Tumbling Time: Trade & Tightening

On Wednesday, there was a significant selloff in U.S. stocks, with the S&P 500 falling 3.29% and the Dow Jones Industrial Average down more than 830 points. Members of the Raymond James Investment Strategy Committee provide their thoughts on Wednesday’s market activity below:

Scott Brown, Ph.D., Chief Economist, Equity Research

A strong economy, increased government borrowing, tighter monetary policy, and the Fed’s unwinding of its balance sheet each put upward pressure on long-term interest rates. Inflation has picked up this year, but is expected to remain moderate – unlikely to force bond yields higher. Long-term interest rates have remained low outside of the U.S., which has helped to restrain our 10-year Treasury note yield. Yet, market volatility often follows periods of complacency. Until recently, bond market volatility has been very low, which usually leads to significant adjustment even if there is no change in the underlying fundamentals – that may be what’s happening now.

The near-term prospects for the economy remain strong, but there are concerns about the November election, trade policy disruptions, tighter Fed policy, a stronger dollar, risks to global growth, and labor market constraints. All else being equal, higher long-term interest rates are not good for the stock market, unless earnings growth is strong enough to offset that. In the short term, a weak stock market normally pushes bond yields lower. Expect increased volatility and see-sawing markets in the near term.

Ed Mills, Washington Policy Analyst, Equity Research

I have spent the last couple of weeks speaking with U.S. and China trade experts and they universally think things are getting worse. A key issue that has not received any attention in the U.S. is how domestic political pressure in China is making it really hard for Xi to cut a deal. They do not want new foreign competition. I am also hearing that China is placing too much hope on a Democratic victory in November, thinking it weakens Trump. Even if Democrats win, it does not change things. I think the concern that we are in for a bumpier and longer ride than expected is contributing to the uncertainty.

Nick Goetze, Managing Director, Fixed Income Services

The fixed income markets, which have been showing some softness on the long end, firmed up today as the equity market looks to be going through a legitimate pullback. While much of the focus is on the equity markets, do not ignore the fact that we are seeing higher yields in bonds than we have seen in some time. 4.0-4.5% in solid taxable names inside ten years is very attainable. The muni market has also fallen off where you can now get 4% bonds at par and great kicker structure yields with over 3% to call and yields exceeding 4% to maturity. On a tax equivalent basis, these are very attractive returns.

Jeffrey Saut, Chief Investment Strategist, Equity Research

Our short-term model turned negative after the close a week ago on Tuesday (October 2) and we wrote about that, telling traders to abandon trading positions on a short-term basis. Coming into this week we noted that there was a negative energy blast due early week, which would likely be over by late week.

Well, it is now "late week" and the Relative Strength Index (RSI) is about as washed out as it was during the February 9, 2018 "undercut low" that we recommended buying. Likewise, the S&P 500 is about one standard deviation below its 50-day moving average, and the various stochastic indicators are also washed out. So, unless this is a crash (we doubt it), you should get your buy lists ready.

Nicholas Lacy, CFA, Chief Portfolio Strategist, Asset Management Services

• It’s too early to tell if the recent selloff in the U.S. will be followed by a larger global selloff in equities.

• While all equities tended to decline today as well as this week, other investments also experienced a risk off decline (such as oil, which was off 3% today).

• Some areas of the market offered investors places to help mitigate the selloff either from a correlation perspective (going up when stocks go down a lot) or from offering a lower downside relative to the markets.

• As we have been saying for some time, when there is a significant decline in the stock market, the bond market tends to rally. This is especially true for U.S. high quality bonds (such as U.S. Treasuries), which rallied at the end of the day. In fact, the longer maturity Treasury market had a positive total return today as it is supposed to during these markets.

• Not all bonds act as equity risk tools like Treasuries. For example, high yield bonds declined today similar to stocks. The lower the quality, the worse the performance has been during selloffs.

• Other equities declined less today. Those areas that generate dividend income and those areas with lower volatility relative to the market held up much better as one might expect.

• On the flip side, the technology and high growth areas of the market that have driven much of the return this year felt the largest declines as stress from a variety of places put downward pressure on their prices.

• While international markets did decline, they held up better than the U.S., but most were already closed by the time the U.S. market experienced its largest declines.

• We have been advocating improving the quality of investors’ portfolio allocations, including moving up the market cap, improving quality in fixed income, and adding exposure to low volatility U.S. stocks. There is no way to know when the markets will go up or down, but there are some themes that are worth following. It makes sense to allocate to areas of the market with favorable fundamentals, and one must be careful owning too much low credit when the yield advantage is very low.

Michael Gibbs, Managing Director of Equity Portfolio & Technical Strategy, and Joey Madere, CFA, Senior Portfolio Strategist, Equity Portfolio & Technical Strategy

After spending all of Q3’18 with zero daily moves of 1% or more (as a reminder: 29% of days in the first half of the year had a 1% move in either direction), volatility returned in the past week. The low volatility in Q3 suggests investors were too sanguine given potential issues (trade being the main issue). The surprise move in interest rates and the Fed Chair’s comments woke investors up. Now the complacency is quickly shifting to fear, and a much needed “wall of worry” is being rebuilt. Today’s pull back of -3.29% on the S&P 500 was the worst day in the market since February 8th, and the first 1% daily move since June 25th. The technology sector has felt the brunt of the decline to begin Q4, with the tech-heavy Nasdaq Composite down -7.8% since the end of September.

The move over the past five days has been very sharp. For example, the five day price change of the S&P 500 is -4.78% (two standard deviation move). Similarly, the S&P 500 has pulled -3.74% below its 10 day moving average, which is also a two standard deviation move. Moreover, 91% of volume on the NYSE and 90% of volume on the Nasdaq today was to the downside. These moves are typically consistent with the market approaching oversold conditions in the short term. The CBOE Put/Call Ratio1 and Volatility Index (VIX) have also approached oversold levels.

The S&P 500 closed on its lows today, undercutting numerous support levels throughout the day (which is often the case when the market cascades down). We look for an area near the 200 day moving average (2765) to act as support, which the S&P 500 has been able to hold near during the pullbacks earlier this year. On a valuation basis, the S&P 500 now trades at 16.0x next 12 month earnings, which is in line with this year’s lows and below the five year average of 16.45x.

Economic and earnings growth support our buy the pullback theme. We think the new worries regarding interest rates are "noise" given our belief that U.S. yields are not set to run to the upside (due to modest inflation and wage growth, low global yields, U.S. economy growing above trend and likely to moderate in the coming years). Earnings season begins on Friday "unofficially" with the banks. S&P 500 Q3’18 estimate revisions have been solid heading into the quarter, and currently reflect very strong sales and earnings growth of 8.1% and 20.6%, respectively. Should earnings growth reach expectations, current negative investor sentiment will likely improve.

From here, stocks are unlikely to race back to new highs in short order. Likewise, they are unlikely to plummet to levels too far beyond the 200 DMA. Range-bound trading may develop over the coming weeks as investors balance strong economic and earnings growth with rising interest rates and the trade battle with China. Nevertheless, strong economic conditions and earnings growth outweigh other issues for now, and reinforce our buy the pull-back mentality.

Andrew Adams, CFA, CMT, Senior Research Associate, Equity Research

No way around it – yesterday was not a good day. The S&P 500 had not closed down 1% in over 70 sessions coming into Wednesday, and, as is increasingly the case these days, the market made up for that lack of volatility by giving up much of its gains over the last few months in one session. The S&P 500 is now back to where it was in early July and has now fallen a bit over 5% from its all-time high set last month. While it’s happened very quickly, that’s still very much in the realm of a normal market dip, so it’s still too early to panic or overreact. We wrote in Wednesday morning’s commentary that we would start to get a little more concerned about the near term if the S&P 500 took out support at Monday’s low, but, while we thought breaking that support might lead to a further 2-3% decline in the near term, we did not expect it to happen in one day.

The bad news is that we did not really see a bounce into the close, which increases the chances that we see continued selling today (Thursday). The good news, though, is that the market is already hitting washed out levels that have historically marked bottoms. Yesterday’s move took the S&P 500 almost three standard deviations beneath its 50-day moving average, a level of "extendedness" that’s not really supposed to happen. Fewer than 20% of stocks on the NYSE are currently above the 50-day moving average as well. There have only been four other times over the last five years when that has happened and at least a near-term bottom has occurred each time shortly after such poor breadth levels are hit. The volatility curve inverted yesterday too, which has also been a pretty good indication that selling is hitting extremes the past few years. And while yesterday was not a 90% downside day on the exchanges, selling was still close to that extreme (see below), and we did see signs toward the end of the day of indiscriminate selling that often comes near turning points.

Now, we look for signs of buyers coming in to support this market. If we do see continued selling today, the first area I’ll be watching is the S&P 500’s 200-day moving average at 2765. The 200-DMA has not been touched since May, and it’s a sign of just how good the market has been that we can get a bad day like yesterday and still have the S&P trading above its 200-day moving average. If that were to fall, next I’ll be looking for 2740-2750 to provide some support and then 2700. Ideally, if selling does continue today, support will be found at one of these areas and that will lead to a bounce that can restore some confidence.

Pavel Molchanov, Senior Vice President, Energy Analyst, Equity Research

Energy stocks followed the broader market down yesterday - despite the fact that the commodity landscape remains very healthy. Spot oil prices for both WTI and (especially) Brent are near their highest levels since mid-2014. While 2018 has been a good year for energy on the whole, it is certainly true that the stocks have lagged behind the commodity. What explains this divergence? The short answer is that the futures curve has been, and remains, highly backwardated (i.e., downward-sloping). Simply put, the commodity market is indicating that oil prices will be heading lower from here on. We disagree. Notwithstanding normal short-term volatility, we believe that prices will be generally higher in 2019, with a likely cyclical peak in 2020 due to the IMO 2020 sulfur regulations. Thus, we would take advantage of any equity dislocation to buy quality oil-levered equities.

All expressions of opinion by the Investment Strategy Committee reflect the judgment of Raymond James & Associates, Inc. and are subject to change. Information contained in this report was received from sources believed to be reliable, but accuracy is not guaranteed. Past performance is not indicative of future results. No investment strategy can guarantee success. There is no assurance any of the trends mentioned will continue or that any of the forecasts mentioned will occur. Economic and market conditions are subject to change. Investing involves risks including the possible loss of capital. Bond investments are subject to investment risks, including the possible loss of the principal amount invested. The market value of fixed income securities may be affected by several risks including: Interest Rate Risk, a rise in interest rates may reduce the value of your investment; Default or Credit Risk, an issuer’s ability to make interest and principal payments; Liquidity Risk, the inability to promptly sell bonds in the market prior to maturity. U.S. Treasury securities are guaranteed by the U.S. government and, if held to maturity, offer a fixed rate of return and guaranteed principal value. These risks are greater in emerging markets. The Standard & Poor’s 500 Index (S&P 500) is an index of 505 stocks issued by 500 large companies with market capitalizations of at least $6.1 billion. It is not possible to invest directly in an index. Technical Analysis is a method of evaluating securities by analyzing statistics generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security’s intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity. Investments in the energy sector are not suitable for all investors. Further information regarding these investments is available from your financial advisor. Material is provided for informational purposes only and does not constitute a recommendation.

Material is provided for informational purposes only and does not constitute a recommendation.

The NYSE Composite Index is an unmanaged index of all stocks traded on the New York Stock Exchange. VIX is the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market’s expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. The VIX is a widely used measure of market risk. The NASDAQ Composite Index is an unmanaged index of all stocks traded on the NASDAQ over-the-counter market. Investing in oil involves special risks, including the potential adverse effects of state and federal regulation and may not be suitable for all investors. Commodities’ investing is generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising. The Relative Strength Index - RSI is a momentum indicator that measures the magnitude of recent price changes to analyze overbought or oversold conditions. It is primarily used to attempt to identify overbought or oversold conditions in the trading of an asset. The Dow Jones Industrial Average is an unmanaged index of 30 widely held securities.

IMO- International Maritime Organization (IMO) is an agency of the United Nations which has been formed to promote maritime safety.

The 200-day moving average is a popular technical indicator which investors use to analyze price trends. It is simply a security’s average closing price over the last 200 days. The 50-day moving average is one of the most commonly used indicators in stock trading.

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