Painting a New Picture for Equities

November 1, 2018

Painting a New Picture for Equities Photo

Two weeks ago, we wrote about the sharp decline in equity markets at the start of October. Equities have continued to face tremendous selling pressure, with the S&P 500 and Dow Jones Industrial Average Indices giving back all of their year-to-date gains, and more, during the month. The past four weeks have certainly been gut-wrenching for anyone invested in equity markets, but this week’s blog post hopes to shed some light on the recent turbulence. 

October isn’t the first month in 2018 to have this magnitude of equity sell-off; February also experienced a massive decline in equity prices. At that time, signs of rising wage inflation started a rout in equities that was exacerbated by a large contingent of money that had been short equity volatility (i.e. selling protection against sharp movements in equity markets) and was violently wiped out in the first few days of the decline. In October, the downward pressure on equities has felt steadier and more organized. For example, the CBOE Volatility Index (VIX) – a measure for the cost of buying one to two months of protection against stock market volatility – peaked below 30 this month versus close to 40 in February. 

This time around, the finger-pointing for the sell-off hasn’t been at quantitative strategies, such as short volatility, but rather toward fears of an economic slowdown. This week’s chart shows the price-to-earnings (P/E) ratio of the S&P 500 Index and the MSCI Cyclical Sectors-Defensive Sectors Return Spread Index. The former calculates the price the market is willing to pay for a dollar of earnings, while the latter is a measure of the performance of cyclical sectors relative to defensive sectors. When the market feels economic growth will slow, it lowers the price it is willing to pay for equities. Additionally, sectors whose businesses perform better during economic expansions (i.e. homebuilders and automakers) tend to underperform those less affected by economic cycles (i.e. utilities). 

While this week’s chart suggests the market may be in the midst of a large-scale revaluation of equities, U.S. GDP exceeded expectations by posting a 3.5% gain, and employment and manufacturing data remain strong. Yet the market may now be pricing in greater headwinds to growth from rising borrowing costs as a result of rate hikes by the Federal Reserve (Fed) and fallout from the trade war with China.


Key Takeaway

The backdrop for equities in recent years has featured a pro-growth political agenda and easy monetary policy. Any weakness in equity prices in the past was taken as a buying opportunity. Today, the overall feeling is more pessimistic toward equities. In investors’ minds, the tax cuts, deregulation and easy money of yesteryear are now being replaced with tariffs and interest rate hikes. Even though the majority of companies have done well so far this earnings season, the market has punished companies that missed expectations far worse than it has rewarded those that exceeded them. The market may need to see a pause in rate hikes from the Fed or progress with China on the trade front before it finds its footing. Otherwise, trying to determine when stocks are cheap enough to buy may prove challenging while the market is in the process of redefining what cheap really means.

Tags: GDP | Volatility | Equity market

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This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.  This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.

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