“… Double-digit drop likely …”
“… So many unbelievable opportunities in front of us ...”
— Commentary last week from different analysts at the same market research house
Last month I wrote how the markets were rallying ahead of the expected short-term interest rate cuts that would follow the July Federal Reserve meeting. The Fed delivered, reducing the Federal Funds rate by 0.25%, or 25 basis points, but the markets have been highly volatile ever since.
Some market participants took Fed Chairman Jerome Powell’s press conference commentary as an indicator that only one rate cut was in the cards, when others were expecting two or three in the coming months.
It seems others took the cut as a “sell the news” event, a phenomenon in which traders buy in advance of expected good news and then take their profits by selling once the event occurs.
Still others point to the reescalation of trade war rhetoric from the White House has justification for a more cautious outlook. But, with markets reapproaching all-time highs in late-July, our commander in chief might have been harvesting some market gains of his own to use as “cover” in the midst of the Chinese trade negotiations.
The last few weeks have been highly volatile in the markets, with stock indices fluctuating as much as 3% in a given day — rare levels of volatility.
Last week, the Dow Jones Industrial Average fell 800 points in the worst trading day of the year. The culprit seems to have been the famed 2-10 spread, which measures the difference between the 10-year Treasury rates and the two-year Treasury rates.
Readers of this column will remember past articles recapping how this measure has a strong track record of predicting recessions when it moves into negative territory (what many call an inverted yield curve). Last week the 2-10 spread briefly went negative in intraday trading.
Large institutions with risk-parity funds that use buy-sell computer algorithms fired off sell orders when the intraday signal was seen. Those sell orders were amplified by other index funds that have to mimic broad market activity.
By some measure, this makes sense. Over the past 40 years, recessions have always been preceded by a 2-10 yield curve inversion. Data from Oxford Economics suggests the probability of a recession in the next six months has risen to 50%.
But in previous cycles, the inverted yield curve persisted 30-60 days, rather than just a few minutes. Perhaps traders have gotten a bit too jumpy?
Either way, market participants are now pricing in almost a 60% probability of three more Fed rate cuts this year. Some might say this is the beginning of new interest rate regime ahead of a coming recession.
But falling Treasury yields have reduced mortgage rates substantially, driving up new loan and refinance applications. This should cushion a potential economic slowdown.
Another contrarian indicator might be the level of pessimism among fund managers. This month’s fund manager survey by Bank of America is the most pessimistic since 2011. The last time asset managers were this concerned about a recession, markets rallied 22% over the next 12 months.
A more Machiavellian take: This is exactly what the White House wanted ahead of the 2020 election cycle. By escalating trade tensions and elevating growth concerns, Trump has put the Fed in the corner, forcing them to lower rates.
This provides a cushion for the economy as his team negotiates a deal with the Chinese that covers issues like the trade deficit, technology transfer and fair competition. Many doubt any real progress can be made on this front, but it is highly likely some kind of “deal” will be done by early spring, just as the campaign is getting into full swing.
Data released last week showed fluctuating industrial production activity. Overseas (Germany, U.K., China) activity is very weak, while U.S. activity seems OK. The U.S. consumer is still very strong.
With wages moving up and unemployment so low, consumers continue to spend — buoying the U.S. economy in a turbulent and uncertain global macro environment.
One analyst we read last week showed stocks are as “affordable” now as they were in 2009. This analysis looked at the difference between the earnings-yield of U.S. stocks and 10-year Treasury yields. An earnings yield is simply the inversion of the P/E ratio to an E/P ratio — so, if the P/E ratio is 20, then the earnings yield is 5% (1 divided by 20).
With interest rates so low, and company earnings still pretty strong, the analyst pointed to the recent sell-off as a great opportunity to add to stocks.
So, the debate goes on. Are we on the cusp of a recession? Maybe.
Are stocks a good buy? Some probably are.
In our own fund, we harvested some gains in June and July to build cash and have been putting some of the money back to work as markets have become more volatile. We tend to look at big price swings as opportunities to add to companies we want to own for a long time.
The bull-bear market debate is good for media commentators. It drives up attention and helps sell adds. Long-term investors should continue to focus on the operations of their businesses and take advantage of opportunities the market inevitable tees up for us.