By Pete Biebel, Senior Vice President

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Excuses, excuses.  Some are believable, some are laughable.  The past several weeks of unusual market volatility have inspired a need for excuses.  For the cable business shows, it seems that making excuses has become a full-time endeavor.  Perhaps the most incredulous of the popular excuses is, “Stocks are down because the yield-curve is flattening.”  Actually, stocks are down for a combination of other reasons, which in turn has sparked a flight to the safety of Treasury securities, which is the true cause of the flattening curve.  As safety-seeking investors bid up Treasuries, the yields on the Ten-Year Notes and long bonds come down.  The yield-curve is flattening because stocks are down.

Still, the markets over the past two months or so are acting differently than they had been in recent years.  After years of improving economic conditions, the prognosis for the future is beginning to look less rosy.  The rate of economic growth, both domestically and internationally, is now probably slowing.  The rate of earnings growth of many companies probably peaked a quarter or two ago.  The rate of future Fed rate hikes has recently become much less certain.  The universal popularity of high-momentum stocks reached its zenith last summer; since then, former owners of those stocks have increasingly realized that they needed to abandon their positions before the remaining believers accept that the party is over.  And, the ebbs and flows in the possibility of an economically costly trade war have increasingly caused tidal shifts in market action.

Those are some of the new realities.  In the same way that changes in temperature, humidity and wind speed combine to occasionally create a thunderstorm, the changing conditions noted above have combined to create a storm to shake the market out of its quiet slumber.  The environment now is dramatically different than it has been in recent years.  From the time the first clap of thunder hit, we knew that we could face an extended period of discomfort as the market adjusts to the new reality.  We shouldn’t expect the market to behave as sedately in turbulent times as it does during periods of relative tranquility.

We all enjoyed the calm northerly bias as the market averages cruised higher over the past several years.  Everyone knew that stocks were getting a little pricey.  Everyone knew that the Fed’s “free money” tailwind had faded and we all wondered how long it might be until the market began struggling to make headway.  The first scare came last February when the market suddenly veered south just after sailing to new highs.  The major indices all held at their 200-day averages and the market managed to tack higher in brief advances into late-summer.  But, there were increasing signs that, this time, conditions were not quite so favorable.  Sectors that had been leaders became headwinds for the market: Small-caps and Tech stocks were trending lower, the over-loved big internet stocks (the very stocks that accounted for all the market’s gain through the first half of the year) were suddenly out of favor and several industry sectors had broken lower.

The first lightning strike hit in early-October and the storm has been rumbling since then.  During these chaotic market states, little shifts in direction often become one-way romps.  Imagine a bowling ball on the floor of the main salon of your yacht.  We could make bets on which way it would roll or on how far it might roll before it stopped.  In relatively calm seas, the ball might roll back-and-forth a bit, but there might not be enough action to keep us entertained.  That was pretty much the state of things for the past several years.  The seas were unusually calm.  The overall stock market had record low volatility.  “Buy the dip” was the mantra that “always” worked.  Every time the ball rolled a little to the south, we all knew to bet on it rolling back north.

The market’s downdraft in October was the storm that roiled the seas.  The good ship “Equity” was suddenly rocking back and forth, listing steeply from side to side.  Because the steep sell-offs left vacuums in their wake, rebound rallies could cover a lot of ground with just a little push.  It was an odds-on bet that when the bowling ball would ricochet off the starboard wall, it would surely tumble quickly all the way back to the port side.  There was no stopping midway, no instant calm.  It would be a sure-fire, one-way move that seemed inevitable, and all the big betters knew it.  I would have had a tough time finding anyone to take the other side of that bet.

One glaring example of that phenomenon played out on Tuesday.  Last week, I wrote, “…if/when SPX falls back below its 200-day moving average (currently 2762), that would likely be a good time to take defensive action.”  I suspect that many others saw a break of that level as a negative development.  Tuesday’s move lower clearly accelerated when that moving average was taken out (see chart).  This was a very short-term development that meant almost nothing in the long-term scheme, but it illustrates how one-sided markets can become during turbulent times.

S&P 500 Index – SPX – Five-Minute Bar Chart, 12/3/2018 – 12/7/2018

Chart courtesy Pershing NetX 360 and Interactive Data.  Used with permission.

Last week’s action, peaking on a gap-up opening on Monday, then plunging to losses of 4% to 5% for the week on the major averages, confirmed that the storm is still raging.  Even with the holidays approaching, we shouldn’t expect that the current level of volatility will quickly subside.

One analyst published the following two historical observations Friday afternoon.  First, consider that, since 1970, there have been just ten instances, like last week, in which the S&P 500 Index (SPX) had a bearish outside reversal week and closed below its 50-week moving average after gaining at least 2% in the prior week.  (That’s just ten times in well over 2500 weeks.)  The average return over the subsequent three-week period was a loss of about 2%.  The good news is that the positive three-week returns were in the 8% to 10% range, but that only happened twice, i.e. 20 % of the time.  The other eight instances were followed by losses of about 1% to more than 17%.  The message is that the seas are likely to continue to be stormy for at least several weeks.

Second, consider also that, since 1970, there have been just ten instances, like last week, in which SPX followed a week in which it gained at least 4% with a week in which it lost at least 4%.  The most recent occurrence was in September of 2011; six months later, SPX was about 20% higher.  The first such occurrence was in December of 2000; SPX skidded 40% lower over the next year-and-a-half and took more than seven years to get back to that 2000 high.  So, neither a definite bullish or bearish sign, but a sign that an immediate return to tranquility is unlikely.

The over-loved, over-owned internet glamour stocks have been obvious casualties of the market’s sea change.  What is less obvious is that the same shift in popularity has spread across the high momentum, high beta stocks as well.  Those groups have been among the poorest performers over the recent months, while the dull, boring, low volatility, dividend paying stocks have become the safe harbor of choice for riding out this stormy stretch.

One development in the bond market that probably is a real factor in the weakness in equities is the continuing deterioration in junk bonds.  I have repeatedly suggested in recent articles that if the relative weakness in the high-yield bond and direct lending markets persists, then it’s likely that the stock market would see continuing hazardous weather.  Over the past five weeks, while Ten-Year Treasuries have rallied to their highest price level since August, junk bond indices have fallen to their lowest levels in 2 ½ years.

The volatility is not likely to subside anytime soon.  And, with last week’s rejection of both the recent Powell rally and the post-G20 Monday morning pop, a negative bias now seems even more likely.  The 2600 level of SPX seems to be the next critical level and it’s only about 1% away.  Breaking below that level would likely cause another rush of selling and an eventual test of the February/April lows in the 2540 – 2550 area.  The good news is that there are plenty of stocks out there that already appear to have slumped to bargain prices.  The strong probability of continuing volatility suggests that there’s no rush to buy but keep working on those shopping lists.

While it could be a while before SPX sees the 2800 again, that is the level to hope for over the near-term.  Sustained trading above 2800 would be the first ray of sunshine for the market since the storm began in October.

Date Report Previous Consensus
Monday 12/10/2018 JOLTS Job Openings 7.009mm 7.000mm
Tuesday 12/11/2018 NFIB Small Business Optimism Index 107.4 107.0
Producer Price Index-Final Demand, M/M +0.6%  0.0%
PPI-Final Demand, less Food & Energy, M/M +0.5%  +0.1%
Wednesday 12/12/2018 Consumer Price Index, M/M +0.3% 0.0%
Consumer Price Index, less Food & Energy, M/M +0.2%  +0.2%
Thursday 12/13/2018 Initial Jobless Claim  231K       228K
Import & Export Prices, Imports, M/M +0.5% -0.7%
Import & Export Prices, Exports, M/M +0.4%  +0.1%
Friday 12/14/2018 Retail Sales, M/M +0.8%  +0.1%
Retail Sales, less Autos & Gas, M/M +0.3% +0.4%
Industrial Production, Production, M/M 0.1% +0.3%
Industrial Production, Manufacturing, M/M +0.3% +0.3%

Links to previously published commentaries can be found at News/Blog/Market.