Look at them yo-yos, that’s the way you do it, trade the market down and then up on Monday, and then do it all again on Tuesday. It’s almost as if people can make money for nothing. At one point, the U.S. stock market was heading for a perfect repeat, with the S&P 500 dropping 2% before coming all the way back to positive territory by mid-afternoon. By the close, the symmetry had dissipated, as the market took another dive. The intraday volatility remains extreme, and alarming, ahead of Wednesday’s announcements from the Bank of Canada (to which the market ascribes a 70% chance of a rate hike) and the Federal Reserve.
Step back only a little, however, and some clear patterns emerge. This leg of the selloff has been led by the largest stocks which had previously proved immune, particularly the internet platform groups still generally known by the FANG moniker. As this chart shows, the Russell 2000 index of smaller companies has escaped damage over the last three days. Larger companies haven’t been so lucky, and the NYSE Fang+ index has had the worst of it:
Bigger companies have had by far the worst of the turbulence
Viewed in terms of investment factors or styles, there is also a clear direction. Figures from the U.S. from the Bloomberg Factors That Work show a huge shift toward value for the year so far, with the value factor gaining 14.4% while growth drops 5%. Investors are getting out of big growth stocks that had previously had the momentum (such as the FANGs), and putting money to work in value and income-producing stocks. This is exactly what might be predicted to follow a rate shock.
2022: Year of Value (So Far)
Beneath the turbulence, there has been a strong rotation to value
Bloomberg Factors that Work
This, then, is a drastic shift away from predicting growth. As I’ve mentioned often, stocks in the U.S. look hugely expensive by any metric that doesn’t take into account historically low interest rates, so it’s logical that stocks will fall as rates rise. Those high valuations also mean that there’s potentially a long way to go down. What can we rely on to halt the decline?
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Monday and Tuesday showed that there’s still a phalanx of investors ready to “buy the dip” at all times — but in aggregate they haven’t yet been able to stop a substantial drop and now seem to be ranged against “sell the bump” traders. When trying to explain some very strange behavior, target-dated funds need to enter the equation. Much money is directed into equities these days as part of portfolios that are programmed to rebalance regularly. If stocks have risen more than bonds, then there will be big rebalancing flows at the end of quarter as these funds sell stocks and reallocate to bonds. For any given individual, rebalancing is a sensible and disciplined way to ensure buying when things are relatively cheap, and taking some profits when they are relatively expensive.
The issue is that what makes sense for any one individual doesn’t necessarily make sense for the entire market. And managers of target-dated funds have few ways to distinguish themselves apart from, perhaps, getting ahead of other rebalancing flows. Much hope is circulating that there will be a target-date “put” by the end of the quarter, as stocks have fallen much more than bonds lately. A resumed rise in bond yields would mess this up, but at present it looks like some rebalancing flows will be heading into stocks, and as though some traders have been trying to “front-run” or get ahead of them by buying early. This is how the Vanguard Group’s biggest ETFs covering stocks and bonds have fared since the beginning of November:
Target-dated funds may need to buy stocks at the quarter's end
If we don’t get a put from the target-dated funds industry, what about the Fed? It has no mandate to prop up the stock market — but it does want to maintain financial conditions at a level where the economy can function properly. Sharp falls in equities make it harder to raise equity capital and have the effect of tightening financial conditions. This leads to the hope that the stock market has already done some of the Fed’s job, so there will be less need for higher fed funds rates — and also that the Fed might have to act at some point if the stock market fall tightens conditions too much.
So far, this selloff has perceptibly tightened conditions, as the following chart from Goldman Sachs demonstrates. This is mostly due to equities. But there is quite a long way to go before the Fed would feel any great need to come to their rescue:
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All this means that Jerome Powell and his colleagues will have a difficult job as they try to thread the needle. The sentiment has become quite strong in the last few days that the selloff, along with some data showing hints of omicron-induced economic weakness, will probably be enough to persuade the Federal Open Market Committee to try to walk back its hawkishness a little. Backtracking on raising rates in March isn’t going to happen, and the Powell Fed would lose credibility if it did. But predictions of an instant hike, or an instant reduction to the Fed balance sheet, are now being withdrawn. Both hawkish and dovish surprises are plenty possible. The FOMC may yet preside over another yo-yo session.
You Just Haven’t Earned It Yet, Baby
I get some charming feedback sometimes. This is a missive I received over the weekend:
I wish someone, someday would note that for the great bear market you and hundreds of others keep calling for to occur you need for companies to miss forecasts en masse. This is what happened in 2000, 2008, 2020. If you want to make that call, feel free… If this isn’t the “big one” that you and so many are calling for, we are looking at 1994, 1998, 2014, 2018, not 2000, 1973 or 1929 as many like to say. However, if you and the cohort of those exhorting everyone to sell or at least regret ever owning stocks would at least admit that underlying cause, it would give your argument more credibility.
He ended by saying he doubted this would matter because “everyone has an agenda these days.” Such is the breakdown of trust in our society. Let me take this seriously.
First, when you buy a stock you are buying a claim on its future stream of earnings, so there’s no doubt that earnings forecasts should and do matter.
But, second, whether an earnings miss compared to expectation is a cause of big selloffs or a symptom of them is a trickier call. Charles Kindleberger, in what is still regarded as the definitive book on bubbles and manias, argued that the universal trigger for the bursting of a bubble, the necessary condition, was the withdrawal of cheap money. When stock valuations have reached excessive levels, this makes sense. It would also make sense that earnings forecasts would tend to come down in an environment of rising rates.
That said, what does the earnings season now unfolding suggest about the outlook for the market? Unfortunately, it’s not great. It’s hard to attribute the dramatic selloff of early 2022 primarily to earnings, when the Fed has dominated attention, but earnings have failed conspicuously to thwart it. If some degree of earnings disappointment is a necessary condition for a selloff, it looks so far as though it will be fulfilled.
Entering this week, expected earnings for the fourth quarter of 2021 (in cyan in the chart below, from Jim Bianco of Bianco Research), and for the current quarter (in green) have been flat, after a succession of quarters in which the recovery from the pandemic drove big positive surprises:
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Earnings “momentum” — looking at the proportion of upgrades among all forecast revisions — is also appearing weak, although far from disastrous. Both globally and for the U.S., upgrades have dropped but remain above 50% of all revisions. This chart is from Andrew Lapthorne, chief quantitative strategist of Societe Generale SA. More intriguingly, hopes for 2022 were beginning to develop strong momentum until the beginning of last month (when both omicron hit the headlines and markets grasped that the Fed was taking a hawkish turn) :
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Momentum within the market is also very different, and influenced by the inflationary environment. Sectors that might benefit from inflation, such as commodities, are seeing earnings estimates rise, while sectors that have led over the last couple of years are experiencing outright downgrades:
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As for surprises, corporate investor-relations departments continue to play the game of expectations well and set a bar that they can beat when it comes to the announcement. But after the first full week of earnings, the S&P 500 excluding financials (buoyed by the investment banks' great trading revenues) was only 0.7%. Revenues came in at only 0.4% ahead of expectation. The following chart is from the equity and quant strategy group at Bank of America:
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It’s early days in the reporting season, but so far it doesn’t look as though profits are going to help arrest the market’s fall. And there’s also some fundamental basis for the way that the selloff is now being led by the big technology groups that had previously dominated. This is BofA’s account of Nasdaq 100 earnings revisions as a proportion of S&P 500 revisions:
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Some companies have still enjoyed a big bump from earnings season, generally because of bullish predictions for the future. Procter & Gamble Co. and American Express Co. are cases in point. Three-quarters of the S&P 500 is yet to report. But as it stands, corporate earnings are not posing a significant barrier to further market declines. That is my best attempt to be fair; I hope I don’t have an agenda.
The January Effect: 2022 Edition
In stock markets, the January Effect generally means a great bump as investors deploy cash for the new year, often having taken gains for tax reasons at the end of the previous one. That phenomenon isn’t at work this time. But another effect, currently playing out largely away from the spotlight, promises to be vital.
Jan Hatzius, chief economist at Goldman Sachs Group Inc., points out that January is by far the most important month for wage settlements in the service sectors. A year ago, wages were negotiated against a non-inflationary background, and unemployment was still high. This time, workers have a tight labor market to help them, and 7% inflation over the last 12 months is a big incentive to push for more. Much of last year’s inflation was undeniably transitory, driven by supply effects that should dissipate over time. If inflationary psychology is really to take hold this year, it will be through the mechanism of the labor market. And that makes this month critical:
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Much of the expansion of the last decade, and the growth of inequality that accompanied it, was driven by very low pay rises for temporary workers in service sectors such as retailing. Wage data toward the end of last year, as featured in Points of Return, showed that these were now the workers securing the best raises as employers struggled to fill vacancies. And it turns out that a massive 80% of wage growth in retailing takes place in January.
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What will happen? The latest consumer sentiment survey from the Conference Board suggests that the workforce is feeling bearish. It asks a question on whether people expect their income to increase, and the diffusion index built from the results is falling. The following chart, compiled by Steve Blitz, chief U.S. economist for T.S. Lombard, shows that income index proves to be a very good leading indicator for subsequent wage growth, as tracked by the Atlanta Fed:
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Nothing is set in stone, then. It’s reasonable to expect heavy upward pressure on wages, but it’s not a done deal. This could be 2022’s critical January Effect. And it will still be several weeks before we can get evidence of how wage settlements are going. There’s plenty of scope for surprises in either direction.
Survival Tips
Some things are just wonderful. One of them is baseball’s Hall of Fame. In the middle of winter it gives everyone the chance to have heated arguments over who belongs, citing ever more complicated baseball statistics. (And baseball statistics are, of course, much more interesting than financial data.) And occasionally they give us moments of joy.
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Personally, I would have voted for Roger Clemens and Barry Bonds, on the basis that the evidence is that they had already amassed careers worthy of the Hall before they started enhancing their performance with drugs. I would also have voted for Curt Schilling, despite some very unpleasant behavior since his retirement, on the basis that his performance plainly make him worthier than other pitchers of his generation who have already been enshrined (such as Mike Mussina). Schilling and Clemens both gave me much pleasure when they wore Red Sox uniforms. But if only one player could be elected, as has happened this year, I am glad beyond telling that it was David Ortiz. There’s nothing rational about following sports; we do it because, ultimately, it makes us happy. The risk of disappointment makes the great moment all the better when they happen. And, outside of people I’ve actually met personally, I don’t think any human being has made me happier than David Ortiz. That baseball writers voted him in at the first attempt is almost enough to restore my faith in democracy. Gracias Papi.
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