in contrary positioning to their mantra- The DXY is back down at 94.76 having touched 97 in mid-August. What is wrong in this equation? Is it that finance ministers and central bankers from the International Monetary Fund’s 189-member nations are gathering in Bali, Indonesia, on Friday, but don’t expect it to be a joyous affair. Economic policies are diverging more so now than at any time since the financial crisis a decade ago. The Fed is away ahead of its counterparts in major economies in returning interest rates to more normal levels. That’s helped bolster the dollar, sparking criticism from officials in emerging markets that the U.S. central bank is moving too fast and causing havoc in their economies. Also, the U.S. and China are locked in an escalating trade war. The European Union worries that it may be the Trump administration’s next target. As such, tensions are likely to be higher than usual, as are the odds that some officials may inadvertently say something that moves markets or causes even more bad blood.


The US$ yield curve is flattening further, Dollar is soft and the VIX (the fear index), well the VIX rocketed-up this week through 24 (a huge jump!) but not as scary as the spike to 41 in mid-February this year, during our previous “market-scare”. WTI oil prices tracked equities this week, falling back to $71.50 or so from almost $78 at the start of October… What is going on here? We start the run of Q3 earnings today. Will the truth of the underlying strength of the economy outshine investor panic and trading algorithms gone haywire? Well, Friday morning we see Asia reconsidering the need for a fall, Europe ticking back up and US futures implying an open some 2% upwards. Thursday saw stocks tank in markets around the globe. Asia-Pacific indexes like the Shanghai composite fell 5% while the pan-European EuroStoxx 600 Index hit its lowest in 20 months. The sharp decline has raised concerns that trade tensions and rising interest rates could contribute to the end of the bull market – the current state of trading where stock prices are steadily rising. Paul Donovan, chief economist for UBS, told CNBC that Thursday’s tremors would not have a long-term impact, dubbing the recent challenges for investors as mild constraints that were “not that important economically.” The analyst claimed that for anyone who was in the market in the 1990s, it was clear that current bond yields were not going to cause significant damage. “In real terms we adjust for inflation,” he noted. “You’ve barely got positive real rates — this is not, economically speaking, a significant constraint. I don’t think this is the end of a bull market, I think this is noise.”


The sell-off this week isn’t the start of a major or prolonged bear market, but rather, simply a correction, experts said on Friday. Despite those moves, financial services firm Barings said in a note that there’s no cause for panic yet. That sentiment was echoed by asset management firm Amundi, which said that the “bear checklist is not yet flashing red.” “Economic indicators are still sound with growth above potential albeit slowing also in the US, while on financial market indicators, the picture is more scattered but not scary,” Amundi experts said in a report. Shane Olivier, head of investment strategy at AMP Capital, said “history tells us” a major bear market requires a recession in the U.S., but that is not happening. Barings suggested that markets are reacting “emotionally,” with U.S. President Donald Trump saying the Fed was “crazy” for continuing to raise interest rates, and tensions with China getting worse after a speech by Vice President Mike Pence.


We side with these views and suggest we keep in mind that these falls, albeit dramatic to watch, painful to compute, come after a huge and long run-up of many years. The S&P 500 last ‘all time high’ dates back barely ten days… We hate the wiggles as much as anyone out there and dare hope and expect a settling down into the to be announced earnings, a true economic catalyst for P/E ratios’ expansion. Back to the highs? Maybe new ones around the corner of October? The S&P had a high at the end of January of 2’872, fell dramatically by 10% to 2’581 within ten days. Only to rise to a series of new all-time highs through September. Like back then, nothing happened and 8% were wiped out. We think we are just re-experiencing February in October.


Unless the Hemline adage is true… Fashion shows are showing a lengthening of skirts, and this predicts a lower stock market… Who knows…




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