November Investment Comments


November’s midterm elections are likely to result in a divided congress.  Forecasting website FiveThirtyEight.com currently predicts an 85% chance that Democrats win control of the House but only a 19% chance the Senate swings blue as well.  A surprise sweep by one party could cause further asset price volatility as investors contemplate the implications for the important 2020 elections.  As 2016 proved, unlikely things can happen.

October is a famously volatile month.  1929’s Black Tuesday and 1987’s Black Monday both occurred in October.  This year, the S&P 500 dropped more than 5% during the first two weeks of the month.  Pullbacks of any magnitude have been rare during this long bull market.  One notable feature of this retreat was that it failed to spare the high-growth technology companies who had long been the market’s most resilient leaders.  Although smaller companies generally fared worse than large ones, Amazon.com and Netflix, both of which had approximately doubled over the prior 12 months, both dropped about 10% (Netflix would recover on the back of its Q3 earnings announcement). Alphabet—a.k.a. Google—has now only about matched the overall market over the past year.  Facebook fell way off the pace when its stock declined more than 20% in late July.  The unstoppable FAANG (an acronym from the first letters of these tech giants) trade is not necessarily over, but it looks vulnerable.

The market pullback coincided with an accompanying 0.25% shift upward in the yield curve.  Such a shift would not have been news before the era of Quantitative Easing, but here in the early stages of the Fed’s exit from QE, interest rates on long-dated bonds have remained stubbornly depressed even as short-term rates have risen.  We wrote about the resulting flat yield curve last month.  Now we can say that while the curve remains quite flat by historical standards, it is no longer flattening.

The first catalyst occurred on September 26th when the Federal Reserve raised its target overnight lending rate another 0.25% to a range of 2%-2.25%.  Fed observers noticed that its official policy statement no longer refers to its own monetary policy as “accommodative,” implying that the Fed no longer considers low short-term rates to be an express stimulator of economic growth.  Since the rate increase was expected and was also paired with a less hawkish statement, the market’s reaction on 9/26 was initially quite muted.

It seemed to take a few days for the market to realize that removing the word “accommodative” does not necessarily mean the Fed feels confident about keeping inflation in check.  In an interview following the policy statement, Chairman Jerome Powell stated that he believes the Fed remains “a long way from neutral,” implying more hikes are coming.  He also said that he isn’t sure where neutral is.  These comments became a second catalyst, spooking longer-term rates higher.

Now that interest rates are no longer pinned near zero, people have strong opinions about them again.  President Trump called Chairman Powell’s hawkish stance “crazy.”  Presidents always seem to want very low interest rates, however, except when their inflationary consequences are running rampant.

It is no shock the Fed sees inflationary risks.  We recently discussed potential inflationary pressures due to rising wages and tariffs, which are effectively taxes on imported goods.  Commodities may be joining the inflation party.  The Dow Jones Commodities Index, an equal-weighted basket of 23 commodity futures, is up about 5% since last month.

A notable laggard in the commodities rally is lumber, down 11% over the past month according to Finviz.com.  Lumber enjoyed a sharp increase in early 2018, peaked in the middle of May, and subsequently fell 40% from its highs.  Despite Hurricane Florence pounding the Florida Panhandle and southeastern Atlantic coast, which will necessitate major rebuilding, the lumber market continues to match supply and demand at prices in keeping with historical norms.

This signals a downturn in homebuilding.  There are many other confirming signals. The strongest is the sluggish performance of homebuilding stocks.  Amanda Fung of Yahoo Finance published an article on October 8 with the succinct title “The housing market is peaking,” arguing that an expected 1% decline in total home sales in 2018, along with a 13% increase in year-over-year inventory likely predict a sharp slowdown in home price appreciations.  Unfortunately for buyers, mortgages are becoming more expensive in a rising interest rate environment.  We don’t see anything strange going on here.  The slowdown in home prices is part and parcel of declining affordability.  As the old saying goes: high prices cure high prices.

The notoriously cyclical industrial sector was last month’s worst performer according to Finviz.  Weakness in cyclical stocks likely signals profit margin pressures, as companies struggle to pass on higher input costs.  Profit margins recovered before the economy did, and they are likely to contract before the economy cools again.

Third quarter earnings season is here to shake things up as well.  John Butters of FactSet writes in his October 12 “Earnings Insights” that the S&P 500’s blended earnings growth estimate is 19.1%.  This is ahead of the S&P’s approximately 11% total return over the past 12 months.  It isn’t just tax cuts spurring those impressive profits either.  Revenue is also expected to grow a strong 7.3%.

That growth won’t be evenly distributed however.  Some companies will power through Q3 earnings season looking stronger than ever, and others will be left behind making excuses.  The market’s volatility may be signaling that this is a particularly good time for leaders to distinguish themselves from the also-rans that have been swept up in the bull market.  The market always provides special opportunities to selective investors who keep their eyes peeled for good growth at a fair valuation.

Miles Putnam, CFA