There’s an old stock market riddle that asks, “What’s the most important factor that determines where ABC Corp will trade today?” The clever but initiated will reply with “Changes to expected earnings” or “an upcoming product announcement”.
The correct answer: “Yesterday’s closing price for ABC”. I know… It’s more a trader Dad-joke than a riddle….
Like all semi-stale aphorisms, it survives because it reminds us of an easy-to-forget truth: everything happens at the margin. We might think Tesla or Snap or even the entire S&P 500 is wildly overvalued, but the world doesn’t just wake up one day and magically reset to our version of reality. For that, you need a catalyst to pry open the market’s eyes. And the more specific and dramatic your expected unexpected truth telling is, the better your investment case becomes.
All of which brings us to today’s thought: what potential risks sit outside the US equity market’s field of vision? These are the issues NOT baked into today’s close, and therefore unseen by tomorrow’s open. Until, of course, they are.
Three come to mind:
#1. Political Risk.
The one thing we learned reading through the leaked special counsel’s questions for President Trump is that you never want to be the subject of a Federal investigation. The list is peppered with queries that require you to accurately recall your state of mind months and even years ago. Personally, I can’t remember what I was thinking last week…
Markets have done yeoman’s work ignoring a range of DC-related factors, from tariff/trade disputes to the Russia investigation. The S&P 500 is down all of 1.4% this year, after all, mostly because of rising long-term interest rates.
It is therefore fair to say that US equity markets have precisely zero political risk discounted in stock prices. Investors even seem to have accepted President Trump’s negotiating style (tough at the beginning, but rapidly evolving to near status-quo reality), so there’s less chance of market volatility such as we saw around NAFTA and the steel/aluminum tariffs.
At the same time, the topic nags us on a daily basis. What sequence of events might draw the public’s attention and potentially ding consumer confidence? For all the hand wringing inside the Beltway, that is the only issue that matters to equity prices over timeframes longer than a few hours.
For the moment, the path here is hard to see. We worry, however, that once the first few road signs appear markets will swoon precisely because they thought this risk was already fully discounted at a zero probability.
#2. Seasonal volatility patterns.
Jessica has been highlighting this topic regularly, but we’ll sum it up in one sentence. The CBOE VIX Index basically never peaks for the year in February. The closing high for 2018 to date was on February 5th, at 37. We sit at less than half that level today.
What could lift volatility later in the year, when it customarily ramps to its annual high? Here is one general scenario:
- As we’ve discussed recently, the marginal buyers of US equities are US public companies. Net investment flows from mutual funds/ETFs are negative, and this is unlikely to shift any time soon given demographic trends. Aging populations tend to buy bonds more than stocks.
- That leaves US stocks to the whims of corporate CFOs and the capital allocation committees of public company Boards of Directors. As long as the near term profit picture remains robust, they will repurchase their stocks. That’s what happening right now.
- As soon as the next economic downturn commences, all bets are off. At the beginning of the last cycle (2003) mutual fund investors were large net buyers of equities. In fact, the largest inflows of the last 20 years occurred just then (ICI data shows that clearly). Given that this cohort has been absent in the current rally, they are unlikely to play the role of early-cycle investor when stocks drop.
Line up the seasonal volatility patterns with investment flows and you get a plausible bear case. Sometime in October (historically a peak month for volatility), markets and corporate boards will both start to discount a recession in 2019. On Q3 earnings calls, CFOs talk about reducing buybacks “until things clear up”. US equities take the news poorly, and stocks decline by 10-15%.
As with Point #1, markets discount zero risk of a reduction in buybacks. Valuations remain at healthy levels by historical standards. Except that historically, actual investors put money to work in equities. Now, companies retire their unneeded capital by repurchasing their own stock. That seems like an important difference when considering cyclical investment flows, but there is no discount in US equity valuations for this factor.
#3. Geopolitical risks that increase the price of oil.
We’ve read the idea that “The Federal Reserve kills every bull market” many times in this year. With respect, we disagree. Oil price shocks are the real-world culprit, and 1973, 1979, 1990, and 2001-2002 all support our conclusion. You can even make a case that $140/barrel in early 2008 predestined the US to a recession, even without the Financial Crisis.
For the moment, US equities seem unperturbed by modestly higher oil prices. The recovery in crude this year looks like a natural rise after a long period of stagnation. Putting an exclamation point on this sentiment: large cap Energy stocks have only rallied in the last month. Investors clearly didn’t want to believe the commodity was in an uptrend, and needed to see it stick for a few months before buying the stocks.
How the current administration deals with the Iranian nuclear deal is a wild card, and Israel’s recent actions in Syria point to the chance of a regional military conflict. If you buy into our thought that it is the Middle East, not the Fed, that kills bull markets, it seems remarkable that US stocks place little chance of any broader problem in the region.
Summing up: the purpose of this note is not to bury markets or, for that matter, to praise them. You pay us, in part, to provide some visibility on what others ignore. We can safely say markets are paying little heed to political risk, the market’s over-reliance on buybacks, and Middle East risks. We have no explicit catalysts to prove them wrong. And neither does anyone else at the moment, otherwise markets would be responding.
That doesn’t mean we should ignore them. Sometimes tomorrow’s open isn’t quite too tightly tethered to today’s close.