Emerging Markets: An Opportunity?

For a period of time this year, the U.S. equity market avoided the weakness that was occurring in many other equity markets around the world. October has certainly changed this though. As can be seen below, the S&P 500 Index is in correction territory now, i.e., down greater than 10% from its high at the end of September.

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Much To Like About The Economy

Recent equity market volatility has raised the question about the health of the current economic expansion. I must confess it is difficult to find too much in the way of negative news. What is important about this is the fact that a recession does not seem to be around the corner in our view. William Delwiche, CMT, CFA of R.W. Baird noted in a recent commentary, "Bear markets are almost always associated with a recession. Given the latest economic data and the leading indicators that point to further growth, the odds of recession are low." We would agree.

Following are just some of the favorable data points and charts.

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VIX Curve Moving Back Towards Contango A Positive For Stocks

The level of the VIX is one measure to gauge fear in the equity markets. When the near term VIX index is trading at a higher level than the VIX further in the future, for example, the 3 month VIX (or ticker VXV), then the VIX curve is said to be in backwardation. This is not the normal structure for the VIX curve as the VIX curve is usually in contango, meaning prices in the distant future are higher than those nearer term. For equity market volatility, i.e. the VIX, this makes sense as volatility inducing events are less predictable in the distant future versus today thus, the future VIX should be at a higher level than the near term VIX. As the below chart shows, in instances where the near term VIX is higher or significantly greater than one, this tends to occur near equity market bottoms.

As the near term VIX begins to decline or fall below the future VIX or VXV, the equity market tends to move higher. This process can take place over a several week period, but nonetheless, the equity market does tend to bottom 'near' spikes in backwardation. The recent spread between the VIX and VXV of 3.4 may have marked a near term peak in backwardation. If this is the case, the equity market may be setting the stage for a rally into year end.

Many Individual Stock Returns Are In Correction Territory

On a price only basis the S&P 500 Index remains up 3.08% year to date and up 4.66% on a total return basis. As the following chart does show, the S&P is off its late September high by 6.54%.

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Fall 2018 Investor Letter: A Midterm Election Year

There are many indicators pointing to continued strength in the U.S. economy including increased manufacturing activity, robust readings from the service sector and low unemployment levels last seen 49 years ago. Employee wages are rising, and the labor market is benefiting from the current growth in the economy. We view the low levels of unemployment and continued wage growth as a positive signal for the economy.

As we discuss in the Fall 2018 Investor Letter, history shows the fourth quarter of a midterm election year combined with the first quarter of the following year are the two strongest returning quarters for the market over the four-year presidential cycle. The start of the fourth quarter may lead investors to believe something other than the historical data though. Days into the quarter, markets have turned lower and volatility has increased to a more normal level. Although this is unsettling, the underlying economic and market fundamentals are still supportive of favorable equity returns looking ahead. As the above chart shows, the performance of the S&P 500 occurs late in a mid term year.

For additional insight into our views for the market and economy as the year nears and end, see our Investor Letter accessible at the below link.

• Fall 2018 Investor Letter

Hiring Pace Continues To Lag Job Openings Growth

If job openings are an indication of the economy's strength, yesterday's Job Openings and Labor Turnover (JOLTs) report is confirmation of economic strength. Job openings reached another record high of 7.136 million. Compared to last August's openings of 6.044 million, openings are up 18.1% on a year over year basis.

The timing of the unemployment data is one month ahead of the JOLTs data, however, the number of unemployed looking for work is 1.172 million lower than job openings. This is hard evidence that labor is a scare resource at the moment. This is not the type of data output that occurs in a recessionary environment. 

Pullbacks, Fear And Opportunity

From early 2016 to early 2018 the S&P 500 Index moved higher with very little downside volatility. As the below chart shows, that stretch of time was an abnormally long one in terms of very little downside market move. One consequence of this low volatility period is many investors' began to believe the equity market does not go down. In reality, a low volatility market is not normal though. Having the market pullback between 5-10% once or twice a year should be expected by equity investors. The current decline from peak to current level is only 6.9%.

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Large Decline In Bullish Sentiment

Today's Sentiment Survey release by the American Association of Individual Investors reported a  15.1 percentage point decline in bullish sentiment. Of course this report comes one day after the 800+ drop in the Dow Jones Industrial Average Index. Two-thirds of the decline moved to the bearish camp with the other one-third moving to the neutral category. When all is said and done, the three categories of sentiment, bullish, neutral and bearish, fall in the 30-35% range.

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A Favorable Small Business Environment

The NFIB Small Business Optimism Index for the month of September was reported at 107.9 and just slightly missed consensus expectations of 108.0 for the month. Also, the Index declined .9 points from the recording setting 108.8 reported in August. However, the September reading represents the third highest reading recorded in the 45-year history of the Small Business Optimism Index. In short small businesses remain optimistic about their operating environment.

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Equity Put/Call Ratio Approaching Overly Bearish Level

Not too long ago the concern around interest rates was the fact the yield curve was flattening and the Fed's rate hikes might end up inverting the interest rate curve by pushing short rates above long term rates. This past week though the focus seems to have shifted to a quickly rising long term 10-Year U.S. Treasury rate and a resulting steepening of the yield curve.

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Increasing Bullish Equity Sentiment And Declining Bond Prices

As of Wednesday's market close, the S&P 500 Index is up 11% on a year to date basis, while most bond strategies have struggled to breakeven at best. Longer term bonds have been the most challenged as evidenced in the below chart. The iShares 20+ year Treasury Bond ETF (TLT) is down 7.7% year to date. Through Wednesday's close, the 30-year U.S. Treasury is down 11.1% year to date. Of course, as interest rates rise, longer term bonds tend to be the least favorable bond investment as prices move inversely to the move in bond yields.

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Inverted Yield Curve: Could This Time Be Different?

In our recent article, “Respect The Predictive Power Of An Inverted Yield Curve”, a colleague noted that investors ignore this highly reliable indicator at their own peril. Today, I will argue for why investors should perhaps ignore this highly reliable indicator because “it may be different this time”.

To be clear, it may not be different this time, but it is always worth considering both sides of an argument.

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Small Caps And Cyclical Stock Sectors Underperforming

During the early part of this year quite a bit was written about the outperformance of small cap stocks versus large cap stocks. One commonly referenced reason for the outperformance was based on the trade and tariff issues and the potentially greater negative impact this would have on large cap stocks. It does seem though the trade issues are slowly being resolved and this headwind subsiding for markets broadly and for the large cap stocks in particular. As a potential consequence, the small cap outperformance has completely unwound and large cap stocks, as measured by the S&P 500 Index, are outperforming small caps as seen in the chart below.

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