We will dedicate today’s note to one topic: what could go wrong for stocks between now and the end of the year? As positive as we are on US large caps and European equities, it is always a useful exercise to consider when and why the tides may turn. That sentiment is doubly true just now, given the remarkable run in equities both since the March 2020 lows and over the last 3 years.
Three thoughts on this:
#1: There is a lot of chatter about US equity return seasonality for the month of September, so we’ll start with this topic. Consider the following monthly return data, courtesy of Yardeni Research (link at the end of the report).
First: since 1928, September is the only month to show more down months than up – 50 down versus 42 up.
Second, September is the only month to show a noticeable negative average return at -1.0 percent:
Worth noting: while the sample size is modest (93 observations), both September’s up/down count and its average return are greater than 2 standard deviations from the mean. The 2-sigma levels are 43 down days and a -0.9 percent return.
Takeaway: the historical data confirms there is something “special” about September, but at a mean return of negative 1.0 percent this fact falls into the “good to know” bucket rather than something more worrisome. Moreover, the Yardeni data shows that October and November (+0.4 pct, +0.9 pct) recoup September’s average losses and December rounds out the year with fresh annual highs.
#2: There are numerous bear cases making the rounds, all of which we’d call “obvious risks”; here is a list of those and a suggested hedge for each if they resonate with you:
First, a geopolitical event that hurts consumer and small investor confidence. Post-World War II historical examples include 9-11 and the second Gulf War. Most of the chatter at present revolves around China/Taiwan and/or what may come from the change of control in Afghanistan. We tend to discount the former, if only because of the obvious risks associated with large-scale military action during a pandemic. The latter is impossible to assess with any clarity, which is precisely why it is a risk.
Hedge: US defense stocks. It’s worth noting that the group (using the ITA ETF as a proxy) are underperforming YTD (+12 percent) and have not made a new high since early June. If there is a geopolitical storm brewing, the defense stocks don’t see it.
Second, an oil shock as a distinct variant of the above concern. Examples include 1973 (Saudi oil embargo) and 1979 (Iranian Revolution), of course, but also 1990 – 1991 (first Gulf War) and even 2008 (oil at $140/barrel). Each had a negative effect on discretionary income since oil prices rose dramatically. Oil shocks, simply put, have caused more recessions than any other sort of event over the last 50 years.
Hedge: Energy stocks. We like the group anyway, but they are also the only logical hiding place in equity markets during an oil shock.
Third, delta and other pandemic variants force a return of economic lockdowns in the US and Europe through Q4 2021 and Q1 2022. The current US/European infection data appears to be peaking but we are going into Fall and Winter, when transmission rates rose last year. Vaccination rates vary by region (US) and country (Europe), so virus spread remains an issue.
Offsetting this risk is any potential fiscal/monetary response, especially in the US. The track record is clear enough from the 2020 experience, even in a divided Washington.
Hedge: cash, tech stocks. A sudden worsening of the pandemic certainly qualifies as a shock, in that it would challenge the market’s current belief in further corporate earnings improvement. Cash is the only hedge when sector correlations suddenly go to 1.0 in a downdraft. Past that, and if policymakers respond, then the 2020 experience says Tech should lead. Worth noting: it already is, so perhaps markets are giving this scenario some weight even now.
Fourth, Q3 US earnings season doesn’t surprise meaningfully, limiting the chance for further upside earnings revisions. Wall Street’s earnings expectations for 2020 are up 20 percent since the start of the year ($167/share to $201/share). The S&P 500 is up 20 percent YTD. Not to be glib, but that’s pretty much all you need to know about why US large caps are where they are. And why it is so important that Q3 earnings surprise to the upside.
On top of actual earnings reports, business conditions must be strong enough to give corporate managements the confidence to make positive comments about their Q4 outlook. As we’ve written virtually every Sunday evening for months now, Q3 expectations remain too low so we have no concerns about Q3 earnings. But … A sudden deterioration in consumer spending/business confidence this month would inform future earnings guidance.
Hedge: defensive groups like Consumer Staples and Utilities. These tend deliver steady earnings and pay high dividend yields regardless of economic conditions.
Fifth, Washington DC policy/news flow. So many things can go wrong … Neither infrastructure bill passes. President Biden chooses a controversial new Fed Chair… The Federal Debt Limit debates take a nasty turn and cause a protracted government shutdown… Chair Powell flubs tapering or rate policy communications … Congress is slow to act if the pandemic suddenly worsens and further fiscal stimulus is needed …
Yes, this is a grab-bag of issues, but current market valuations leave very little room for DC policy missteps in what is still an uncertain world. We don’t put much of a probability on any of the negative scenarios presented above, but since we’re outlining risks they certainly merit a mention.
Sixth, further slowing of the Chinese economy. Given our recent work highlighting reduced pollution levels across China’s major cities, we were not surprised by yesterday’s reports that economic growth there appears to be faltering. On top of this, the country’s policymakers have a lot of irons in the fire just now, ranging from a local Big Tech crackdown to a zero-tolerance pandemic policy. As with the US and Europe, the virus may become more of an issue in the Fall and Winter months.
Hedge: underweight China by shifting any Emerging Markets exposure to Taiwan, South Korea, India or other EM economies.
#3: On top of the issues above, we have a 4 less-consensus “What if …” bear cases for your consideration:
First, what if the pandemic starts to wind down quickly? While this would be a huge positive from a societal standpoint, it would also make for a very different macroeconomic backdrop from today. Employment would, presumably, recover quickly. Inflation would accelerate. While the Fed would be loath to shift its policy stance too quickly, markets would start discounting a faster end to bond buying and eventual rate hikes.
We often liken the current equity market environment to wartime (WW II, Korea, Vietnam) because US stocks saw multi-year bull markets in those periods, just as they have from pre-pandemic 2019 to now. In all cases, however, once the war is over the next year’s equity returns are always negative. The economic transition from war to peace always has its challenges, so why would a sharp post-pandemic transition be any different?
Second, what if inflation finds new vectors? It has been easy to dismiss high headline and core inflation readings as a function of easy comps to 2020; one must really torture the data to see structural inflation just now. As we noted last week, even if you take the highest readings for every US Consumer Price Index segment over the last 10 years and assume they all hit over the next 12 months you still get less annual inflation than last month’s 5 percent reading.
But … how the CPI measures “Shelter” inflation has always been problematic and could certainly be so again. As a category, Shelter is 33 percent of headline and 41 pct of core inflation. Over the decades, the BLS has:
- Defined Shelter inflation solely as the annual change in rent prices (1953 – 1964) …
- … then shifted its approach to include the marginal financing costs of purchasing a home as well as rent (1964 – 1982) …
- … and when high interest rates in the late 1970s combined with Shelter’s relative heavy CPI weighting (31 pct in 1980) made for very high headline and core CPI prints, they shifted gears again and started using a homeowner survey-based measure called “Owners’ Equivalent Rent” in 1983.
This chart of annual Shelter inflation from 1954 – present shows how these changes have affected this important piece of overall US consumer price inflation. Pre-1964, it was very low (0 – 4 percent). From 1964 – 1982, it ripped higher (peak of 21 pct) right along with interest rates. In the post-1983 OER era, it has been modest (0 – 4 percent since 1991).
Now, this is not likely a problem for the rest of 2021, but it could be an issue in 2022 and beyond. Home prices have risen very quickly, and this fact may inform how survey respondents answer the question “what would your home rent for?” which is at the core of the BLS’ OER question.
Third, what if US Big Tech regulation finally gathers steam? Apple, Microsoft, Amazon, Google, and Facebook are 23 percent of the S&P 500 and 13 percent of the MSCI All-World Index. They all trade like US regulators are powerless to curb their operating margins and competitive positions. So far, that’s been correct. But, what if there is some catalytic event that pushes this issue to Washington’s front burner?
Lastly, what if there is a crash in virtual currencies? This is now a $2.1 trillion market, and many small investors (especially in the US) have their virtual assets in the same place as their stock portfolios (a trading app). In the event of a virtual currency crash, novice investors will likely do what they always do during periods of stress: sell relative winners (stocks, in this case) to double down on sudden losers (online currencies).
Closing out with 3 thoughts:
- Bear cases always sound smarter than bullish ones, but they are more often wrong than right. Today’s list is not a warning to “sell everything”. Rather, it is a (hopefully) comprehensive look at what could go wrong.
- Stocks discount two – and only two – inputs: the sustainability of earnings growth and interest rates. Only bearish arguments that directly inform one or both of those two factors are worth your time and worry.
- If, as a matter of prudent risk management, you want to sell down some equity exposure here you’ll get no argument from us. Valuations leave little room for error, September’s seasonality is statistically real, and US/China economic growth is wobbling. There’s still more than a quarter to go in 2021, after all, and therefore plenty of time to reenter positions at lower prices if markets do show more volatility than has been the case for so much of the year.
Yardeni Research seasonality data: https://www.yardeni.com/pub/stmktreturns.pdf