The October (Cause) and Effect
by Mark Causer and Chris Lioutas
As Mark Twain was famously quoted “history never repeats itself, but it rhymes”, would seem apt for October 2018 past. I prefer the more recent lines from a Split Enz classic “history never repeats I tell myself before I go to sleep. Don’t say the words you might regret, I lost before, you know I can’t forget!”.
October is a unique month. In the west (and the US being the world’s biggest market), October is a transitional month, autumn sliding relentlessly towards winter. It also boasts the only holiday where people are encouraged to dress up, scare each other and extort candy with threats of mischief, a practise that has now become popular in Australia in more recent times.
October also has a special place in finance, sometimes referred to as the October Effect, and is one of the most feared months in the financial calendar. The events that have given October a bad name over the last (say) 80 years include;
The Panic of 1907 - a financial panic threatened to engulf Wall Street, mostly owing to threats of legislative action against trusts and shrinking credit. There were multiple bank runs and heavy panic selling at the stock exchange. All that stood between the U.S. and a serious crash was a J.P. Morgan led consortium that did the work of the Fed before the Fed existed.
Black Tuesday, Thursday and Monday - The Crash of 1929 was bloodletting on an unprecedented scale because so many more people were involved in the market. It left several "black" days in the history books, each with their own record breaking slides.
Black Monday - Nothing says Monday like a financial meltdown. In 1987, automatic stop-loss orders and financial contagion gave the market a thorough throttling as a domino effect echoed across the world. The Fed and other central banks intervened and the Dow recovered from the 22% drop quite rapidly.
Historically, the month of October has been a pretty challenging month for financial markets and unfortunately 2018 was no different. Over the month local markets were off about 6% and global markets, led by the S&P 500, were off close to 9%. This is causing some concern for many investors, leading to overall concerns about the direction of financial markets in the near term.
Why has this happened?
There have been plenty views on the ‘why’, but to borrow from Financial Keys’ recently appointed investment consultant, Chris Lioutas, he believes that understanding investor behaviour is always difficult, especially over shorter periods of time.
Chris goes on to say that from the information we’ve seen and the ongoing analysis conducted, we can see four main reasons for the current turbulent market movements:
1. US central bank policy (not new, ongoing concern)
2. US-China trade wars (not new, ongoing concern)
3. US technology stock valuations (new, shouldn’t be surprising)
4. Panic / algorithmic / ETF selling (potential opportunity)
As mentioned, the first two are ongoing issues, which continue to stoke investor concerns. The US central bank has turned a little dovish more recently softening some of their rhetoric, however, they remain somewhat clear that they expect to raise rates another 5-6 times over the next 12-18 months before stopping their tightening cycle. In contrast, market expectations are that they stop after 3-4 rate rises (middle of 2019) as the US economy rolls over and gets too soft for them to raise any further. At this point, it’s a 50/50 bet either way.
The consequence of higher cash rates is the impact on bond markets. Bond yields have moved higher over the last couple of months and that’s led to some rotation (selling / buying) between equities and bonds.
On US-China trade wars, the market got a little optimistic earlier in the month that some sort of common ground might be reached when President Trump and President Xi meet, which may pave the way for the end to the trade conflict. That optimism was short-lived. It is obviously in both Presidents’ best interests to find some common ground. The trade wars are having a material impact on global economic growth, with growth rolling over in Europe and Japan more recently, and manufacturing and other business data down quite sharply as a result. Business and investor sentiment and confidence has been sapped.
On US technology stocks, the falls that we’ve recently seen were somewhat inevitable given the unnecessary rally we saw this year up until September. Case in point, Amazon’s share price went from $1,189 to $2,039, before closing at $1,516 (21 Nov 2018).
Did much change at the company level in that time? NO. Is anything fundamentally wrong with these technology stocks? NO. They generally have little to no debt on their balance sheet, sky high margins, significant volume growth, and earnings growth compounding annually in the high teens to early twenties. Nothing wrong with that picture. However, more recently investors have begun to question how sustainable those earnings are into the future, and the recent company reporting season showed investors move their attention to revenue growth (top-line) rather than earnings growth (bottom-line), effectively using revenue growth as a barometer for sustainability of those earnings.
We agree that technology stocks should demand a premium price and hence valuation, but that does need to be kept in-check from time to time. Extrapolating recent or current growth into perpetuity is plain stupid.
On panic / algorithmic / ETF selling, whilst panic selling is not new, and we’re definitely in the midst of it right now given equity valuations look rather compelling, the paradigm shift comes from algorithmic and ETF selling. Algorithmic (automated) trading, simply, involves computers programmed to follow a defined set of instructions at a speed and frequency that’s impossible for a human trader to replicate. ETF buying and selling involves indiscriminate buying and selling of whole markets - regions, countries, sectors, sub-sectors, themes, etc. Once panic or trends set in, indiscriminate selling results in quicker and sharper down movements, which can be hard to reverse. We’re seeing more and more this of late.
Is there any need for concern?
Potentially, especially if trade wars escalate from here and/or if the US central bank mis-reads conditions and goes too hard on rates i.e. continues to increase rates. However, we see the recent downturn as a somewhat rational pull-back (for those not panicking) and plenty of opportunity for those investment managers with excess cash, those who have been waiting for a better price point to buy back into the market.
As mentioned above, equity valuations remain undemanding and some markets look very cheap at present, all with a long term view in mind obviously.
When these type of market conditions prevail, noise of recession starts to hang in the air. It might be useful to consider the following points;
For a major bear market to develop, where markets fall 20%, and the following year are down another 20% (as was the case for the global financial crisis) you really need to see the US economy going into recession and dragging the rest of the world down with it. At the moment there is no sign of that happening.
Interest rates around the world are still low (historically). Yes, the US Federal Reserve is raising interest rates, but they have a long way to go before you could say interest rates are painful. And other countries are still a long, long way from raising interest rates. If anything, countries like Australia may still engage in monetary stimulus.
As mentioned above and from a pure ‘technical’ perspective, we often see weakness around October. The good news is that historically the market rallies into the end of the year and that strength continues into the early New Year. So, what we have seen in October is typical of seasonal volatility we get around this time of the year. It usually starts around August and September, but this year it started a little bit later in October.
What should I do?
Don’t panic. Whilst volatility will continue to rise from here, that will also mean opportunity for those investment managers holding cash. Fundamentals look sound even in light of some economic and political headwinds arising. Don’t get too caught up in the near term and avoid selling low and buying high at all costs. Analysis shows that missing the best 50 days over the last 20 years in Australian equities resulted in a 0% return versus a near 9% return for those that remained invested.
While it’s not easy for investors when they see significant financial market moves, it’s important not to overreact to headline ‘news’. Decisions need to be fundamental in nature. It is important to look at where the market is heading in the near and long term so as to best position portfolios to take advantage of those opportunities as well as manage portfolio risk.
While we take on Chris’s comments above, as always, the team at Financial Keys welcomes your call to discuss your portfolio in detail or any updated views that we might have on global investment markets.
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