On Friday, JPMorgan strategist John Normand revealed a striking statistic contextualizing the recent global risk-asset selloff: only on two prior occasions - the 1970s stagflation and the global financial crisis - have so many asset classes had negative returns in one year, and almost never has every market - including the Nasdaq, commodities and US Leveraged Loans - underperformed the trade weighted USD as is the case in 2018:
"the percentage of asset classes that has generated positive returns this year is only 20%, a share that has never been so low outside of 1970s stagflation episodes and the Global Financial Crisis."
According to JPMorgan there are three likely explanations for this "misery":
- the global economy and US earnings have reached a major turning point;
- the Fed is committing its habitual policy mistake by overtightening; and
- after the pre-Lehman experience with complacency, markets are so paranoid they will overreact late-cycle to even minor changes in fundamentals.
Not surprisingly, JPMorgan - whose strategists have been encouraging the bank's clients to keep buying the dip, even as Morgan Stanley recently showed that in 2018 for the first time in 13 years the "BTFD" strategy has generated negative returns...
...remained optimistic and as we discussed yesterday, suggested that the market, which has become "paranoid" after failing to spot the 2008 financial crisis, is overreacting by pricing in a major economic, and market, inflection point well ahead of time.
If complacency is one of the words most associated with the pre-Lehman years – even Queen Elizabeth asked publicly afterwards, "Why did no one see this coming?” – then paranoia may be the one most tied to what remains of this cycle. The second-longest expansion in post-war history and the slowest Fed tightening cycle in three decades has given investors plenty of time to build exposures, but also to study the anatomy of turning points and to contemplate the exit constraints from lower market liquidity.
As a result, Normand - who is "not yet willing to run the year of tracking error implied by holding broadly defensive exposure until the global economy weakens materially" - believes that "2018 looks like the year of overreaction."
He is not the only one.
In his latest Weekly Kickstart note, Goldman's chief equity strategist David Kostin agrees with JPMorgan and concludes that the "sell-off appears overdone relative to fundamentals" with the market pricing in "too sharp of a near-term growth slowdown" in response to which Goldman "expects continued economic and earnings growth will support a rebound in the
We believe the market has moved past fair value and expect earnings growth will lift the S&P 500 toward our year-end target of 2850.
Even so, Goldman is realistic about the slowdown that has gripped the global economy, noting that in the context of the sharp contraction of economic growth in Europe, Japan and EMs, US economic activity had been an outlier until recently:
US economic activity had been a bright spot: the GS US Current Activity Indicator has averaged 3.5% this year and the ISM Manufacturing Index sits near a cycle high at 60.
However, the latest downside surprises this week from the Richmond Fed survey and new home sales as well as weak investment in the Q3 GDP report have raised concerns about slowing US growth. Yet even despite the growth worries, investors still believe the Fed will continue its quarterly hike path. Futures price 1 additional hike this year and 2 hikes in 2019, unchanged versus a month ago.
Echoing JPMorgan, Goldman then notes that while the US economy may have indeed peaked, the S&P 500 appears to be pricing in a far sharped slowdown in US economic growth (ironically, one which is somewhat validated by Goldman's own forecast for US GDP growth to gradually slow from 3.5% in 3Q 2018 to 1.6% in 4Q 2019.) However, Kostin notes, "the move in equity prices reflects a sharp adjustment in growth expectations: based on historical relationships, current prices would correspond with a near-term drop in the ISM to roughly 52 or a deceleration in US economic growth of roughly 1-2 pp."
An alternative take of this relationship is that the ISM print has been artificially boosted by sentiment which is simply not justified by the hard data.
In addition to the market scare over the economic slowdown - which has been also manifest in the drubbing of homebuilders stocks which have underperformed the S&P 500 by 33% from January through September as housing affordability drops to the lowest level in 10 years, while automobile manufacturers have also significantly underperformed the S&P 500 YTD amid similar fears for a slowdown in the auto industry - Goldman notes a peculiar technical development, namely a sharp narrowing in market breadth during the recent price volatility.
Some of the large-cap stocks that have led the market in 2018 have remained relatively resilient. Our GS Breadth Index sits at 3, on a scale of 0 to 100 (page 31). A second measure of market breadth that we track compares the distance between the current price and 52-week high of the S&P 500 index versus that for the median index constituent. This measure of market breadth has rapidly declined by 5 pp during the past 12 months (11th percentile since 1985), similar to episodes in 2016 and 2007.
Why is this material? Because according to Kostin, "consistent with recent weakness in equities, rapid declines in market breadth typically precede larger-than-average drawdowns." He goes on to notes that since 1980, the typical S&P 500 peak-to-trough drawdown has equaled -4% over a six-month horizon. Following sharp declines in market breadth, the typical S&P 500 drawdown has been more than twice as large (-11%).
Having listed the negative factors, Kostin then proceeds to lay out the potential catalysts for a bounce, the chief of which is that earnings are nowhere near the disaster that the market has made them out to be. To wit, with 48% of S&P 500 companies reporting earnings, 54% have beat consensus estimates by more than one standard deviation. However, as we showed previously, the market has been punishing companies that miss while not rewarding those who beat, and the typical firm beating EPS expectations has outperformed the S&P 500 by 36 bp, below the average of 103 bp, as investors focus on the outlook for 2019 earnings.
Bank of America had a slightly different conclusion, one which showed that the market has reacted negatively to earnings beats, the first time it has done that since the launch of Reg FD in August 2000.
To Kostin, one explanation for this is the market's obsession with the upcoming negative inflection point in margins, i.e. JPMorgan's "paranoid" market thesis.
In addition to concerns about economic growth, investors and managements have focused on margin pressures from rising wages and other input costs. FY2 EPS revision sentiment is negative for the first time since the passage of tax reform. But consensus has almost always been too optimistic in its EPS estimates. This year’s positive EPS revision is only one of six years since 1985 with positive revisions.
And while the market appears to be discounting still solid earnings, amid concerns of "peak profits", one critical catalyst may prompt a substantial return of optimism this week: the return of buybacks.
As Kostin calculates, nearly half, or some 48% of S&P 500 firms are now out of their blackout windows and will be able to resume discretionary share repurchases.
To be sure, the buyback blackout period has been the subject of intense focus in recent weeks. For example, as Deutsche Bank shows the frequency of Google searches for the phrase “buyback blackout” has soared to its highest ever in October.
As the blackout period rolls off for more companies, especially those with large buyback programs, the pace of buybacks will ramp up sharply. According to Deutsche Bank calculations, this week companies with $50bn of quarterly buybacks were off their blackout periods, and the number jumps to $110bn by the end of next week and to $145bn the following.
And as we have noted previously, from a demand-supply perspective, buybacks have been the main driver of the equity rally in this cycle.
So in the absence of outflows and further positioning cuts, which would require incrementally more negative news at a time when much of the future adversity appears to be priced in, buybacks should - according to both Goldman and Deutsche Bank - finally drive equities higher.
In other words, the pain for the market may finally be over as corporations once again step in and start doing what they do best: buying back their own stock with little to no regard for price.