October 2018 L&S Risk Pulse™ Monthly Update

November 14, 2018

L&S Risk Pulse™ Score

Caution +

The composite economic picture is mixed or unclear, indicating confusion in global markets. Valuations are questionable and volatility must be monitored.

L&S Risk Pulse™ Insights – “The Election Cycle that Never Ends”

General Comments

As the final election tallies are still being counted, the results of the election are fairly well-known.  Democrats regained control of the House of Representatives while the Republicans kept a solid hold on the Senate.  This is pretty much as expected, and we hoped to heave a sigh of relief that the uncertainty surrounding the mid-term election was finally over.  That was not to be the case.  In his first press conference following the election, Donald Trump asked Mike Pence to be his Veep for the 2020 election.  We do not even get a day off before the next campaign begins.

October was a rough month to be sure.  U.S. markets corrected, and foreign markets were dragged down along with domestic indices.  By late in October, more than 44% of the stock in the S&P 500 were down more than 20% from their 52-week highs.  We typically define a bear market as being down 20% from the recent highs, so much of the market was already in a bear market.  The market decline (peak to trough) was just over 11%, highlighting how the construction of indices, such as the S&P 500, obscures the damage done to individual stocks.

By late October, U.S. markets had given back all of their gains for the year.  Even without positive returns, the US market was the shining star of world’s stock markets.  The UK was down 11%.  Emerging Markets were down 16%.  Italy was down 17%.  Germany was down 18%, and China was down nearly 25%.  There was no place to hide, and any exposure to foreign markets was an albatross on performance.

Market concerns seemed to focus on a few key factors.  First, economic growth has been slowing all year, particularly in international markets, and markets became concerned that the weakness overseas would drag down the domestic economy.  As if adding insult to injury, comments from the Fed suggested they would continue to raise interest rates unabated through this year and into next.  Market participants worried that if signs of slowing economic growth were prevalent, why was the Fed continuing down the path of raising rates?  While the probability of an interest rate hike in December remains quite high, many traders are hoping that the Fed will back down about raising rates so aggressively as the New Year unfolds.

The economic uncertainties created an environment where people started to sell their winners to book some profits.  Soon, the most successful names and sectors were down dramatically, and computer trading algorithms pushed prices ever lower.  There is an old adage that stocks take the stairs up, but the elevator down, and October was no exception.  Hard-earned gains for the year disappeared in a very short period.

 

Conclusion

October has historically been a difficult month, while November and December are frequently significantly friendlier to investors.  Corporate profits are reasonably strong, but it would not surprise us to see slower profit growth as we look ahead to 2019.  The positive impact of the tax cuts will not be repeated next year, and higher input costs, caused in part by tariffs, suggest that profit margins may also be peaking.  Peaking profits and margins have often made for a more trying environment for investors.

Economic growth has slowed, especially in Europe and China, although it is tough to find developed or emerging economies that are on the precipice of a recession.  Still, at the margin, growth is slower today than it was at the start of the year.  As we wrote last month, we do think that risks have increased somewhat, although the recent correction does make equity ownership somewhat more palatable.

We do not expect a recession over the next several quarters, but as we saw in October, that does not negate the potential for market corrections.  We take some solace in the knowledge that corrections that occur without economic recessions tend to be milder.

With the calendar friendlier, and with companies able to buy back their own shares after a mandated delay following the reporting of quarterly results, we think the markets may be poised for a positive finish to the year.  Should there be any thaw in the constant trade war bickering between the U.S. and China, that could even add more fuel to the potential for a year-end rally.