Market Commentary Going Into September 2015
It’s important to remember that the catalyst for the current selloff in U.S. equities was an event originating outside of the U.S.: devaluation of the yuan on August 11th followed by capitulation in the Chinese equity market. Chinese equities and leverage rates had been driven to unsustainable levels by wealthy citizens that had already saturated their investment exposure to speculative unoccupied real-estate. The buying became self-filling and drove the market higher for longer than what seemed justified. Markets always overshoot, to the upside as well as downside, so we shouldn’t be too surprised. I imagine we will see a similar capitulation in Chinese investment real estate next.
Given the multiyear upward trajectory of the S&P500 with the relative absence of significant pullbacks, U.S. shareholders have been in essence waiting for a reason to take some profits and over the last few weeks the U.S. market collectively agreed that the Chinese stock market selloff was that reason.
The last pullback of this magnitude in the S&P500 was in August 2011 in the midst of another multiyear rally (there was a 16% pullback in Spring 2010 before taking out the previous high by year end). While the catalyst in 2011, a U.S. credit downgrade, differed from what we are seeing today given that it was an event directly related to the U.S., both of these catalytic events are similar in that they were foreseen as probabilistic or even inevitable to anyone closely following the financial markets.
These multiyear runs in U.S. equities are an example of just how powerful a strong, persistence upward trend can be as investors with a multiyear profit cushion can be reluctant to reduce exposure despite rational fundamental reason to do so, e.g. concern of a sovereign credit downgrade or Chinese stock market bubble burst. Over the last half-decade-plus, investors have been rewarded for standing their ground as long as technical trends remained intact, of course with the backdrop of aggressive accommodative monetary policy led by the U.S.
However, an imminent end to an era of overtly accommodative policy may make a relatively swift market rebound less likely this time around. That said, high-quality U.S. equities probably remain the best option in town for domestic and global investors alike with debt yields still too low, a broken commodity market, and emerging markets decisively turned for the worse. A lot of the money that came out of U.S. stocks over the last few weeks is probably just sitting in cash at the moment as investors wait and watch how the market responds to the recent technical and sentiment damage that has been done; with the anticipation of getting back in, if and when, the market appears to have stabilized. The alternative for investors is a longer-term fundamental rotation out of U.S. equities into one of the other arguably more problematic asset classes mentioned above.
Retracing the S&P500’s August 25th intra-day low of 1867 would indeed be painful for longs. If the level is retested I think an overshoot would be likely, marking a new near-term low; however holding the level could provide a much needed sentiment shift in confidence needed to build a technical base and move higher from there. A test and hold of this level in late-September or October, when trading desks are back from vacation and fully staffed, would further support the significance of a successful retest.
With hedge funds down on the year, the current market volatility could provide just the opportunity they need to salvage the back-half of 2015. Hedges funds buying the dip could become self fulfilling, especially if the global financial weakness continues to originate from non-U.S. centric fundamentals, justifying buying U.S. stocks at reduced relative valuations.
While the U.S. market is by no means completely isolated from the rest of the world (the S&P500 generates roughly a third of it's revenue internationally), in recent history the S&P500 has held together relatively well during times of global economic distress as long as the damage wasn't self inflicted (in 1987, 2000, and 2008 too-easy credit and over-leverage originating in the U.S. was the responsible common denominator).
Despite the current weakness, it's important to remember that there still is profit growth in the U.S. which accumulates as retained earnings, is returned to shareholders, or is reinvested in the economy, even as stocks are selling-off. Yes, the rate of growth in U.S. could slow, but most likely not to recessionary levels near-term in the absence of a disastrous unforeseen domestic economic event.
Weak inflation, or dare I say "deflationary pressure", may have run its course led by what appears to have been a bottoming in oil, after a 27% bounce in 3 days from a multi-year low of $37.32/bbl WTI on August 24th. Its important to note that crude has been driven lower by an increase in supply more so than a global decrease in demand, this distinction important because supply driven trends tend to be less sustainable than more macro global demand trends. Producers, not only in the U.S. but elsewhere in the world including the Middle East, have economics that are precarious at best at <$40/bbl oil, with most shale and deep water offshore production being outright uneconomic at that level.
Along with oil, metals and materials seem to have already sustained the brunt of the current correction, thus somewhat alleviating accompanying deflationary pressure that would come with further weakness, which arguably further paves the way for the Fed to proceed with the first rate hike since 2006 by year end.
The implication of a rate hike will probably be more profound for growing economies out-side of the U.S., as global borrowing costs will rise and further strengthening of the dollar reduces relative income for workers paid in weaker currencies. This dynamic further supports what has been one of the primary drivers of the U.S. equity market in recent years, international investors diversifying out of weaker currencies, buying dollars, and parking the dollars in liquid large-cap U.S. stocks.
In coming days, market action will continue to be driven by Chinese equity market volatility and Federal Reserve rate decision speculation. China’s ability to support their equity market with government assisted end-of-day mark-up buying will be put to the test this week. The Fed meets September 16-17.
There has certainly been technical damage done to U.S. stocks and sentiment has understandably shifted. In times like these its apparent that the market’s job is to elicit as much pain as possible for longs and shorts alike. That said, the market is finally providing opportunities to buy favorite names like Apple (Nasdaq: AAPL), Netflix (Nasdaq: NFLX), and Tesla (Nasdaq: TSLA), stocks that seemingly have not pulled back for an eternity if you have been waiting patiently to get in.
Apple has been the clear market leader and a good proxy for the rest of the market especially intraday. VIX futures are in backwardation, a move back to contango could be telling that the worst might be behind us. Last week Google reacted positively to a sell-side upgrade and Tesla traded up after a very encouraging Consumer Reports review (in really weak markets, news like this tends gets quickly thrown aside and dismissed). The Schlumberger (NYSE: SLB)/Cameron deal (NYSE: CAM) is an indication of current value in the energy space, and miners making multiyear lows on record volume is a welcoming sign for those looking to get in or add to positions.
At the time of writing the author was long Tesla Motors, Inc.