From Nick Colas of Convergex
Loose Lips Sink, Well Everything
Summary: As painful as today’s selloff may have seemed, it had none of the characteristics of a genuinely panicky pullback. A VIX at 15.6 may be up from super-depressed levels, but +20 is the level that correlates with real warning bells. Today’s lowish-correlation price action among different sectors tells the same story; the day’s decline was mostly just Technology (down 2.7%) and Financials (down 3.2%). You didn’t even get a real flush in the A-list names (FB, AMZN, GOOG, TSLA, NFLX and AAPL), which were only 2.2 – 3.9% lower and in line with the Tech sector generally. The right way to consider today’s move is a “Warning shot” to Washington, essentially saying “What happens in DC doesn’t stay in DC”.
In our note today we review what to look for next, both within the Beltway and on Wall Street. Key takeaway: DC is a very leaky place and any dramatic price action in equity prices will certainly be a sign of headlines to come. For good or for bad. Buy the dip, sell the grind.
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Markets hate uncertainty. That’s the oldest investing cliché in the book. So given today’s Trump/Comey induced selloff, let’s review what we do and don’t know to see where we can find some signal amidst all the noise.
- Republicans control both chambers of Congress and will do so until at least the end of next year.
- Why that is important: impeaching President Trump is all but impossible. The recent history of presidential impeachment proceedings is clear: both Clinton and Nixon (resigned before impeached) faced opposition parties with majorities in Congress.
- Vice President Pence is a veteran politician.
- Why that’s important: Should President Trump resign (something we doubt will occur), VP Pence will be a strong position to push the same business-friendly legislative agenda currently stalled because of recent events. Call it a “Pence Put”.
- President Trump is a DC outsider and won the presidency with an unconventional campaign that mirrored his unique management and personal style.
- Why that’s important: Equity markets have known from Day One of the Trump Presidency what they were getting with the new commander in chief. Yes, things have gone off the rails a bit. But evaluating a Trump presidency through the lens of equity markets has always been a calculus between the good (tax cuts, infrastructure spending and deregulation) and the unpredictable (a rookie/unconventional politician in the White House).
- How will the current political dust-up change the timeline for tax reform and could it damage business and consumer confidence?
- Why that is important: it is sort of a myth that US stocks have been on a tear this year, especially after today’s selloff. The S&P 500 is still up 5.3%, but the Russell 2000 small cap index is flat and the S&P 600 Small Cap index is down 1.8% on the year (-2.5% today). Tax reform would boost both capital spending and earnings, especially at smaller, and therefore more domestically-focused, companies. Long story short: US equities need an external catalyst like tax reform to move meaningfully higher.
- What exactly happened between President Trump and FBI Director Comey?
- Why this is important: at issue here is the long standing concern about Russian involvement in the US elections. That makes it a larger topic than just the firing of a government official. The whole story seems to be a maze with no solution, and that means it can suck all the oxygen out of Washington for months to come.
- Are there any other shoes left to drop on this issue, and what else might go wrong?
- Why this is important: Investors know all too well the saying “There’s never just one cockroach.” A company fires its CFO, and you know they are about to miss earnings. That kind of thing. And, fairly or not, that is the approach we take to bad news generally. Events in Washington seem to be playing out in a similar fashion – lots of problems, one after another – and investors may well decide to wait for the Chinese water torture to subside before allocating incremental capital to US stocks.
At this point, I want to remind you of a critical factor: Washington is a very leaky place. People talk. A lot. And among the people listening are some of the most plugged-in investors on the planet. As a result the information asymmetry is profound.
That makes watching the tape during periods of politically-induced volatility extremely important. If there is real trouble afoot, you would expect to see:
- A strong and relatively uniform selloff in most S&P sectors as correlations go to 1.0 (they always do in tumultuous markets).
- A very strong decline for highly liquid market leading stocks, as investors raise cash where they can.
- Panic buying of downside protection, exemplified by a VIX that trades around 20 or higher.
If you were trading back in 2008, that “Panic playbook” should look familiar.
And if you were watching the tape today, you know that we didn’t see many of these points come to fruition. For example:
- The CBOE VIX Index closed at 15.6. Yes, that is dramatically higher than the 10-11 handle levels of recent weeks, but the VIX has a habit of spiking and fading with equal speed. Wake me up when it hits +20…
- The A-list of the current rally – Amazon, Facebook, Google, Netflix, Apple and Tesla – were only off 2.2 – 3.9%. On average that’s not far off the 2.7% decline for large cap Tech stocks.
- Consumer stocks fared pretty well (-0.2% for Staples, down 1.6% for Discretionary, both beating the S&P 500). So did Health Care (down 1.3%), Energy (down 1.0%), and of course the interest rate sensitive Utilities (up 0.3%). Bottom line: this wasn’t a wholesale selloff, but basically derisking (out of Tech, with its +1.0 beta) and yield related (2-10 year spreads below 1.0 killed the Financials).
So where to from here? Based on what we know now, there are 2 positive outcomes and one negative when it comes to the direction of US stocks.
- Positive possibility #1: Markets shrug off the current volatility, seeing Trump/Comey as nothing more than a sideshow that will not ultimately derail Republican plans to pass business-friendly initiatives. Moreover, the White House learns from the past few months and smooths out the kinks in its policy and communication practices.
- Positive possibility #2: Things get really ugly really fast, with some as-yet-unknown political bombshell in the offing. I can assure you: equity prices will flush hours or days before this is revealed, simply due to the nature of chatter in DC I described earlier. After an initial negative reaction, markets will rally on an expected resolution. You can fill in the blank on what that would be…
- Negative possibility #1: DC lives up to its reputation as a swamp, complete with quicksand. In this scenario we get the drip-drip-drip of bad news but no resolution. Investor confidence falters, even in the current environment of strong earnings and low rates. The wealth effect of the market on consumer spending goes into reverse, and economic growth slows.
How do you handicap these three outcomes? I recently came upon a website called “Predict It”, which allows users to place small wagers on various future events. You can guess what the most active contracts are: whether President Trump will last through 2017 and 2018. Odds of “Impeachment” currently stand at 26%. As for whether it is still “President Trump” at the end of 2018, odds there 57% “Yes”.
You can see more here: https://www.predictit.org/Browse/MostPredicted
The bottom line here is simple: aggressively buy any real selloff (as defined by that checklist), for it is the sign something big is coming. If we just meander or grind lower, that means no resolution is nearby and US equities are probably stuck in a range that is lower than where we are today.