Between a little too much candy and the stock market slide, my house had its fair share of tummy aches in October. Blame for the market rout was put on a myriad of concerns from rising interest rates to trade wars to mid-term elections. The S&P 500 dropped 10% from its recent peak, putting it officially in correction territory. Despite the sometimes gut-wrenching swings in the market, stocks are still flat to up for the year, and bonds are down modestly. The good news is that while October is often ghoulish, we are heading into a period of the year that is typically positive for markets, particularly after a mid-term election.
Equity markets moved significantly lower in October, exacerbated by a sell-off in Technology stocks. Following a very strong third quarter, a number of factors finally caught up with investor sentiment in October and removed the appetite for risk. Hawkish comments from Fed Chairman Powell got the ball rolling early in the month. Rising rates, a strengthening U.S. dollar, continued concerns over a trade war and a slowing global economy all helped push equities lower.
Large-capitalization stocks in the US declined 7% for the month, but have managed to hang onto a year-to-date gain of 3%. Small-capitalization stocks, as measured by the Russell 2000, declined 11% in
October and are down 1% for the year. In this risk-off environment, value stocks outperformed growth stocks by a significant margin. International Equities experienced strong selling pressure in October as well, with the MSCI EAFE index declining 9% for the month and the MSCI EM index down 11%.
The October sell-off brought valuations to a more comfortable level from a historical perspective. The S&P 500 is currently priced at 15.6x forward earnings estimates, now just slightly below the 25-year average of 16.1x, and the index’s dividend yield of 1.95% is right in line with its long-term average. Earnings growth for the third quarter is currently 24.9% and expectations are for continued double-digit growth in Q4. Next year, without the added bonus of a tax cut, corporate earnings are expected to increase by a more modest, though still impressive, 9% year-over-year.
Corporate buybacks, a significant driver of the current bull market, dropped meaningfully in October. Much of this is likely due to the blackout period for share repurchases around quarterly earnings releases rather than an alarm signal. Future buybacks will be an important factor to watch as rising U.S. rates weigh on companies with large amounts of debt. In the meantime, favorable changes to the tax code continue to support corporate spending.
As the broad market declined in October, investors rotated out of previous high-flying stocks into more defensive names. The so-called FAANGs, which include household names Facebook, Apple, Amazon, Netflix and Google, suffered an average decline of over 14% between the four stocks compared the S&P 500’s more modest 7% decline. Leading into October, these companies had an average gain of over 40%.
With the exception of Communication Services, the other two sectors housing these companies, Consumer Discretionary and Technology, both underperformed the broader market for the month.
The Consumer Discretionary sector was tied for the worst performer for the month, down over 11% in October. Amazon was recently reclassified into this sector as a result of changes to the GICS sector classifications. As the largest weighted position in the sector at 20%, Amazon’s monthly decline of 20% was a major drag on the sector’s performance.
In contrast to the earlier part of the year, defensive sectors outperformed more cyclical sectors by a wide margin in October. The only two sectors with positive returns for the month were Consumer Staples and Utilities, up 2.3% and 2.0%, respectively. The Real Estate sector rounded out the top three with a modest loss of 1.7% for the month. The rotation into these sectors is consistent with the risk-off environment that persisted for the majority of the month; however, if the market returns to supporting growth, these sectors will likely lag the broader market. Q3 earnings growth is 7.5% for Consumer Staples, 7.7% for Real Estate, and 12.3% for Utilities, all below the S&P 500 average of 24.9%.
Going forward, we could see these more defensive areas continue to outperform. For instance, when dividing the broad market up into Value stocks (those with lower valuations and lower growth expectations) versus Growth stocks, the latter group has greatly outperformed since 2009. In fact, Growth stocks have outperformed Value stocks by the widest margin since 1999. And since the start of the year, Growth stock valuations have declined by 10%, while Value stocks have declined by a full 20%, making them much more attractive from a valuation perspective.
During October, followed the equity markets lead in shifting toward more defensive areas, and away from risks associated with higher interest rates and credit quality. Longer term bonds (which have more interest rate risk) and corporate, high yield, and municipal bonds (all of which have more credit risk), both underperformed Treasuries and the Bloomberg Barclays Aggregate Bond index (often known simply as the “Agg”), in data according to Bloomberg.
While the Agg decreased 0.6% in October (including both price changes and interest income), the Bloomberg Barclays 10-20 year maturity Treasury lost a bit more, 0.7%. Both were affected by a rise in Treasury yields during October, as investors weighed the possibility of greater inflation against a strong economic backdrop. Concerns were exacerbated by increased bond issuance by the U.S. government to finance deficit spending resulting from the tax cuts.
As bond investors searched for safety, credit spreads increased, sending high yield bonds down 1.8% and municipal bonds down 2.2% for the month. Higher credit quality bonds fared better, with the Bloomberg Barclays Corporate bond index down 1.2% and the Bloomberg Barclays High Yield bond index lost even more, 1.8%.
The Economy and the Fed:
Despite the sell-off in stocks and some bonds, economic data continues to paint a robust picture. The labor market remains strong with unemployment holding steady at a remarkably low 3.7%. Meanwhile wages are growing at an annual rate of 3.1% in October, the fastest pace in nine years. Manufacturing activity has been robust even in the face of trade wars as evidenced by the latest reading from the Institute for Supply Management at 57.7.
Just as tricks are often followed by treats, so is volatility followed by opportunity. While markets have historically underperformed leading into midterm elections, performance over the following 12 months has been overwhelmingly positive. With a Democratic House and Republican Senate and Presidency, it is likely that Congress remains deadlocked for the foreseeable future. This creates a level confidence that major policy changes are unlikely over the next two years and allows businesses to plan accordingly. Unlike me during my commute, the market usually likes gridlock. With the backdrop of positive and improving economic conditions, strong corporate earnings and the fact that we are entering a seasonally strong time of the year, the bull market is in good shape to dust itself off from a very difficult October and move higher into year-end.
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