Monthly Market Update- August 2019
’30 Days hath September, April, June and November…..’ I think we all remember that little calendar ditty from our childhood. If July had only 30 days, my first paragraph would have been the following –
Nobody should have any complaints over portfolio performance this past month. Stocks did just fine in July with a fully diversified equity portfolio up about 2%. Not surprisingly given the ongoing economic weakness in Europe, U.S. stocks did the heavy lifting in the month, as the S&P 500 rose 2.5%. Within the S&P, it was the largest of the large that really drove the index. Riding strong earnings reports, Apple soared 10% and Microsoft rose nearly 6%. Big new highs through round-number index levels were surmounted – the Dow Industrials rose over 27K and the S&P 500 sailed over 3000. It was a month of relative blissful serenity, with not one trading day resulting in even close to a 1% move, up or down. In fact, we haven’t seen one of those since early June.
However, July hath a full 31 days, and though the Federal Reserve did as widely expected with its 0.25% cut announced at 2PM on July 31, traders took some degree of umbrage at perhaps not getting even more and sold down stocks significantly. Whether this continues into August or is just a 90-minute end-of-month anomaly will only be known tomorrow and beyond.
I will now return you to the ‘regularly scheduled programming’, i.e., the note already written and fully ready to go by 1:59PM. You will note my ongoing degree of skepticism, which I have been referencing in prior Updates.
In addition to that continued ample supply of liquidity I discussed at length in last month’s Update, there were a number of factors that contributed to the positive performance for stocks in July.
Let’s start with the U.S. economy.
Aggregate activity as reflected in the official data is fine, especially those data series that measure all-things-consumer. Though arguably lagging indicators to some degree, the employment numbers were solid all through June and well into July. More jobs means more consumer spending, and the ongoing retail sales data, in-store or on-line, has been very strong. Interest rates were already low and just went lower. Housing starts and homebuilder sentiment are up. Gasoline prices remain at 12-month lows. So it’s no wonder that the Conference Board’s Consumer Confidence Index, reported yesterday morning, soared to its highest level in the current 10-year up-cycle, auguring for even further strength. Since the consumer makes up about 70% of GDP, all this is good, at least on the surface.
Let’s talk China trade.
No, there’s been no progress and this morning came a report that this week’s talks in Shanghai ended abruptly, perhaps with some degree of contentiousness, but it is now viewed by Wall Street as purely a political sideshow. The stop-and-go, hurry-up-and-wait nature of the prior talks, plus the ongoing bluster by various policymakers in the meantime, had already made it impossible to develop any kind of conviction about it…but now it doesn’t matter to Wall Street. Maybe it will later.
There’s also no real concern about Second Quarter (of 2019) earnings reports, so far anyway. Yes, they’re better than expected but they’re always better than expected. Future guidance is only so-so but that’s also always the case, and the stock price performance dispersion around the earnings ‘surprise’ is pretty much ‘standard operating procedure’ where a ‘beat-and-raise’ is rewarded modestly (Apple being the exception that proves the rule) but a miss is punished severely. With about half of U.S. companies already in, so far, so okay…and that’s better than it could have been.
Debt ceiling and federal budget agreement.
It was reported last week that Congress and the White House came to a debt ceiling and federal budget agreement, essentially postponing any real contentiousness over fiscal policy until July 2021. It has already passed the House and is due to be passed by the Senate later this week. Market-wise, it’s nice to have this off the table, since a bitterly partisan refusal to agree on either was the major catalyst for the mini-bear market during the summer of 2011.
Second Quarter 2019 GDP
Now let’s cast a more weather-wary eye. Last Friday’s first look at Second Quarter 2019 GDP showed only a 2.1% annual growth rate, down from the 2.5% forecast and well below that from the year before. Furthermore, there were quite significant downward revisions to a number of prior quarters, reducing the actual 2018 growth rate in GDP to 2.5%, versus the 3.0% originally reported. As all college economics majors know very well, GDP is made up of C (consumption) + I (corporate investment) + G (government spending) + NX (net exports). The G has also been up and up and the NX has only been a modest incremental negative. Since we already know how explosively strong the consumer side has been, it’s pretty simple to connect the dots to a significantly weaker corporate environment. Net trade, inventories, capital spending – all took hits. A Midwest measure of manufacturing activity fell in July to its lowest level since late 2015.
With a tighter and tighter labor market finally exerting wage pressures, so did profit margins, and it’s the direction of profits that really make a difference going forward. Accordingly, even as today’s consumer confidence is roaring, corporate CEO confidence has sagged. Every mid-cycle slowdown and every recession begins on the corporate side and then eventually spreads to the consumer. Maybe today’s relative corporate weakness is a temporary phenomenon that can be reversed in fairly short order. Certainly today’s Federal Reserve action to cut its benchmark short-term rate is targeted to that end. Maybe, but maybe not.
So now let’s look at the markets.
Yes, the index numbers are great. However, as discussed immediately below, market breadth is still of concern. Trading volumes are okay but nothing to write home about. With a day here and a day there to the contrary, small cap stocks are lagging. The absolute number of new 52-week highs (roughly 250 a day and many of those not real stocks but rather bond proxies) is very, very muted compared to past strong market periods. There’s no question that the optics of having the ‘largest of the large’ outperform is very positive, but it can also paper over some inherent flaws.
Citing a study by Bank of America Merrill Lynch, a front page article in Monday’s Wall Street Journal highlighted this issue of the ‘crowded trade’, where so much money has flowed into all the same stocks. To get a little wonky, Visa was noted as being held by fully 60% of institutional investors, at an aggregate weighting of 2.6x its weight in the S&P 500. Others well above that 2x level include MasterCard, Amazon, Facebook and Netflix – all massive consumer powerhouses. Quoted in the article was Savita Subramanian, a top strategist for BAML, who observed ‘This huge world of investible assets has shrunk down to a small cohort. We’re all in the eco-chamber where everyone goes to the same dinners and drinks the same Kool-Aid”.
This is a function of the nature of the buyers of stocks in July, the same folks noted in last month’s Update who drove the June rally, i.e. the active traders. Due to their ultra-short-term time horizons, virtually all algorithmic (that done purely by machine) trading programs are set to key off stock price momentum, and only stock price momentum. There’s an old Wall Street saying that the true definition of a ‘good stock’ is ‘one that goes up’, never mind any other consideration.
Increase in leveraged derivative trades.
There are very few negative bets out there. An article in today’s WSJ noted an increasing number of leveraged derivative trades against the VIX (short-hand for Volatility Index, itself a derivative calculation of various measurements around stock option prices and interest rates), essentially a bet on continued rising stocks. A Wall Street strategist noted this morning that Put/Call ratios are in the 5th percentile of past observances, reflecting a near unanimity of positive opinion among options traders.
This is true even within the long-term investor community. According to my friends at Ned Davis Research, there are three times as many bulls among Wealth Advisors and the level of consumer optimism about rising stock prices is at nearly 65%. Both of these approach the levels seen last October 3, from which stocks fell a full 20% in less than three months.
Okay, so what? If there is any disappointment, at any level, just as we saw in the major sell-offs during the first and fourth quarters of 2018, all these trades can get unwound in a relative heartbeat…and nobody is going to step in and buy. There’s no loyalty to anything. Once these high octane ‘algos’ go into reverse, selling begets selling, and we all know that stocks go down a whole lot faster than they go up. No, it’s not happening now, and might not any time soon, but it’s a risk we must respect.
What do August and September hold?
We now enter the seasonally weakest two-month period of the year, first August and then September. Honestly, I have no conviction at all about where stocks will trend over the next few months, but I have long learned that having no conviction is just as important a portfolio management signal as having one because, frankly, it keeps you out of trouble. Therefore, I am still cheering on stocks ‘from underneath’, keeping plenty of portfolio flexibility in case of a downside reversal, while still having enough of them in a diversified portfolio to be pleased if they continue to make new highs. The truly beautiful thing about being in the Wealth Management business, as we are here at KLR Wealth, is that you really do get to play both ends against the middle, which is exactly what we’re doing here for you.
Published on: 08.01.19