Q: Last week’s sell-off was the biggest this year, outside of the first quarter. What drove it?
A: There was a lot of turbulence in the market. The VIX jumped over 44%, one of the biggest single-day rises outside of a couple of days in the first quarter of this year, but this felt very different. This did not feel like a market panic. Looking at corresponding market factors across asset classes through sectors, rather than a panic, it felt much more like a rotation.
Q: Why do you believe this sell-off does not represent a panic by investors?
A: The reason is things are still good. There is no recession in sight. The economy is supported by strong fundamentals. This sell-off is more about investors starting to pay closer attention to those ignored and unloved areas of the market because they have much more attractive valuations. That is why investors generally benefit from being balanced across several key areas in the market.
Q: Is this type of market disturbance normal, and likely to get worse continuing into year-end?
A: Just because we have a correction in equities, it does not mean we are moving into a recession. Over the last 80 years, there have been only 12 recessions, but we have experienced more than 43 larger-than-10% market corrections. The volatility ramp-up is quite normal considering its historically low levels in recent years. Even the 45% increase in the VIX last week only brought us up to a VIX of around 20 to 25. The long-term average is around 20, so market volatility is now much closer to average. It is worth noting that the return spread between value and growth has reached close to historical highs – not quite 1999, but getting there. It is the second largest spread we have seen. The growth trade was starting to seem even more expensive: growth was trading at a 35% premium to value and a 30% premium to its 10-year trailing price/earnings ratio; while value was trading at a discount to its 10-year average. The market risk for growth versus value is also starting to change. Year-to-date, growth stocks were 25% more volatile than value stocks. In the long run, they are much closer in alignment. All this reinforced what unfolded last week.
Q: If economic fundamentals are good, and corporate earnings still look pretty robust, why did the market still experience this seemingly unexpected sell-off?
A: The sell-off was driven, essentially, by having to deal with the consequences of success. Some result from the 10-year bull market in growth stocks: the market has become fairly narrow with a lot of crowding. The top five stocks in the S&P 500 – all technology and consumer discretionary – account for over half of the index’s gains this year. They are also some of the biggest holdings among active managers. Crowded trades are popular for a reason. These are good companies, but the question is, at what price? Looking at company multiples and reevaluating other economic conditions, investors are starting to reprice expectations. The other key driver of the sell-off was interest rates rising a bit faster than initially expected. The U.S. Federal Reserve (Fed) will continue to raise rates and investors are starting to catch on. There was a very strange disconnect in the market between last week and the week prior. Two weeks ago, the bond market had a significant repricing of 10-year U.S. Treasury bond yields and other areas on the curve based on very strong comments from Fed Chairman Jerome Powell. The equity market didn’t really move until last week.
Q: Does part of this stem from the fiscal stimulus from the end of 2017, with the U.S. tax cuts?
A: Those tax cuts produced faster growth: over 4% of GDP in the second quarter, but with unemployment below 4%, at 3.7%. The market was paying very close attention to the positive sides of a faster, improving economy, but discounting the fact that it was going to bring along a much more aggressive Fed. That is now being adjusted. The market realizes the Fed is likely to continue this slightly more aggressive tightening cycle.
Q: Has serious overconfidence been building in certain areas of the market?
A: Yes, and for good reason. Corporate profits have been solid; earnings growth has been extremely large; and economic fundamentals continue to be robust. But this has emboldened investors to take on bigger risks. This year, we saw the largest percentage of IPOs with negative earnings per share (EPS) since the 2000s, and that was at over 83% of companies that listed. (Meaning, in the 12 months up to their listing, they actually had negative EPS.) That is the highest number of companies in that position since the dotcom boom. All this confidence is making investors focus more on tomorrow than today. They are thinking less in terms of where are company earnings coming from today in terms of things like valuations, dividend yield and cashflow, and more about where investors think growth will come from. This has continued to fuel the run up in growth stocks. Growth has outperformed value this year by 8%. Going back to 2008, growth has outperformed value by over 100% in eight of the last 10 years. This is very much a continuation of that very strong growth trade.
Q: What repercussions has that had in the fixed income markets?
A: Bond returns this year have not been particularly stellar. If you look at the US Agg year-to-date, it is down over 2%. During this most recent sell-off, with the S&P 500 drawing down 5%, bonds also drew down. It was only 50 basis points, but they were negative. We are starting to see slightly higher positive correlations between stocks and bonds. We are also seeing interesting flow activity out of the fixed income sector, as investors start to realize we are moving into a more robust rising rate environment. Some of the largest bond ETF withdrawals in a single day occurred last week, including over $2 billion in AGG, the iShares bond product.
Q: How do you assess the concern overs trade tensions with China and the rest of the world?
A: This is an area where we have seen progress, particularly with NAFTA. As it relates to China, though, there is very, very little progress. It is not about who can win. It is about how much is everybody going to lose. The market is not focused on the positive, that the U.S. might be able to “win” a trade war because China trades a lot more with the U.S. than the U.S. trades with China. The U.S. trades only about $150 billion worth of goods to the Chinese market, and the Chinese export over $400-500 billion worth of goods into the U.S. Mathematically, we can inflict more harm on them than they can on us. But that is not a very prudent economic model. This year, China was close to 30% of global GDP growth. Since around the half point of the year, there has been a significant decline in international and emerging market stocks, partly because of uncertainty around trade. If that starts to harm global growth, it will affect long-term U.S. growth. That 2017 trade continued into 2018 with growth momentum occurring across developed, international and emerging markets. Starting in April there was a split: the U.S. continued that growth momentum trade, but international and emerging markets started to sell off. The spread between international and developed markets has really become wide. Year-to-date, emerging markets are down 14%, developed international markets are down 7%, yet the U.S. market is still positive, up 4%. That spread will be harder to maintain as many of the headwinds the international and emerging markets are facing will start to seep into the U.S.
Q: Some of the most vulnerable stocks to a trade battle with China are information technology companies, chipmakers and the like. What will this continuing pressure bring to this sector?
A: It really has more to do with market crowding: investors becoming more uncomfortable with such a large contribution coming from so few opportunities in the market; implications of a rising rate environment; and trade tensions getting worse and not better. This is not a panic. There has not been the broad-based type of selling we saw at the start of the year. In the February drawdown, there was very little dispersion among sectors. Comparing the worst sector versus the best sector, it was a very, very tight spread on a whole. This sell-off brought a much larger spread. Consumer Discretionary and Information Technology are down about 7-8% in October. Utilities are up 1%. There is more dispersion as investors have bid up value in defensive areas of the market as they start to rebalance.
This material was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. It is intended for informational purposes only and it is not intended that it be relied on to make any investment decision. It does not constitute investment advice or a recommendation or an offer or solicitation and is not the basis for any contract to purchase or sell any security or other instrument, or for QS Investors to enter into or arrange any type of transaction as a consequence of any information contained herein. QS Investors does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this document. Except insofar as liability under any statute cannot be excluded, no member of QS Investors, or any officer, employee or associate accepts any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this document or for any resulting loss or damage whether direct, indirect, consequential or otherwise suffered by the recipient of this document or any other person. Any forecasts provided herein are based upon our opinion of the market as of this date and are subject to change, dependent on future changes in the market. In preparing this presentation, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. We consider the information in this update to be accurate, but we do not represent that it is complete or should be relied upon as the sole source of composite performance or suitability for investment.
QSCR 18274 (October 2018)