The sharp pullback in stocks in October is another correction in an ongoing bull market, in QMA’s view, rather than the early stages of a more prolonged downturn. In a recent Market Pulse PDF opens in a new window, QMA explains why it believes U.S. equity markets are much more likely to rebound and end the year higher from current levels (as of October 29th) than continue selling off.
The proximate spark for the sell-off appears to be U.S. Federal Reserve (Fed) Chair Jerome Powell’s October 3rd comments on Fed policy and the possibility that the Fed’s planned rate hikes were at risk of overshooting the hypothetical neutral rate. This raised fears that the Fed might be headed toward overtightening and making a policy mistake. However, even before that, the list of downside risks was long: emerging market turmoil, continued U.S.-China trade tension, Italian fiscal troubles, the Brexit stalemate, and concerns about peak economic and earnings growth. The U.S. stock market had largely been shrugging off the building stress, but no more.
Should this drawdown reach 10%, it would be the second correction for U.S. stocks this year. Overall, equity market volatility has picked up this year from unusually tranquil levels in 2017. QMA believes the pickup in market volatility and higher frequency of drawdowns is a normal side effect of central bank tightening and the maturing cycle but does not herald the end of the bull market.
The Return of Volatility
QMA’s more constructive outlook for equities supports the decision to rotate some exposure from cash and core bonds to U.S. equities based on what it believes to be temporary weakness.
Macro environment is still benign and corporate fundamentals sound
The U.S. economy is still in an expansionary phase with a low risk of recession given the still positively sloped yield curve, reasonably tight yield spreads, near historic lows for initial unemployment, and continued uptrend in the Economic Indicators Index. Additionally, third-quarter GDP came in at a solid 3.5%, underpinned by an impressive jump in consumer spending, pushing the quarterly annualized rate to 4%. Meanwhile, scattered disappointments aside, corporate earnings reported for third quarter have so far been positive, with nearly 82% of companies delivering positive earnings surprises, well above the historical average. In addition, now that the buyback blackout period is nearly over, QMA expects U.S. corporations to resume share repurchases at a brisk level, providing additional support for stocks.
Valuation has improved
The S&P 500 is now trading at 15 times its forward earnings, compared to 17 just a month ago and 18.5 at the end of January. This is a significant reduction, in the 49th percentile relative to 20 years of history. As a result, QMA believes valuation is much less of a headwind looking forward.
Sentiment is shifting
QMA’s analysis of a host of sentiment and technical metrics, such as volatility, short-term price momentum, and investor flows suggests that the market is in a state of panic, spanning multiple asset classes and sentiment metrics. However, its empirical analysis suggests that extreme stress typically recedes and a relief rally ensues. Therefore, QMA believes the recent rout should be followed by a sharp rebound especially given the solid fundamental backdrop described above.
While QMA believes global stocks are also discounting an overly bearish outlook for global earnings and the global economy, it is concentrating its buying on U.S. stocks as the very solid near-term U.S. fundamentals give it greater conviction that this market is due for a near-term bounce. U.S. stocks could certainly fall further, but QMA is fairly confident that we will see a typical post-election rally into year-end.
VIX refers to the CBOE Volatility Index, which is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. The Economic Indicators Index refers to the Conference Board’s composite economic indexes which are the key elements in an analytic system designed to signal peaks and troughs in the business cycle.
The views expressed herein are those of QMA at the time the comments were made and may not be reflective of its current opinions and are subject to change without notice. Neither the information contained herein nor any opinion expressed shall be construed to constitute investment advice or an offer to sell or a solicitation to buy any securities mentioned herein. This commentary does not purport to provide any legal, tax, or accounting advice. Certain information in this commentary has been obtained from sources believed to be reliable as of the date presented; however, we cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. Each manager has no obligation to update any or all such information; nor do we make any express or implied warranties or representations as to the completeness or accuracy.
This material is being provided for informational or educational purposes only and does not take into account the investment objectives or financial situation of any client or prospective clients. The information is not intended as investment advice and is not a recommendation about managing or investing your retirement savings. Clients seeking information regarding their particular investment needs should contact a financial professional.
QMA is the primary business name of Quantitative Management Associates LLC, a wholly owned subsidiary of PGIM, Inc. (PGIM), a Prudential Financial company. © 2018 Prudential Financial, Inc. and its related entities. PGIM and the PGIM logo are service marks of Prudential Financial, Inc. and its related entities, registered in many jurisdictions worldwide.
For Compliance Use Only: 1012519-00001-00 Ed. 11/2018