Market Review For October 2018

October Review and Outlook - November 2, 2018

Index Performance:

Summary:

• A confluence of factors are leading to tighter financial conditions resulting in steep equity declines which could impact the future pace of Fed rate hikes.
• Higher rates across the curve are impacting housing and auto affordability, as well as stock valuations.
• Q3 earnings growth is +22% vs. +19% expectations, but down from 25% in Q1 and Q2. 2019 is looking like 10% earnings growth.
• Q3 earnings are good: 80% of companies that have reported through 1/26/18 beat expectations (vs. the 77% average for the past year). However, earnings are not beating by as much, +3.9% vs. +5.4% over past year.
• Value outperformed growth by the widest margin in over ten years.
• Specter of "trade war" with China still looms as the Shanghai declined more than 30% from its highs.
• Next week's midterm elections could see a change in party in either chamber (House or Senate) for the fourth consecutive election.

Following a robust Q3 where the S&P 500 saw its best quarterly performance in five years, equities reversed sharply to the downside in October with no shortage of headwinds dragging on the sails of the high speed U.S. economy. The confluence of rising rates, strong dollar, trade wars, a slowing global economy, midterm elections, and slowing revenue and earnings growth finally came home to roost in the U.S.

October started with long term rates "breaking out" through multi-year resistance levels leading to accelerating upside momentum as stops were triggered and momentum investors jumped on board. At the same time Fed Chairman Powell made four public appearances touting the strong U.S. economy and for the first time suggested the path of rate hikes could continue above the normalized rate. This was new, hawkish information confirmed by the end of month Fed minutes. The short end of the curve continued its 13-month parabolic ascent with the 2-year Treasury yield topping at 2.91% near month's end, +166bps from last September's 1.25% low.

To the dismay of the global markets the U.S. dollar Index (DXY) resumed its uptrend, up six of the last seven months, including a breakout to fresh 52-week highs in the final two sessions. Global indices responded accordingly with the Shanghai Composite losing 7.7% for the month and now more than 30% from its January highs. The emerging market ETF (ticker EEM) gave back 8.8% for its worst monthly decline since August 2015. Developed markets weren't much better with Japan dropping more than 9%. In Europe France, Germany, and Italy saw declines ranging from 6.5% to 8%. Italy's FTSE MIB Index is now down more than 22% over the last five months. Most global indices peaked back in January and aside from sporadic counter trend rallies, have since been in a trend of lower highs and lower lows. The global economy has been slowing throughout all of 2018 and its impact finally appears to be washing up on our shores. The below weekly period chart of the German DAX shows a major break-down below the neckline of a large 16-month H&S topping pattern which projects a minimum move down more than 11% to 10,140.

Other factors now in play are creating even more uncertainty. While average Q3 earnings are coming in better than initial forecasts, top line revenues have not been as robust and future earnings growth appears to be slowing. Factoring in next week's mid-term elections, a Democratic victory in the House could actually see the dysfunctional political environment in DC turn into gridlock which may not be the worst outcome for stocks.

On the economic front, higher rates are making housing and autos less fordable. The iShares homebuilder ETF (ticker ITBN) declined 11.8% in October, its worst performing month since September 2011, and nearly 37% from its January highs. And despite the late cycle stimulus of tax reform, repatriation, and deficit spending, headline CPI and core CPI peaked seven and five months ago, and last Friday's core PCE - viewed as the Fed's favorite measure of inflation - came in at 1.6% vs. 1.8% expectations. Q3 GDP registered a more than respectable 3.5%, however it was down sequentially from 4.2% in Q2 and the 4% whisper figure reported by Bloomberg. With the safety net of fiscal stimulus already casted and a potentially divided Congress soon at the helm, the peak of economic activity could already be in the rearview mirror.

Index Performance:

Four out of the seven major U.S. indices we track saw at or near double digit declines and without a late two day rally closing out October, many indices were on pace for their worst monthly performance since the '08-'09 Financial Crisis. Large caps benefitted from the flight to safety trade with the best relative performance coming from the Dow Industrials and S&P 500 with declines of 5.1% and 6.9%, followed then by the Nasdaq 100's loss of 8.7%. Conversely the smaller companies were hit the most with the Russell 2000 and Russell MicroCap indices each declining 10.9%, and down 10.4% for the S&P 400 Midcap. While the Dow saw the least damage, it was also the last index in the group to make a new all-time high (September) and like a caboose could very well be the last to the bottom.

For only the third time this year value stocks underperformed growth which is to be expected during periods of risk off sentiment. This year's pace of outperformance by growth (seven out of ten months, or 70%) is right in line with the 10-year average of 63% (75 of 120 months), as measured by the Russell 1000 Value (RLV) and Growth (RLG) indices. Both indices were launched as of August 31, 1992 with the same base value. Over the last decade, the total return of the growth index (321%) has outperformed value (+192%) by a remarkable 129%. However in October the value index outperformed by 366bps, its widest margin since September 2008. The outperformance stands out more so when we see the spread between the two indices has just reached its previous all-time highs, and is now reversing lower, made back during the height of the dotcom era. It could be nothing, or it may suggest the relative performance of value is due for a period of outperformance.

Sector performance:

With equities and bonds each in decline, the defensive sectors outperformed cyclicals despite their higher yielding properties. Staples and utilities were the only sectors in the green with gains of 2.1% and 1.9%, followed closely behind by REIT's with a modest loss of 1.9%. The remaining eight sectors were at the other end of the barbell including double digit declines by discretionary (11.3%), energy (11.3%), industrials (10.9%), and materials (9.5%). While the technology sector has been a leader for much of this bull market, the month of October brought it crashing back to earth as the macro concerns due to many of the above aforementioned headwinds hitting the broader market. Technology as a whole fell by -8% but there were two main drivers to this decrease. In one of the more crowded trades of the year, the FAANG stocks sold off due to a combination of earnings concerns and diversification. The Semiconductor space also took it on the chin as several manufacturers warned of weakening demand. The Semi space alone was down -12.1% during October and more than 23% from YTD highs, while Software Services fell -8.5% and Hardware and Equipment declined by -7%

Volatility Returns:

S&P changes of more than 1% have spiked again after a quiet 2017. The average change, up or down, is 0.83%. In October, we witnessed two 3%+ declines, rivaling dates like Brexit and other past volatility events.

In reviewing the chart of S&P 500 % moves, we note that some of the largest spikes occurred with markets feared a global growth slowdown (January 2016 and current) or higher rates (April 2018 and current). China also figured into the story in January 2016. The market rallied in subsequent months as we know. Can it bounce back again?

In 2017 investors were wondering where the volatility went. In 2018 the number of times the S&P has moved by more than 1% (close to close) is fast approaching the totals for all of 2016.

And here is the VIX over the same time period:

The CBOE VIX was closing in the mid 20's at month end, up from the low teens at the beginning of October.

Dollar Yuan Exchange rate:

China has devalued its currency by about 10% which could negate tariff effects. But, a breach of the 7 level would risk market turmoil and capital flight. China wants a stable currency to further policy goals so this is a key area to watch, especially in light of "trade war" volleys.

The Federal Reserve is reversing the largest experiment in monetary policy history. Taking liquidity out by shrinking its balance sheet and embarking on a rate "normalization", i.e. increase, path.

At the worst of the October declines, some called for the Fed to hit the pause button on rate hikes. However, with the month ending on a positive note, there is still a 3 in 4 chance that the Fed will once again hike rates in the December meeting.

Implied probability of a December Fed Rate Hike in December moved below 70% in October but moved to 74% as equities rallied in the final 2 days of the month:

Looking ahead:

On a positive note stocks rallied to end the month on two consecutive daily gains. This may sound like a small achievement but according to Ryan Detrick, CMT of Nasdaq-listed LPL Financial, the gain on Halloween saved the S&P 500 from having its first month in history without ANY back-to back gains. Nonetheless investors are understandably uneasy after a rough October with many debating whether the price declines were a healthy pause in an ongoing bull market, the market repricing global risks, or the beginning phases of a longer bear market with new lows ahead reflecting an economic slowdown.

During October investors sold "risk-on" sectors and retreated to "safe" sectors. Crude Oil's sharp, steady decline from $75 to $65 during the month seemed to confirm a global slowdown. Equally concerning market volumes were higher on the down days and the dip buying often seen in other downdrafts was absent. The SPX declined 336 points in October. The 50% and 61.8% Fibonacci Retracements come in at 2,771 and 2,811. This is the key price zone to watch for expected resistance and whether or not the flagship large cap Index can break through and continue on towards new highs, or rollover in a resumption of the Q4 downtrend.

A key event is next week's midterm elections. The last three each resulted in a change of party control in either chamber (Senate or House), according to Deutsche Bank's Slok and Brody. China and the U.S. remain far apart from resolving their trade disputes, and there does not appear to be high expectations this will be resolved when Xi and Trump are expected to meet at the G-20 is late November. Seasonal factors are favorable for stocks with November and December the top two performing months on average for the S&P 500 going back to 1950. And while many emerging markets have been hemorrhaging throughout most of 2018, the 11/1 Midday Market Update ( CLICK HERE ) argues they could be in the early stages of a meaningful relief rally over the near to intermediate time frame.

The information contained herein is provided for informational and educational purposes only, and nothing contained herein should be construed asinvestment advice either on behalf of a particular security or an overall investment strategy. All information contained herein is obtained by Nasdaq from sources believed by Nasdaq to be accurate and reliable. However, all information is provided "as is" without warranty of any kind. ADVICE FROM A SECURITIES PROFESSIONAL IS STRONGLY ADVISED.

Nasdaq's Market Intelligence Desk (MID) Team includes:

Charles Brown is Associate Vice President on The Market Intelligence Desk with over 20 years of equity capital markets experience. Charlie has extensive knowledge of equity trading on both floor and screen based marketplaces. Charlie assists with the management of The Market Intelligence Desk and works with Nasdaq listed companies providing them with insightful objective trading analysis.

Steven Brown is a Managing Director on the Market Intelligence Desk (MID) at Nasdaq with over twenty years of experience in equities. With a focus on client retention he currently covers the Financial, Energy and Media sectors.

Christopher Dearborn is a Managing Director on the Market Intelligence Desk (MID) at Nasdaq. Chris has over two decades of equity market experience including floor and screen based trading, corporate access, IPOs and asset allocation. Chris is responsible for providing timely, accurate and objective market and trading-related information to Nasdaq-listed companies.

Brian Joyce, CMT is a Managing Director on the Market Intelligence Desk (MID) at Nasdaq. Before joining Nasdaq Brian spent 16 years as an institutional trader executing equity and options orders for both the buy side and sell side. He also provided trading ideas and wrote technical analysis commentary for an institutional research offering. Brian focuses on helping Nasdaq's Financial, Healthcare and Transportation companies, among others, understand the trading in their stock. Brian is a Chartered Market Technician (CMT).

Michael Sokoll, CFA is a Senior Managing Director on the Market Intelligence Desk (MID) at Nasdaq with over 25 years of equity market experience. In this role, he manages a team of professionals responsible for providing NASDAQ-listed companies with real-time trading analysis and objective market information.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.