September Monthly Market UpdateAugust 29, 2019
Equity markets had a generally discouraging performance in August, and it looks like this could carry through to September, due to the growing trade war with China, economic data in Europe and interest rate fluctuations.
Writing and releasing this a day early because of the long holiday weekend. Unlike last month when high market volatility affected the last business day, I suspect Friday will be as dead as a doornail as most of Wall Street is likely to make an early escape.
August’s performance= generally discouraging. A prime reason for the probable lack of activity at Wall Street is the generally discouraging performance of the equity markets in August. Yes, we’ve had a very robust bounce in this last week of the month, but even so, a fully diversified equity portfolio has dropped more than 2%, with smaller capitalization (-5%) and emerging markets (-4.7%) stocks particularly on the weak side. Within the large cap space (the S&P 500 down 1.8%), the weakest macro groups were the banks (-10%), energy (-8.5%) and retailers (-5.5%). The Dow Jones Transportation average fell 5.1%, with many airline stocks down over 8% and shipping giant Federal Express down 7%. More on this below.
Positive performance of fixed income securities
Offsetting to some degree for balanced portfolios was the very positive performance of fixed income securities. This is to some extent a good news/bad news situation. The good news is that the value of bond portfolios rose in response to falling interest rates. The U.S. Treasury 10-year yield, generally regarded as the ‘benchmark yield’ around which all other interest rates are compared, fell to below 1.45%.
The yield on the 30-year Treasury (aka the ‘long bond’) fell to below 2%, which I can’t remember in my nearly 40 years in this business. As such, the current market value of intermediate Term U.S. Treasury portfolios advanced about 4%, as did holdings in high-grade corporate bonds. Broadly diversified municipal bond portfolios gained nearly 2%. The bad news is that, with interest rates now quite a bit lower than they were a month ago, the starting point for ‘returns from now’ in bond portfolios is accordingly lower.
Inversion in the yield curve for August
In my opinion, the most significant take-away from the August action in interest rates is the now undeniable ‘inversion’ in the yield curve. An inversion occurs when the yields on shorter-term bonds exceed that of those that mature later. Never mind the Federal Reserve controlled fed funds rate, which now stands at 2.25%. The yield on the 3-month Treasury bill is nearly 2%. The yield on the 2-year Treasury (another major benchmark) is 1.50%. These are market-established rates.
In fact, the so-called 3s-10s (3-month minus 10-year) spread turned negative first in March and, after a month or so of reprieve, has been steadily negative since early May. The 2s-10s (2 year versus 10-year) inversion is only a week or so old now, and therefore I suppose eminently reversible, but this is regarded as the inversion that really, really matters.
So what’s the point?
I have long held that the ‘shape’ of the yield curve is the single best predictor of future economic activity. If the T-bill rate is a proxy for returns on savings and the 10-year is the proxy for the returns on investing, when savings return more than investing, then the natural human response is to save, not invest (or spend, for that matter). Banks depend on a positive spread between taking in our deposits and lending it out to borrowers (except for loans to riskier borrowers, that spread has now been eroded - hence the massive underperformance in bank stocks). More importantly, there is less incentive for banks to maintain as active a lending profile. Is this predicate to a possible recession, at some time down the line? Yes, it may well be. It has been in the past.
Back to the transportation stocks.
There is something called the Dow Theory, a highly regarded market tenet since the 1950s, back when the economy was largely based on manufacturing. It compared the performance of the Dow Jones Industrial Average, then comprised entirely of big ‘metal-benders,’ with that of the Dow Jones Transportation Index, then entirely comprised of railroad stocks. This made complete sense because back then the only way the heavy industrial output could be delivered to end users was by rail. In order for a bull market in the Dow Industrials to be considered as sustainable, it must continuously be ‘confirmed’ by a bull market in the rails.
Does the Dow Theory still hold true?
The world is indeed quite different now but I believe the Dow Theory still holds. The Dow Industrials now include all major segments of the economy (Disney, JP Morgan, Visa to name but a few relative ‘newbies’) and the Transports include the airlines, truckers and shippers, along with the rails. But whatever the specific context, if investors judge that the prospects of the companies that make America move are getting relatively weaker, then it is hard to argue that the prospects for America’s producers of goods and services are likely to get stronger.
The so-called market ‘internals’ such as daily trading volumes and daily advance/decline data are getting progressively less encouraging. In the several big up days this week, volume of the NYSE barely broke 700 million shares, as opposed to nearly 900 million during Tuesday’s decline. The selling intensity is far greater than that for buying, and correlations among all stocks, and really all asset classes, have risen significantly, demonstrating just how trading-oriented Wall Street has become.
So now let’s take on, briefly, the headline mainstream and economic issues of the day that have been exacting their own respective ‘pounds of flesh’ on Wall Street.
Trade war with China
Does anybody think the now-burgeoning trade war with China is going to come to a happy ending anytime soon? Not me. The Administration continues to wage war with the policies and even the independence of the Federal Reserve on what seems to be a daily basis. ? The now-violent tinge to the protests in Hong Kong might end up with a major global financial center being put out of business for some duration. Brexit looms on October 31. Wednesday’s report that the new populist Prime Minister has, through a request to the Queen, succeeded in suspending Parliament for the month of September can’t be good.
The economic data in Europe is massively on the weaker side and that of the U.S. is showing signs of fraying on more than just the edges. Yes, the consumer data series remain quite strong but in my opinion those are at best tepid coincident indicators of economic activity and quite possibly lagging, dependent as they are on the jobs numbers, which are very much lagging.
The true leading indicators of inventory, employment and new orders in the manufacturing sectors are now in decline. Capital spending remains quite muted and is limited mostly to software and automation, not exactly ringing signs for future job growth. Plus, does anybody expect the steady unfolding of the U.S. election cycle to lead to anything less chaotic than it already is?
If we can understand all of the above and the resulting uncertainty, so can those who make important macro-economic decisions, most particularly to include corporate CEOs. If they choose to hunker down and cut back, it will be very hard for the aggregate economy to make any forward progress. If anything, it will be quite the reverse.
“Baby” Recession in 2020?
Those who have read my work over time might remember that I wrote from my prior perch (pre-KLR Wealth) back in January that I fully expected a ‘baby’ recession in 2020 and a baby bear market (down 25-ish% from the high, which currently stands at S&P 500 3025 in late July) beginning in 2H’19. Certainly I can be wrong about one or both but they make just as much sense to me now than they did seven months ago.
Now we enter September, with its historically seasonal record for stocks even worse than that of August. I suppose anything is possible in a trading-oriented market subject held largely hostage to massive day-to-day fluctuations in the economic and geo-political headlines, but I’m not going bet the mortgage on a truly sustainable upside surprise.
The good news is that we’re prepared with our modest underweight in stocks for our clients, versus individual long-term strategic targets. We have been for the past six months, and that gives us tremendous flexibility. I’m in no hurry to recommend to our Investment Strategy Committee that we buy more stocks from our bond/cash overweight, but that day will eventually come. Every bear market is followed by a bull market, after the Sturm und Drang has begun to dissipate, in whatever form and fashion. Portfolio values will then rise again, to even higher levels than attained at prior peaks…and we are already well positioned to take advantage of that.
Summer is basically over except for the proverbial shouting and we at KLR Wealth trust it has been terrific for you. As well-worth repeating, please let us do the portfolio-based worrying for you. We’re in good shape and therefore so are you, but please don’t keep any concerns or questions a secret – we’re here to answer them for you at any time.