- Stocks have gone 28 trading days without back-to-back gains; a very unique experience historically.
- Uncertainty abounds, associated with Fed policy, economic surprises on the weak side, and earnings which have dropped into negative territory.
- Investor sentiment is swinging more wildly than is normally the case.
One of our theses for 2015 has been heightened volatility, and with the kind of up-and-down action we’re seeing in the stock market, that view has been accurate to-date. Two weeks ago the S&P 500 was near an all-time high, and then last week lost about 2.5%. In fact, all of the major US equity indices were down more than 2% last week. And as I write this today, the market is up over 1%. With only two trading days (including today) left in the first quarter, the S&P 500 is about flat for the quarter. This type of market action can cause a lot of angst, especially among individual investors.
Bespoke Investment Group (BIG) is among the best in the business at analyzing short-term market movements for any longer-term implications. They show that the S&P 500 has seen nine swings of 3.5% or more—with the largest being the 7% run from early-to-late February. For some of the smaller, less broad-based indices, the swings have been even greater.
Twitter was alive last week around the fact that the S&P 500 has gone a very long stretch without being able to put together back-to-back gains. As of Friday, that streak is now 28 trading days. A streak that long is so rare, it’s only happened twice before since World War II—in May 1970 and April 1994.
To get an idea of how these streaks impacted returns historically BIG looked at a slightly larger sample set, by including streaks of at least 25 trading days. As you can see in the table below, on average, long streaks without back-to-back gains were actually positive for returns looking forward a month.
Source: Bespoke Investment Group (BIG). 1945-March 27, 2015.
What is causing these wild day-to-day swings in the market?
Be very careful about trying to pinpoint a single thing on a daily basis. It’s human nature—and the media’s obsession—to try to find a particular reason for the market’s action on any given day; but more often than not, it’s simply the imbalance between supply and demand (i.e., “more buyers than sellers” or “more sellers than buyers”) that defines short-term market movements.
More broadly though, it is perhaps uncertainty around Fed policy and the recent weakness in US economic data that has contributed to the pick-up in market volatility. Fed Chair Janet Yellen probably hasn’t helped ease uncertainty by noting on Friday that the Fed is data dependent and the pace of interest rate hikes could “speed up, slow down, pause, or reverse.”
As you can see below, the Citigroup Economic Surprise Index (CESI) for the United States has plunged over the past couple of months—the Ned Davis Research (NDR) version of the index below is smoothed over rolling eight-day periods. The index does not measure economic growth in an absolute sense; instead it measures whether economic data is coming in better (above zero) or worse (below zero) than expected.
Source: FactSet, Ned Davis Research (NDR), Inc. (Further distribution prohibited without prior permission. Copyright 2015© Ned Davis Research, Inc. All rights reserved.). 2003-March 27, 2015.
As you can see in the table above, the stock market has historically had its worst performance when the US CESI is in its worst zone; as has been the case recently.
Weather and ports
The culprits behind the weakness have been dominated by the harsh winter weather in parts of the country; as well as the West Coast port disruptions. Once again last week, weaker-than-expected reports outnumbered stronger-than-expected reports, which has been the trend for a couple of months. The most headline-grabbing miss last week was the revision to fourth quarter (2014) real gross domestic product (GDP), which was unrevised at 2.2%; below the 2.4% consensus expectation.
At the latest CESI low, it was 1.7 standard deviations below the historic mean, according to NDR. Importantly though, the index is mean-reverting and showing signs of reversing from its latest slump, which is good news for the economy…and possibly for stocks.
Do notice in the table above that as the CESI has recovered historically, stock market performance picks up meaningfully. Caveat: These are averages and not indicative of the likely path this time (think “past performance is not guarantee of future results”).
What are the indications of a turn in economic data?
Two of the more timely and leading economic indicators—both of which saw better readings upon their most recent releases—are Markit’s composite purchasing managers index (PMI) and initial unemployment claims. Some next-level leading indicators have been signaling a turn for the better as well; including mortgage applications for home purchases, railcar loadings, and hotel revenues. Further supports include existing home prices, bank lending, and consumer net worth.
The problem in the shorter-term though—at least for the stock market—is that economic weakness, the stronger dollar, and the plunge in oil prices have all contributed to a drop in earnings growth. This has been a topic I’ve been covering over various mediums recently.
Foreign profits of US companies s(t)ink
In the just-released broad fourth quarter 2014 corporate profits report (which comes out in conjunction with GDP), foreign profits of US companies fell a sharp 5.3%—the largest quarter-over-quarter decline since 2008. That puts foreign profits only 5% above their 2008 peak. On the other hand, although domestic profits of US companies edged up only 0.3% quarter-over-quarter, domestic profits reached another record high and are 22% above their 2006 peak.
The two main culprits behind the earnings weakness have been the plunge in oil prices (energy sector) and the strength in the dollar (multi-national companies). You can see the effect of the latter in the chart below, which highlights the bias in performance so far this year toward more domestically-oriented companies.
Honing in on the S&P 500 specifically, operating earnings have moved into negative territory on a quarter-over-quarter basis; and are expected to remain negative for the next two quarters. According to BCA Research, since the 1970s, there were three non-recessionary periods when profit growth slipped into negative territory: 1986, 1998 and 2012. In 1986, stocks pulled back by more than 10% (and subsequently experienced the Crash of 1987); stocks fell by about 20% in 1998; and stocks dropped by 10% and then 8% in a short span of time.
The swings in economic data; which have contributed to the swings in the stock market; have all contributed to the swings in investor sentiment. As I’ve noted in recent commentary—as well as on Twitter—bearishness had come back fairly quickly recently, which had been surprising given the market trading near all-time highs two weeks ago. But that has changed, as bullish sentiment on the part of individual investors saw its biggest weekly increase of this year. The dominant measure for individual investor sentiment comes from the American Association of Individual Investors (AAII) and you can see the latest gyrations below.
Source: FactSet, as of March 27, 2015.
The good news is the rebound in bullishness has not taken it above the 2009-2015 bull market average of 38.8%. But it does highlight the skittishness of investor sentiment given the current state of Fed/economic/earnings affairs. We reaffirm our view that although the secular bull market that began in 2009 is not over; it’s likely to be a much choppier ride for investors…possibly until earnings can catch back up to valuations.
(c) Charles Schwab