In many respects 2014 is shaping up similar to 1994 and 2004. In those years the economy finally started to gather momentum several years after the end of a recession and the Federal Reserve began moving towards a tighter monetary policy. Before then, Fed Chairman Alan Greenspan continued to cut interest rates into late 1992—even though the recession ended in 1991—and then held rates in check at 3% from 1992 to early 1994. It was only after three years of a weak recovery before Greenspan felt the economy was strong enough to hike interest rates.
The markets took some getting used to higher rates and from February 1994 to February 1995 the S&P 500 was rather choppy, witnessing nearly a 10% correction in early 1994.
Similar to the 1994 experience, Greenspan held rates in check after the 2001 recession ended and it wasn’t until years later in 2004 before he began to raise interest rates as the economy was slow to recover. Like 1994, stocks made little progress in 2004 as investors had to transition from a high monetary stimulus and low growth environment to a higher growth and less monetary stimulus backdrop. From February 2004 to November of that year, stocks traded flat but like 1994 saw some choppy action and witnessed a 9% pullback during the middle of the year.
Fast forward another decade and the U.S. is again slowly recovering after the end of a recession, aided this time by several rounds of quantitative easing (QE) with the most recent ending this month. Also, we have the prospect of the first Fed rate hike since 2006 forecasted to take place in 2015. Similar to 1994 and 2004, the stock market has made little progress this year as investors grapple with an improving economy and a less accommodative Fed.
Looking Under the Hood
The canaries in the coal mine for detecting large changes in liquidity are the small cap stocks. Currently, the small cap Russell 2000 Index is acting eerily similar to 2004 before the Fed began raising interest rates. In 2004 the Russell 2000 underwent nearly a 15% correction for 200 days. This time around the Russell 2000 has fallen just over 10% for 212 days. This is shown below with the current Russell 2000 on the top panel and the Russell 2000 in 2004 shown on the bottom panel.
Source: Bloomberg
While the small cap space is feeling the pain of this transition from high liquidity and low growth to higher growth and low liquidity, the Dow Jones Industrial Average and the S&P 500 aren’t showing the same level of volatility. While the Russell 2000 was down 4.4% through the third quarter, the Dow was up 4.6% and the large cap S&P 500 Index was up 8.3%; the NASDAQ as well was up 8.6% on a total return basis. However, the headline numbers don’t tell the full story for there is greater deterioration beneath the surface than what the major indexes performance numbers tell.
For example, the S&P 1500 is up 4.96% year-to-date (YTD) as of 10/23/2014 while the median stock in the index is down 0.15%. The NASDAQ Composite is up 6.61% YTD while the median stock within the 2557 member index is down 5.65%. The Russell 3000 comprises roughly 98% of the entire U.S. market capitalization and is up 4.55% YTD while of the 3000 members within the index the median stock is down 1.96%.
Data Source: Bloomberg
Looking at the figure above clearly shows that 2014 has been a rough year as the markets grapple with a less accommodative Fed and the prospect of rate hikes in the coming year on the back of an improved economy. Transitional years are difficult to navigate and the performance numbers from large cap active managers bear this out as nearly 85% of active managers are underperforming the S&P 500. Again, this comes down to stock picking and when the median stock is down 1.96% in the Russell 3000, while the index itself is up 4.55% YTD, beating your benchmark is hard to do.
This was made evident by a recent study done by The Leuthold Group in their October “Perception Express” in which they measured the percentage of stocks within the S&P 1500 beating the S&P 500 over a trailing 12-month basis. As of the end of Q3, only 30.2% of the 1500 stocks in the S&P 1500 were beating the performance of the S&P 500, indicating active managers had a 70% chance of underperforming the S&P 500; this was the worst reading since the technology bubble burst in 2000.
The 2014 Stealth Bear Market
As highlighted in the previous section, returns have been decent YTD on the major averages but not when looking at the individual stocks that make up those averages. The same is true when looking at the strength of the decline since the highs made in September. For example, while the S&P 500 is down 3.39% from its 52-week highs (as of 10/23/2014), the average stock within the 500-member index is down nearly 11%. The data worsens when looking at other major indices like the NASDAQ, which is down 3.88% from its recent highs while the average stock within the index is currently in a bear market, seeing an average decline of nearly 28%. The small cap Russell 2000 is down 8% while its 2000 members are showing an average decline of 24%. The Russell 3000 which comprises 98% of the total US market capitalization is down 3.55% while its 3000 members are down an average of 20%.
Data Source: Bloomberg (As of 10/23/2014)
Looking at a distribution of declines from 52-week highs for the 500 members in the S&P 500 bears this out. The red horizontal line below shows the S&P 500’s decline from its 52-week high (3.39%) and the three red arrows show the number of stocks that are down 20%, 15%, and 10%. We can see that over 10% of the S&P 500 (50 stocks) are still in a bear market (20%+ decline), roughly 25% of the stocks are off by 15% or more, and nearly half of the 500 stocks are still in corrective territory (10%+ decline or more). These numbers come even after the S&P 500 has rallied nearly 8% from its lows on October 15th to its highs on October 23rd.
Data Source: Bloomberg
Big Moves = Big Changes
In addition to the market having to adjust to less liquidity this year, it's also had to grapple with the big move in the US dollar. The large move in the USD has caused some dislocation just as the big move in interest rates in 2013 caused some violent rotations in the market.
Similar to last year, we saw only minor bouts of volatility until a big move in one asset class led to a sharp readjustment in others. Last year that big move was the spike in interest rates. From May 1st through July 8th of 2013, the 10-year US Treasury yield jumped 70.8% from a low of 1.61% to a high of 2.75%. The spike in interest rates pummeled the bond market and interest-rate sensitive stocks like REITS, high dividend yielding stocks, and utilities, which gave back all of their earlier gains and then some (shown relative to the S&P 500 in the bottom panel below). While the S&P 500 declined 7.5% from its May 2013 highs to its June lows, the S&P 500 Utility Index experienced an even sharper decline as it fell 13.4%. Over the same time frame, the iShares US Real Estate ETF (IYR) fell 20%.
Source: Bloomberg
While the spike in interest rates was the big story of 2013 (top panel below, highlighted) that led to a lot of internal volatility in the markets in the middle of the year, the big story of 2014 has been the surge in the US Dollar which just hit a four-year high (red panel below).
Source: Bloomberg
Just as a spike in interest rates hurts bonds and interest-rate sensitive stocks like REITS and utilities, a spike in the dollar hurts commodities and commodity-producing stocks as well as those with large international currency exposure like industrials. You can see this in the figure below, which shows the spike in the USD Index in the bottom panel and the relative performance of the energy sector (black line) and the industrial sector (blue line). Notice the sharp decline in relative performance by the energy and industrial sectors as the dollar rallied.
Source: Bloomberg
Given the expectation for the dollar to undergo a multi-year advance as US and foreign monetary policies diverge, companies that benefit from a strong dollar should continue to do well. One potential sector to benefit from the strong dollar is the retail sector which benefits when commodity inflation falls and consumers spend less at the pump as their discretionary incomes improve.
While most of the industrial sector is hurt by a strong dollar there are other pockets that benefit such as the defense industry. Given the bulk of defense companies budgets come from the US government they do not have large foreign sales exposure that would be hurt by a strong dollar. The outperformance of the retail and defense industries relative to the market are shown below along with the dollar with Lockheed Martin (LMT) and Northrop Grumman (NOC) serving as bellwethers for the defense industry.
Source: Bloomberg
History Suggests Rough Patch May be Ending
If I had to list my number one reason for my long-term success…I think it would be the word ‘humility.’ I tried not to promise more than I could deliver, and I downplayed my ability to forecast or give targets. I believe it was technician Alan Shaw who first said, ‘The stock market is man’s invention that has humbled him the most.’
If you are not humbled in this business, you haven’t been around for long or you are delusional.
- Marty Zweig
This year has been quite humbling for stock pickers given the disparity between the average stock return and the major indices. While 2014 has been a frustrating year with the median stock down over 2% YTD, like 1994 and 2004 there appears to be little evidence of a recession on the horizon and so stocks should regain their footing. In 1994 and 2004 the stock market eventually regained some traction against the backdrop of a less accommodative Fed and an economy that was picking up steam. Currently, my recession model (a composite of leading economic indicators) suggests only a 6% chance of a recession on the horizon and, given the recent rally in the US Dollar Index, we may see the economy accelerate even further ahead.
Going back to the beginning of this bull market in 2009 we have seen the USD Index rally 5% or more in a quarter only four times with Q3 2014 serving as the most recent example. Whenever the dollar has achieved that feat the S&P 500 has seen strong gains the following month and quarter as shown below.
Data Source: Bloomberg
Part of the reason why the market rallies after a strong advance in the dollar is that inflation rates come down as commodities tumble. Oil prices have slid precipitously over the last few months and the national average gasoline price has also fallen below where it has traded the last several years, leaving consumers more discretionary funds in their wallets as they pay less at the pump.
US National Average Gasoline Price ($/Gal)
Source: Bloomberg
As inflation expectations fall, economic conditions typically improve. This is shown below with inflation expectations shown in red (inverted for directional similarity) and the Citigroup Economic Surprise Index in black. Given the decline in inflation expectations on the back of the strong dollar rally we should see the economy improve even further to close out the year.
Source: Bloomberg
In addition to the favorable economic backdrop brought about by the dollar rally in the third quarter, there are some strong favorable seasonality trends ahead of us that can’t be ignored. We are now in the fourth quarter, which typically has been the strongest quarter of the year.
Looking at the S&P 500 going back to 1928 shows the average gain in the fourth quarter is 2.59% and the S&P 500 has finished up during the quarter 72.1% of the time. Breaking out the data even further into years more reminiscent to the present case, the data improves even further. For example, when the S&P 500 is up only single digits going into the fourth quarter like this year, it rallies on average 5.56% in the final three months, nearly double the normal average return and is positive during the quarter 87% of the time.
Favorable Cycles
Another feature that distinguishes this year from others is this is a mid-term election year. During such years the S&P 500 gains 6.47% during the fourth quarter and finishes positive 85.7% of the time. During mid-term lame duck president years like the present, the S&P 500 is up 10.50% for the quarter and in the prior four occurrences has been up 100% of the time.
Source: Bespoke Investment Group, B.I.G. Tips (09/29/14); used with permission
Another seasonal study recently done by Bespoke Investment Group takes a look at where we are in the four-year election cycle. Typically, after a new president, the stock market has weak returns in the first two years and then, in the final two years of a president’s term, the stock market posts its strongest returns; this often begins in the fourth quarter of the second year.
This is shown below with the average S&P 500 performance during the four-year election cycle going back to 1928 with the recent end of Q3 marked by the red dot. History suggests the best returns of the cycle are just in front of us.
Source: Bespoke Investment Group, B.I.G. Tips (09/30/14); used with permission
Given the strong run in the last two years, many believe the four-year election cycle may not play out.
However, Bespoke has shown that strength begets strength in that when the market is strong in the first two years it tends to do even better than the average in years three and four. Of all the cycles since 1928, there have been six cycles where the market was up at least 20% going into Q4 of year two (market is up 38.98% this cycle). Of these six cycles the market is up: 100% of the time in Q4 of the second year, 24.46% over the next twelve months, and 40.85% over the remainder of the four-year cycle.
Source: Bespoke Investment Group, B.I.G. Tips (09/30/14); used with permission
Summary
There are times when the market needs to catch its breath after a strong run to adjust to a changing macro environment—this is one of those times. Last year’s near 30% run in the S&P 500 was sure to be a tough act to follow with the end of QE and the prospect of Fed rate hikes coming closer into view. That said, this year marked a critical transition as investors moved from a high liquidity and low growth environment to one of lower liquidity and stronger economic data.
However, I believe this adjustment process is nearing completion and that better days are ahead of us. In addition to strong historical data suggesting Q4 and the remainder of the presidential cycle into 2016 sees strong returns, I am also encouraged that there is little if any evidence of a recession on the horizon as the economic recovery picks up steam and overall financial conditions remain healthy.
Given the improved economy, the US Fed is more in a tightening mode than its major central bank peers like the ECB or BOJ, which is creating a strong support for the dollar. Consequently, the dollar has rallied to a four-year high and its big move has led to major changes within the market. Commodity-sensitive currencies and companies with large foreign sales have been hurt while the retail sector and companies with predominantly domestic sales like defense companies have benefitted.
Should the market continue on its bullish path after a shaky start to Q4, we are likely to experience increased volatility than we have been used to. This year we witnessed the end of QE3 and next year the market will have to grapple with the prospect of the first rate hike in nearly a decade. As long as financial conditions remain strong and the US economy continues to improve, the market should make the transition just as it did in 1994 and 2004.
