Markets: Risk is a Four Letter Word
Equity markets generated the worst quarterly returns in several years, with some indices experiencing the largest drawdowns since the 2008 financial crisis. The catalyst that prompted investors to suddenly pivot towards risk aversion was Federal Reserve Chairman Powell’s comments at the onset of the quarter, which characterized the economy as remarkably positive and suggested that the central bank was a long way from neutral monetary policy. This triggered a quarter-long rolling bear market, where quantitatively driven algorithms and hedge fund de-risking forced trade execution with minimal regard for company fundamentals, leaving stocks with substantially compressed valuations, despite solid earnings results. Macro influences, including oil prices, inflation, credit spreads and yield curve shape, were more pronounced in stock prices, as earnings and other idiosyncratic factors moved to the background, particularly in the large and mid cap space.
Volatility also returned, as evidenced at year-end when the market saw nearly twice as many instances of daily moves greater than two percent than that of the prior three years combined. Market action on December 24th and December 26th best exemplified these broader fluctuations, as the S&P 500 registered its largest ever Christmas Eve decline of 2.7%, followed by a robust 5% advance on the following trading day for the S&P 500’s largest percentage gain since March 2009. December 27th capped off the week’s rollercoaster ride with the S&P 500’s largest intraday reversal since May 2010. As the year came to a close, investor angst and portfolio de-risking created a backdrop where nearly three-quarters of the Russell 3000 companies were down 20% or more from their highs, and just over half were at least 30% below their annual peaks. While these rolling bear market statistics seem ominous, similar corrective selling exhaustion occurred as recently as 2011 and 2015-16… just prior to equity market recoveries. In addition, for those subscribing to the notion that significant market downdrafts (such as the one experienced in 2018) are harbingers of an economic recession, there have been numerous occurrences of double-digit percentage market declines in the past few decades where an economic contraction did not immediately follow.
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Monetary Policy: Credibility Put to Pasture
The “Bernanke Put” was a moniker introduced a decade ago during the U.S. Financial Crisis to describe investors’ confidence that equity market valuation floors were implicitly established based on a belief that monetary policy would adapt to market conditions and provide accommodation and support when necessary to avert any serious downturns. This signature trust carried through the Janet Yellen era, but has encountered a critical crossroads relatively early in Chairman Powell’s tenure. Conflicting commentary, and a seemingly steadfast commitment to increase interest rates regardless of economic conditions and without sensitivity to the prevailing equity environment, continues to challenge the Fed’s credibility. In early October, Powell gave a hawkish speech indicating that the economic outlook was particularly bright, monetary policy was a long way from neutral, and the Fed may go past neutral. Following this commentary, interest rates declined, equity markets suffered, and portions of the yield curve inverted as investors feared that Powell would champion raising interest rates and the Fed’s actions might plunge the domestic economy into recession.
Midway through the quarter, the Chairman and other key Fed officials finally responded by tempering their earlier comments and suggesting that interest rates were close to neutral and that future actions would be dependent on incoming economic data. After a fleeting relief rally in stocks, investors pre-emptively became concerned with the mid-December Fed meeting and the prospect of higher rates compromising GDP growth, particularly since data such as consumer/business confidence, housing and regional economic activity had rather abruptly moderated. The December Fed meeting did not disappoint in terms of a rate hike, but the Fed modestly disappointed with its barely changed economic forecasts and a rate path outline for two planned increases in 2019. This was less than the Fed’s prior forecast of three hikes, but more than the buy-side preference for 0-1 hikes. The biggest snafu was the manner in which the ensuing press conference was handled. Chairman Powell intimated that the quantitative tightening of the Fed’s balance sheet (gradual unwind of quantitative easing) would remain on autopilot, and that interest rates alone would be used as the vehicle for effecting the desired monetary policy. As investors reacted harshly to the Fed’s perceived insensitivity to equity market concerns about a potential recession on the horizon, the Fed again attempted to address investor fears with clarifying remarks from another Fed official. The dramatic flip-flopping of Fed commentary has created serious credibility issues with the Institution, casting doubt on its ability to navigate the domestic economy through the converging internal and external pressures. This uncertainty contributed to the vast multiple compression that accounted for much of the market’s recent demise, and threatens to extinguish the Federal Reserve Bank Put that has served as a security blanket for some time.
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Valuation: Compression Applied to the Wound
The Fed’s deteriorating credibility, combined with global economic moderation and continued trade friction, resulted in the sharpest compression in S&P 500 valuation multiples since 2002, and among the steepest price/earnings declines in the post World War II era. This landscape change wounded the overall market and, although the playing field was leveled, the shift disproportionally impacted more premium-priced companies (such as those that are the focus of the CCI Positive Momentum & Positive Surprise investment discipline). Despite the highest quarterly earnings growth in eight years and a significant percentage of companies surpassing EPS and revenue expectations, stock reactions to positive surprises during the latest reporting season were dramatically below the five year average. Systematic de-risking and macro factors, rather than company-specific fundamentals, more heavily influenced stock prices, particularly in the mid and large cap investment spectrum. The underperformance of “crowded” positions (where consensus optimism in the near term outlook is most uniformly positive) offered further validation of the disconnect between company fundamentals and equity price fluctuations. Lastly, 2018 was the polar opposite of 2017 in terms of how analyst buy ratings impacted individual stock performance. The quintile of S&P 500 companies with the highest percentage of fundamental buy ratings entering 2018 recorded the lowest average returns for the year, which is in stark contrast to 2017 when the quintile of stocks with the most positive ratings at the start of the year generated the strongest advances during the year. This highlights how fundamental conviction was not the primary driver of returns in 2018, as stocks with the highest opinion ratings (e.g., strongest fundamental views) actually lagged the rest of the S&P 500 Index. Historically, uncertainties and concerns that have driven extreme valuation contraction become resolved to some degree, resulting in solid equity returns the following year. In fact, a UBS study shows that S&P 500 returns in the year after large price-earnings multiple declines have averaged 16%, with the same level of median returns. Combined with the market’s historically healthy returns in the year after mid-term elections, equities would appear poised for recovery in 2019.
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Economy: Everything in Moderation
The former synchronized global economic recovery has transitioned to moderation of growth in virtually every key region across the globe since earlier in the year. Emerging markets have been adversely impacted by the stronger dollar and oscillating inflation pressures, China has been hindered on escalating tariff and trade tensions, and Europe has been hampered by weakness in key export partners, budgetary issues, looming Brexit impacts and the populist revolt in France against excessive tax burdens. Even the U.S. has begun to experience foundational cracks, as seen with initial housing and auto weakness spreading to regional purchasing manufacturer indices, lower consumer/business confidence, decreased capital spending and the wealth effects of a weaker stock market. This global moderation and investor trepidation around its future path have prompted an inversion in parts of the yield curve and widening of credit spreads, indicating heightened concerns for a domestic recession and some form of financial crisis. It bears noting that the S&P 500 generated 15% and 22% annualized returns the last two times that the 2-10 year rate curve inverted (as measured from point of inversion to its peak) in late 2005 and mid-1998, and has traditionally provided solidly positive gains under similar circumstances. In addition, the spike in credit spreads has been from depressed levels and has only achieved historical averages, diluting the threat of an intermediate financial calamity. Here again, equity markets can still prosper despite widening spreads, as evidenced by the 7% average forward returns since 1988 during such environments. The Federal Reserve, fiscal policy and continued strong employment trends, will be integral to improving domestic trends, while global central banks, reignited trade, and stimulative measures would pave the path for international recovery.
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Outlook: Pause that Refreshes
History has shown that periods of sizable multiple contraction, yield curve inversions, and mid-term elections (all of which recently occurred) have proven to be opportunities for stock investors. A recovery in equity markets is predicated largely on a pause in interest rate increases (re-establishing Federal Reserve credibility), and progress in de-escalating trade tensions between the U.S. and China. Such developments would lessen the uncertainty driving compressed equity valuations, and likely restore business/consumer confidence enough to stabilize spending and other economic activity that has been weak. It would also temper de-risking based algorithmic trading pressures that distracted investors from more normal fundamental decision-making. Within this moderate economic backdrop, growth stocks (which are the focus of CCI’s investment discipline and which were disproportionately penalized by systematic selling and excessive recessionary fears) are best positioned, as their secular growth prospects and business models are generally better insulated from negative economic change and have greater scarcity value as corporate earnings growth decelerates. Fundamentals remained strong across all of the CCI-managed portfolios, as evidenced by the magnitude of positive momentum & positive surprise compared to recent results and earnings revision activity relative to the underlying benchmarks. The general disconnect between contracting multiples and better than expected results for CCI holdings has created a coiled spring that could unleash stronger relative performance as the environment becomes even more conducive for active management.
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