Volatility of October

By Ketu Desai

October was a challenging month for global equity markets with some of the most severe moves post-financial crisis. The selling was broad with the average stock in the S&P falling into bear market (-20 percent) during the month. The S&P gave back nearly all of the gains for the year, and now nearly all major markets across the world are negative for the year. Many traditional safe havens provided limited protection during the month, as Treasuries were down for the month, and gold was up only 1.8 percent. The Treasury index has actually performed worse than the S&P for the year.

The market has sold off for a number of reasons, and each of these reasons took parts of the S&P down with it. The Fed chairman made a speech in early October, in which he said that the Federal Reserve was a “long way from neutral." The market interpreted this as hawkish, indicating that the Fed would continue to aggressively raise rates. The Fed will almost certainly raise rates again in December; however, next year remains a question. If the Fed is aggressive, and does three or more hikes next year, this is unlikely to be positive for the markets. It is also important to remember that at the start of the month, the Fed increased the roll-off of its balance sheet, and the ECB accelerated its taper, which tightened financial conditions.

The speech combined with reduced demand and increased supply of Treasuries caused rates to spike. The rise in rates caused equity markets to reevaluate certain sectors, notably rate-sensitive sectors such as homebuilders and autos. Recent housing data has been particularly concerning, as mortgage rates have risen close to 5 percent. New home sales dropped 5.5 percent last month, and 13.2 percent over the last year. The median selling price is down 3.5 percent over the last year. The recent data is certainly weak however, this is not a 2008 type scenario, there have not been major defaults within housing and banks have a strong capital position.

The trade war continues to hang over the market. The Chinese equity markets are in a bear market, and growth figures out of China show slowing. Many companies on their earnings reports have indicated slower sales in China. Many commodities are down significantly this year, including copper, on weaker Chinese growth. The Chinese have been stimulating, however, many are concerned it might not be enough to counter the slowdown and tariffs. The strong dollar and weaker global growth have caused many companies to miss on the top line. According to Factset, only 59 percent of companies are beating sales estimates. That said 77 percent of companies are beating earnings estimates with growth north of 20 percent, and sales growth of 7.6 percent. While these are strong numbers, the market is focused on the narrative of peak growth and earnings. The latest GDP report showed a strong economic growth rate of 3.5 percent. However, the report showed that business investment only grew 0.8 percent.

This is important because business investment is critical for productivity growth, which is critical for sustaining this expansion without significant inflation. With concerns of weaker global growth and capital expenditures, investors were quick to sell industrials and technology names. Global industrials and semiconductors were some of the hardest hit this month. Semiconductors, a critical building block for technology and many other parts of the economy, have been emblematic of this sell-off. They have sold-off for all of the reasons above and more. While many chip stocks have been weak for a couple months now, performance worsened during this earnings season as a few of them including Texas Instruments, Micron and AMD reported weak numbers, and I think this created the negative sentiment for broader technology. Even companies that reported strong numbers such as Netflix, Paypal, Microsoft, Intel, Adobe were sold after an initial pop, and once many of these tech names broke key technical levels, they were in free fall, without regard to fundamentals.

Despite the terrible market performance and sentiment, there are reasons to believe that this is simply a bull market correction. The typical signs for bear market include pending recession, inverted yield curve, earnings decline, tighter credit conditions, excesses in the system, aggressive Fed / hot inflation. Currently, the Fed is the only one that is a concern. The economy is expanding, and is expected to continue to next year, albeit at a slower pace. Global growth is expected to be in the mid-3 percent range this year and next year. The yield curve is flat, but we are not yet at inversion. Earnings will grow north of 20 percent this year, and likely 6-10 percent next year. Credit conditions also do not appear tight, HY spreads remain tight, sponsor deals are getting placed, and credit markets seem open at the moment. The Fed could get aggressive and we need to keep a close eye on it, particularly post-December meeting guidance. The terminal Fed Funds rate will likely be below 4 percent this cycle, and we will not get there until 2020. Inflation at the moment it is not hot, and recent reports suggest that it has actually cooled. Valuations within most parts of the equity markets remain reasonable, and there are not any significant excesses in the system to speak of.

Looking ahead, the midterm elections will be in focus, as well as China/US talks, and Fed guidance.


Ketu Desai is the Principal of i-squared Wealth Management Inc. (www.isquaredwealth.com), an investment management firm based in New Jersey. ketu@isquaredwealth.com