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“Every past decline looks like an opportunity, every future decline looks like a risk.”
Morgan Housel

If past declines look like opportunities and future declines look like risk, declines lived in real-time are trials of patience and fortitude.

The uncertainty around the length and duration of a decline can wear on even the most resolute investors. There are very real risks that brought about the dramatic decline in October and the volatility seen in November. It is important to address the concerns that those risks pose. In this piece, we will review the risks the markets are currently sensing and the opportunities the markets may be overlooking. The case can be made that opportunities are still available, and we will lay out a roadmap for the way forward.

The case for staying the course

The economy is still sound and capable of supporting markets for the foreseeable future — but before we provide details, please bear with us as we first wade through the negative headlines now pressuring the market. If you can make it through all of that pessimism, by the end, we think a compelling case can be made for staying the course. There will be a time to become much more defensive, but we think the data suggest this is not that time.

When surveying the landscape that was October 2018, the start to the fourth quarter of the year looked bleak. If investors thought that month felt awful, they were correct. They were witnessing the worst monthly performance in years for the majority of the index averages. As can be seen below, the NASDAQ suffered its worst decline in about eight years.

Source: Bloomberg L.P. prepared by Cardan Capital Partners

On the bond side of the equation, as has been the case during much of this year, bonds did not provide a positive buffer to equity drawdowns. In fact, different classes of bonds were all down as well — but they did provide diversification as they were down significantly less than their equity counterparts.

Source: Bloomberg L.P. prepared by Cardan Capital Partners

A final point about the difficulty 2018 has presented is found in a report from Deutsche Bank, which notes this year will be remembered as one of the worst in history in regard to the percentage of financial assets (89%) that have declined in value on a year-to-date basis as of 10/31/2018. According to their research, a higher percentage of financial assets has lost value this year than at any time since 1901.

Market curiosities Cardan is monitoring

While the global markets churn like ocean squalls buffeting investors, some new nuggets of intrigue have surfaced since our last writing. As the cycle gets older and volatility picks up, new details of concern make themselves apparent.

We list the following items we find curious — just like the regional banks and homebuilders we mentioned in our last writing. We do not know if any of these will lead to anything other than interesting storylines, but they are worth monitoring:

  • General Electric. What does the decline of the stock mean? Urgent asset sales to cut debt is not the course of action of a healthy company. Is this also rattling the markets and providing a glimpse of increasing stress within the credit markets as a whole? The cost to insure against a default by GE for five years almost has doubled in the last few weeks. The only good news is that the cost to insure is not near where it was during the financial crisis, but the fact that we are now having to watch this again is not encouraging. “The selloff in GE is not an isolated event, more investment grade credits to follow. The slide and collapse in investment grade debt has begun,” Scott Minerd, Chief Investment Officer at Guggenheim Partners Asset Management, tweeted.
  • Issues highlighted in the first ever Financial Stability Report issued by the Federal Reserve.

The Federal Reserve issued a cautionary note Wednesday about risks to financial stability, stating trade tensions, geopolitical uncertainty and a buildup in corporate debt among firms with weak balance sheets pose strong threats. In a lengthy, first-time report on the banking system and corporate and business debt, the Fed warned of “generally elevated” asset prices that “appear high relative to their historical ranges.” In addition, the central bank said ongoing trade tensions, which are running high between the U.S. and China, coupled with an uncertain geopolitical environment, could combine with the high asset prices to provide a notable shock. “An escalation in trade tensions, geopolitical uncertainty, or other adverse shocks could lead to a decline in investor appetite for risks in general,” the report states. “The resulting drop in asset prices might be particularly large, given that valuations appear elevated relative to historical levels.” Source: CNBC

  • A watchful eye is certainly warranted regarding the corporate debt markets. We have recreated the chart below that Jeff Gundlach, chief executive officer of Doubleline Capital, presented recently concerning the high levels of corporate debt in relation to U.S. GDP. At the moment, investors are not penalizing corporations for the debt burdens they are carrying.  Debt levels could become punitive for lower-quality credits in a downturn, which is why we lowered exposure to corporates over the last year.

  • Apple. iPhone sales have provided consternation for technology stocks. Have we reached peak iPhone? Investors have asked this before. Apple makes money many other ways, but what about its suppliers? Do the suppliers have a plan B? How will this type of sentiment weigh on technology stocks and the markets in general?
  • Oil. Six weeks ago, oil was testing four-year highs as concern that shortages loomed, and crude would push higher. Fast forward six short weeks, and oil has plunged more than 20% from that high as both OPEC and the International Energy Agency have voiced concerns about slowing global demand.

Potential market positives

What about potential positives? As certain market tendencies and macro factors will come to bear, seasonality could be favorable into year-end. Investors will have to wait to see if these traditional upward pressures for the market will assert themselves, but the time is right that they may. Some of the catalysts that may begin to help the markets are:

  • The fiscal year-end for many open-end funds closes in October, so the downward pressure from tax-loss selling from those funds may abate.
  • According to CNN Business (Sun, October 14), the stock buyback window will now open. As evidence of the importance of buybacks, from CNN Business: “US companies have bought back $4.3 trillion of their own stock since 2009, according to Yardeni Research. Noting the pre-earnings blackout window, Sandler O’Neil analyst Scott Siefers asked Wells Fargo finance chief John Shrewsberry when the company can turn buybacks back on. ‘Monday,’ Shrewsberry responded. Just like Wells Fargo (WFC), U.S. companies will soon be able to resume purchasing gobs of their own shares. The flow of buybacks and dividends will triple over the next six weeks, spiking to $48 billion by mid-November, according to UBS.”
  • The fourth quarter of the year historically provides the best returns of the year, averaging about 4% over the final three months of the year.
  • The tendency for the market to rise from November to April, averaging a gain of 6.8% over that period and being positive 79% of the time. Source: CNBC
  • Last but not least, there is the fabled Santa Claus rally, which encompasses the last week of December, coupled with the first two days of January. Historically, the stock market rallies about 1.4% over that period, according to the Stock Trader’s Almanac.

Elephant in the room

The elephant in the room is what to expect after the mid-term elections. It may be easier to assess what is not changing rather than to speculate as to what could change.

  • The Federal Reserve is still raising rates and is expected to raise again in December. The Fed is forecast to continue its rate path higher into next year. Most central banks globally are still forecast to be either removing stimulus from their economies or remaining neutral for 2019. The decline in oil may give the Fed cover for slowing the rate hike process, as falling oil should bring headline inflation down.
  • Tariffs on China and other countries are driven by presidential authority. This economic force does not appear to be winding down. Starting in January 2019, tariffs that currently sit at 10% on about $200 billion of Chinese goods are set to step up to 25%. However, recent stock market weakness does appear to be keeping China and the U.S. at the bargaining table.
  • Increased Treasury issuance due to corporate tax cuts and the Federal Reserve reducing its asset purchase program.
  • Companies still will have to meet earnings, or they will be punished by the markets as participants continue to seek growth that may become harder to find.

Longer-term Trends

Two very important trends that have been with the market since the end of the Great Financial Crisis (GFC) and still appear to be intact are corporate earnings and jobless claims. As can be seen in the chart below, corporate earnings in red are still climbing, and the fact that U.S. economy also is still growing should continue to be a positive.

Source: Bloomberg L.P. prepared by Cardan Capital Partners

The chart below reflects job growth. We have inverted jobless claims — our rationale being that if fewer people are claiming joblessness, the better for the economy and good for the stock market. This positive employment trend at this time appears to be relatively uninterrupted.

Source: Bloomberg L.P. prepared by Cardan Capital Partners

Big Picture

Looking at the big picture, the U.S. has not had a recession without the Leading Economic Indicators (LEI) Index going below zero, and it currently sits at 5.9. That said, some metrics, like the Global Purchasing Manager Index (PMI), are showing slowing rates of change, but not outright negativity. Slowing rates of change are obviously the first signs of a potential slowdown. The market is trying to sniff out if the slowdown in the rate of change is merely a bump or the end of the road. Again, the road has never reached recession with leading indicators where they currently are sitting.

Source: Bloomberg L.P. prepared by Cardan Capital Partners

If the leading Indicators are still positive, corporate earnings are still growing, unemployment is still falling, and oil has fallen from its peak, investors may get a scenario where markets cool down from the cauldron they are in right now. Make no mistake: the economy is late in its cycle, but not at the end of its cycle, and that should underpin riskier assets, such as stocks. If the economy is still growing and the fall in oil shows up as a reduction in inflation, this combination of economic growth and lower inflation should forestall the Bondmageddon in the corporate bond market, or at a minimum, push into the future downgrades and defaults.

We are still cautiously optimistic and believe overall that risks are balanced and that remaining engaged — but not overly aggressive — is the right course of action for the time being.

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