I recall saying recently that bull markets are like escalators on the way up and bear markets (and corrections) are like elevators on the way down. That is the history of the market and we are living this now in real time.
What got lost in all the jubilation of late, with U.S. President Donald Trump as the nation's equity cheerleader, is that markets move in two directions – it is not a one-way ticket up.
And so what happens, of course, since there often is so much psychology behind the swings in asset prices, is that a prolonged period of calm, one-way action (in which we experienced an unprecedented period without even a minor setback – 311 sessions without so much as a 3-per-cent decline; 405 days without a 5-per-cent correction), tests investors' resolve. And investors, in aggregate, failed the test, as they chased the market when it had staged a parabolic surge to the highs less than two weeks ago by plowing a record $102-billion into global equity funds and ETFs.
Bulls can make money, bears can make money, but pigs get slaughtered. The notion of FOMO (Fear of Missing Out) was destined to be a losing strategy. And as such, we just had a chance to have a ringside seat and see Bob Farrell's Rule #5 come to fruition before our very own eyes – on how retail investors can always be expected to buy the least at the lows and most at the highs.
Everybody seems to be searching for a reason for this recent sharp reversal, and, as usual, this is like grasping for straws.
Everyone needs – no, demands – an explanation.
But again, as Bob Farrell, a legend at Merrill Lynch & Co., taught us, it is the markets that make the news; the news does not make the markets. The same pundits who claimed it would take the yield on the 10-year T-note to break above 3 per cent to cause a correction, or the long-awaited inversion of the Treasury curve, well, neither of these ever did occur, either.
The plain fact of the matter is that far too much optimism was priced in at the recent highs. The world is not a perfect place but we had valuations priced for perfection, which is not a timing device but a warning signal, nonetheless. We had the forward price-to-earnings multiple at 18.4 times at the nearby highs and over 23 times on a trailing basis and let me tell you, that doesn't happen very often, even in past periods of low interest rates. Whether you look at P/E, price/sales, price/book, the CAPE, price/net free cash flow, EV/EBITDA, and you can control for whatever discount rate you want, only 10 per cent of the time had the stock market been this pricey in the past. Even our in-house model had this market pegged at 15 per cent above fair-value less than a month ago.
We continue to hear about how great the fundamentals are, but they were even better in 1987, 1994, and 1998. All those years were filled with angst and anxiety, because one always has to take an eclectic and holistic approach to the markets – it is not just about fundamentals at any point in time, though of course this is what the bulls are clinging to at the moment.
Liquidity, technicals, market positioning and valuations are key ingredients to pricing of any asset. And in addition to overly bullish market positioning and sky-high valuations, we also suddenly had liquidity conditions become an issue in recent days. And this is at least partly because of who the principal buyers had been during much of this bull run – machines, indiscriminate buying into passive ETFs, robo-advisers, low-volatility equity funds and the like. Almost like the program trading and portfolio insurance of the mid-1980s.
Speaking of 1987, by the way, the fundamentals then could scarcely have been better – 50-per-cent year-over-year earnings growth, 7-per-cent real GDP growth and unemployment at cycle lows. That's even better than we have today. We had tax reform back then, too. But we also had exuberance bordering on euphoria. We had a new Fed chairman – another source of uncertainty. And amidst a tightening cycle to boot with more being priced in (the 2-year note yield has soared 90 basis points in less than five months and the last time that happened was back in the first half of 2008). Of course, we have a policy-induced weakening in the U.S. dollar along with growing trade disputes and heightened geopolitical risks. The comparisons are pretty stark even if two cycles are never quite a 100-per-cent match.
Let's just say that the extreme levels of complacency and valuations left the market susceptible to what we have witnessed in the past week or so. For those who don't like to pay attention to valuations, I say this: rare is the day that corrective activity as we have just endured occurs in the context of an undervalued market. Full stop.
So here's where we stand. The past two days have seen 1,841 points lopped off the Dow. That is a swift 7-per-cent pullback. Monday's 1,175-point plunge – down around 1,600 at the worst levels of the session – was the steepest decline ever in terms of points, but actually ranks in the 99th percentile in terms of per cent decline (on Oct. 19, 1987, the Dow fell 508 points but that represented a 22.6-per-cent slide). The recent plunge has now taken many markets into negative terrain on a year-to-date basis – the TSX (down 5.4 per cent), Japan's Nikkei 225 (down 5.1 per cent), Australia (down 3.8 per cent), Euro Stoxx 50 (down 2.7 per cent), the Dow (down 1.5 per cent), the S&P 500 (down 0.9 per cent) and Korea (down 0.6 per cent). Hard to believe that the S&P 500 was up 7.5 per cent for the year less than two weeks ago! But to tell you the truth, as far as market carnage is concerned, there has been little in the way of anxiety over this pullback, and little in the way of any spillover to other asset classes.
Normally, one would see a huge flight to safety as in government bonds – but that hasn't really happened, in part because this Fed now led by Jerome Powell is not likely to be swayed to move off the tightening program. The yield on the 10-year Treasury note at one point rose as high as 2.9 per cent Monday morning and even with the modest rally, is still close to the high end of the recent range at just over 2.7 per cent. A real panic would have at least taken the 10-year down closer to the 200-day moving average of 2.3 per cent. With the VIX soaring above 37 and tripling in just the past three weeks – at a level now we haven't seen since August, 2015 – one would think that credit spreads would have widened sharply, too. But they haven't – at 103 basis points for investment-grade and 353 basis points for high yield, they have only widened 2 basis points, and 17 basis points, respectively, over the past week.
Commodities have weakened too (oil down today for a third session in a row – to US$63.73 per barrel, and the base metals have declined across the board) but have far from collapsed. And as with bonds, no flight to the U.S. dollar either, as the DXY U.S. dollar index is off 10 pips this morning to 89.5. Not even gold, with the sizeable inverse relationship to calmness, has lifted off as much as one would expect with such nail-biting – stuck around US$1,342 per ounce.
So far, this has been a stock market sell-off that seems idiosyncratic and specific to equities alone – it is rare to see such little spillover to other markets. Either they are waiting their turn or this carnage is simply a stock market development on its own (very rare indeed). But the fact that the S&P Financials were down close to 5 per cent Monday and underperformed the broad market often does serve as a canary in the coalmine. And also note the big outperformance here of utilities relative to transports – not exactly a pro-cyclical development.
Let's look at the situation from a few angles.
The market slide has to be viewed in the context of a Dow that surged 25 per cent in 2017 and more than doubled the earnings growth we saw. From election day, the blue-chip index is still up 33 per cent. The bottom line is that we were long overdue for a correction to occur and keep in mind we still have yet to experience one in the major U.S. averages. Yet, since 1900, we have seen interim declines, in the form of bear markets or mere corrections, no fewer than 125 times. That works out to once per year, on average. Not just that, but the forward P/E multiple on the S&P 500 has pulled back about one point, and at 17 times, is still close to a 14-year high and above the peak of the credit bubble in the summer of 2007. So, we still have a market that has yet to officially correct. We still have a market with an excessively high multiple.
But we also have a market that looks oversold on a near-term basis, finding technical support at the 100-day moving average (2,634 on the S&P 500) – a test of the 200-day would mean a move to 2,534. Looking at Fibonacci retracements (from the early 2016 lows to the recent peak), we also have found support at a first-order reversal (2,626). But a second order sets us up for a move to 2,474 (and a fifth order to 2,075 – nice to know what the worst-case outcome can be). The key will be, if we do see a knee-jerk rally here from oversold levels, is what the rebound would look like from a pure technical basis.
Please – ignore the talk of positive fundamentals, that is not the story here. Watch breadth and measures of divergence here if the market does start to come back – a new high that sees the advancers-decliners line roll over, as an example, would be fodder for those that retain a cautious posture.
As for the fundamentals, consider that the Citigroup economic surprise index has rolled over in a material way. The wage recovery is narrowly based and there are few signs that the tax cuts are going to fuel a capital expenditure boom – that somehow escaped the core durable goods orders in December which were revised down from an already disappointing print. The fiscal stimulus was hastily designed and the timing very poor from a cyclical perspective. What it has done, actually, is place this new Fed leadership in a box. And Mr. Powell is not going to be a Chairman who will be as willing as his predecessors to step in and soothe investors' anxiety levels. And keep in mind that we can trace 1,000 points, or half this bull market, to Ben Bernanke and Janet Yellen who made it their goal to generate a wealth effect on spending by inducing a relentless liquidity-driven bull market in equities. No matter what else happens from here, that era just ended at Janet Yellen's last meeting a week ago. And notice just the slightest less dovish tone to that press statement, which had Mr. Powell's thumbprints over it as opposed to Ms. Yellen.
I should add that for all the chatter of how well the U.S. economy had been doing, it was all premised on how the stock market shaped people's views. The surveys had been firm, indeed, but it is one thing to fill out a form for ISM or the Conference Board or the NFIB for that matter, and another to actually act on your feelings. And in terms of the broad economy, when we strip out the post-hurricane "repair and rebuild" stimulus and the credit-card binge that dragged the savings rate down to 12-year lows, real GDP growth in the third quarter was zero. And looking at the deep hole we are in with respect to aggregate hours worked following Friday's jobs data, it will take a productivity bounce of size to get real GDP growth above zero this quarter as well. I doubt a stagnant economy is going to be very consistent with a CAPE multiple that is still flirting at levels that surpassed prior cycle peaks (outside of 1929 and 2001, I should add). So maybe, just maybe, if the stock market is paying attention to the so-called fundamentals, it may actually begin to not like what it sees.
Finally, in keeping with the tip-of-the-hat to Bob Farrell, Rule No. 4 deserves a mention – a classic last but not least: "Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways." I think we can safely say that we had something rather exponential happen through most of January, when the S&P 500 hit the consensus year-end target three weeks into the year. And we have not exactly corrected by going sideways either.
David Rosenberg is chief economist with Gluskin Sheff + Associates Inc. and author of the daily economic newsletter Breakfast with Dave.
David Rosenberg