business October Monthly Market Update September 30, 2019 The total return for all of Q3 2019 is barely on the plus side, due to worsening economic data in Europe and Japan, cuts from the Federal Reserve and a growing possibility for a “baby” recession. How will this impact October and the rest of 2019? On a pure ‘headline basis’, investment returns for September have come in just fine, as a fully diversified equity portfolio will have gained nearly 2%. When combined with the strong late-August rally, the aggregate advance is well over 4% in the past five weeks, even with a modest reversal in the last two weeks. As the saying goes, ‘nothing succeeds like success.’ Dow Theory…Guide for future returns? That said, it’s important to look within the ‘internals’ of the markets to decide how much to celebrate, or not, the recent solid returns. A month ago, I’d discussed the relevance of the long-held Dow Theory as a guide for future returns. In brief, this holds that stock returns for the Dow Transports, comprised of companies that makes America move, must match that for the Dow Industrials, the proxy for what America produces. If not, this creates a ‘divergence’ which must be resolved, which in the current context must happen by either the Transports rallying significantly or the Industrials dropping. This happened to some degree in September. When Wall Street returned from its long Labor Day weekend, it drove the Transports, and in fact all forms of ‘cyclical’ and ‘value’s stocks, considerably faster and farther than the benchmark averages. In the first ten trading days, the Transports rose nearly 7%, exceeded by retailers (10%), major banks (8%) and even energy stocks (10%). In addition, semiconductor stocks and U.S Small Caps gained more than 6%. Sudden increase in treasury yields The catalyst for this sudden jump was easily identifiable, the sudden increase in U.S. Treasury yields. Though without apparent sustainable encouragement from any U.S. economic data, the yield on the long bond, the 30-year maturity, soared from just above 1.90% at its late August low all the way to nearly 2.4% on September 13. Corresponding jumps across all maturity levels also de-inverted the 2s/10s ratio, at one point taking the denominator 10-year all the way to 1.9%. Based almost purely on bond market signals, the economic narrative that transferred to stocks quickly became one of re-acceleration, either in Q4 or early 2020. This new narrative, indeed if it comes to pass, is quite sufficient reason to warrant that switch to value and, furthermore, a reason to become quite bullish about stocks as a whole for at least the next 6-12 months. However, as we’ve noted in prior Updates, a couple of ultra-strong mid-month weeks do not necessarily portend a lasting trend. Though gratefully not enough to undo all the early strength, the tone in the second half of September reverted back to the weakness that pervaded the markets through most of August and even back to July. As I write this, the total return for all of Q3 is barely on the plus side. To get even deeper into the market’s weeds, after a bit of a lift early in the month, trading volumes and the new high/new low numbers returned to only fractional enthusiasm for stocks. Treasury yields remain higher than in late August but have also fallen back quite a bit, with the 10-year at 1.69 and the 30-year at 2.14. The 2s/10s ratio remains positive but only by about .06% (1.63 versus 1.69), and to switch markets briefly, copper had rallied nearly 6% but now stands barely more than a percent higher. Oil, even with the attacks on the Saudi refining facilities, is essentially flat on the month. Let’s take a quick ‘market-based’ look at the two front-of-mind mainstream economic headlines. I suppose one can conclude from September’s give and take from Washington and Beijing that there is reason to be a little more optimistic that a deal of some significance is on the horizon. Maybe so, but there have been so many cries of ‘wolf’ over the past 7-8 months that it’s hard for the markets to really, really believe that the latest iterations will prove to be real this time. The Federal Reserve did cut rates in mid-September as widely expected but, quite correctly in my opinion, left itself an I-95 size opening to do more, or nothing at all, at its subsequent scheduled Open Market Committee meetings in late October and/or mid-December. Nothing to see here folks, for now anyway. I’d previously referred to U.S. economic data as being somewhat lackluster during September. Although true in an absolute sense, there was some relative-to-expectations improvement, at least in the first half of the month…and there’s no question that ongoing housing statistics are very solid. That now seems to be in the rearview mirror, though. To include Monday’s very weak September reading from the Chicago Purchasing Managers (no doubt attributable to the ongoing GM employee strike), the data reported as the month wound down was hardly encouraging. Optimism over growth in consumer spending has been the pillar on which bullish economic forecasts have been built, but now even that seems to be plateauing. So on this front though nothing bad has come out that matters, yet anyway, there seems to be no real case for renewed optimism either. Meanwhile, the economic data in Europe and Japan seems to get worse and worse. On the geo-political front – to include the aforementioned drone attack in Saudi Arabia, Brexit and continued protests in Hong Kong - each consumed, briefly, some Wall Street oxygen but to nothing more than a briefly transient effect. For those of you really attuned to financial market news, there has been a lot of noise over the need for the Federal Reserve to provide tens of billions of dollars over the past week to the banking system, which found itself very short of liquidity to, indeed, maintain its structural integrity. This certainly sounds quite ominous and, quite recently, perhaps the most proximate cause of the 20+% drop in stocks in Q4’18 was a sudden drop in aggregate liquidity. However, there have been a number of quarter-end one-offs (like September 15 corporate tax payments and a surge in U.S. Treasury-bill issuance to finance the federal budget deficit) so perhaps this will also prove to be an ongoing non-event. Potential presidential impeachment? Of course the new 600-pound gorilla in the room is the prospect of a Presidential impeachment. Though totally unforecastable right now, I have no doubt this will have a massive political consequence. The economic consequence, however, which is all a truly pragmatic Wall Street cares about, is potentially negligible. There’s certainly no greater likelihood of a shift in party political power, and therefore in economic policy, with or without impeachment and its eventual resolution, between now and the 2020 elections. So the financial markets, rightly or wrongly depending I suppose on one’s political bias, have barely blinked. Corporate Earnings So that takes us to what I believe is likely to really matter in October, which is corporate earnings. The major banks begin the true Q3 reporting season late next week and the parade continues in force right through until early November. Based on some early disappointing guidance from the steel industry, Micron Technology, Federal Express and even Darden Restaurants, call me somewhat pessimistic here. To be sure, it’s all about actual-versus-expected and I’ll fully admit that expectations are not high and therefore potentially represent fairly low bars to clear. Considerable attention will also be paid to any forward-looking guidance that accompanies the Q3 data and I’m also on the pessimistic side there, too. With all the high profile economic uncertainties, I can’t see any corporate management team willing to go out on an optimistic limb, only to then have it sawed off underneath them. “Baby” recession could be on the horizon I am still not backing away from my call for a ’baby recession’, as fully discussed a month ago, for some time in 2020. With the softer data reported in the past week or so, it’s even possible that we’re already in one now - but will only be revealed to be the case several months hence. We remain modestly underweight stocks for now, with a weather eye on perhaps becoming slightly more underweight as (and if) conditions warrant, but I don’t want to over-state that. As noted before (and no doubt to be noted again) the real value in being underweight stocks, going into any potential baby bear market that accompanies even a shallow recession, is not the amount of wealth that is temporarily ‘saved’ on the way down. Instead, it’s the flexibility it provides in being able to buy back at potentially much cheaper price levels. To our loyal clients, we continue to be grateful for your continued confidence. We are always available to answer any questions or concerns.