Since volatility picked up in early September when Fed speakers began to talk more supportively of a Fed Funds rate hike, the market has descended over the past few weeks into a period of relative calm, with smaller daily changes in the major market averages. This could, however, be the calm before the storm.
From the sharp rebound off the Brexit lows in June, the market has has formed what looks like a topping pattern, with a peak of 2193 for the S&P 500 on August 15. With last Friday’s sell-off, the market is down about 3% from its mid-August high and trading less than a percentage point away from its pre-Brexit levels. The S&P 500 is also down below the previous market peak of 2134.72 set in May 2015.
Last week’s selling was probably driven by renewed expectations of a coming Fed Funds rate hike in December and new developments in the FBI’s investigation of Mrs. Clinton emails. The government’s advance growth estimate of 2.9% for third quarter GDP strengthens the case for interest rate normalization. Meanwhile, the resurfacing of the FBI’s investigation potentially bolsters Mrs. Clinton’s opponent, Donald Trump. In fact, the market dropped like a stone when the FBI news broke, which seems to be a clear signal that the market had been expecting Mrs. Clinton to win the election and that it may not respond favorably to a win by Mr. Trump.
So far this month, the market is down about 2.1% on a market cap weighted basis. Large cap stocks, as measured by the S&P 500, are down 1.9%, but mid-cap stocks are down 3.4% and small-cap stocks have fallen 5.0%. The S&P SmallCap 600 has posted five consecutive weeks of declines, the largest of which came last week.
All eleven industry sectors have fallen during October. The declines have been led by telecommunications, real estate and health care, which are down 6%-7%. Most other sectors are off 1.0%-2.5%. Financials and technology have outperformed with declines of less than 0.5%. The stronger relative performance for financials is due to better-than-expected third quarter earnings reports from the major banks possibly supported by the view that financial institutions perform better in a rising rate environment. Technology has benefited from favorable outlooks for software and internet stocks, especially the so-called large-cap FANG stocks, (Facebook, Apple, Netflix and Google; but not Amazon which reported weaker third quarter results).
Energy stocks are down a little more than 2% in aggregate, but many mid-cap and small-cap energy stocks are down 6%-10%, even though oil and natural gas prices are up slightly. (Natural gas prices had been falling sharply for nearly two weeks, but they rebounded on Thursday, apparently due to a smaller than expected inventory build.)
Bonds have had a rough October. Like stocks, no sector within fixed income has been spared. Barclay’s Aggregate Index, a broad measure of the fixed income market, is down 0.9%, with one day of trading left to go. Treasury securities are down 1.25% on average. Mortgage-backed securities have slipped 0.3%. Municipals and investment grade corporates are down about 0.9%. High yield bonds are down 0.6%.
The U.S. Treasury yield curve has shifted higher since Sept. 30. As in early Sept,, most of the increase in yields has occurred at the long end of the curve. So far, short-term Treasury yields are little changed. It is difficult to determine a clear rationale for the upshift, especially with yields still near historically low levels. Nevertheless, the shift does not necessarily seem to suggest a higher probability of a December Fed Funds rate hike, but rather an expectation perhaps that this period of exceptionally low interest rates is coming to an end.
The recent weakness in stock and bonds is an ominous prelude to the approaching end of highly contentious and acrimonious presidential campaign. Investors may be nervous right up to election day. Even though Mrs. Clinton was perceived as having a commanding lead, recent polls show that the candidates are nearly neck-and-neck in the nationwide vote.
Under the circumstances, I do not have a strong view about the market’s likely performance over the next week or two. At this point, nothing is likely to surprise me. I believe that the Income Builder model portfolio is reasonably well positioned to handle most likely scenarios. I will also be keeping my eye on the dollar, because I believe that the dollar’s performance in the coming weeks and months could play a big role in the overall performance of the financial markets.
October 30, 2016
Stephen P. Percoco
Lark Research, Inc.
839 Dewitt Street
Linden, New Jersey 07036
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