It is getting real nasty out there for the stock market. Biotech, growth and tech stocks which led the market rally are getting taken out one by one and getting shot between the eyes.
There is plenty occurring below the surface which is likely contributing to the market weakness and volatility. To the casual observer these may be unnoticed. Such examples are mutual fund tax selling, pension fund rebalancing, a strong US Dollar and computerized algorithmic trading.
Monday’s trading got off on solid footing after IBM (IBM) announced that it would be taking over Red Hat (RHT) at a hefty premium. Initially stocks opened higher and then rolled over. Remember that a higher opening on Monday is normally faded. By 2PM the markets were flat or slightly higher. Then they fell off a cliff.
Why did they roll over? First, Angela Merkel announced that she would not be seeking another term as German Chancellor. Next, the crash of a Lion Air Boeing 737 (BA) took nearly a 7% divot out of BA stock. By the way, BA has such a huge backlog that if you order a new plane today, you won’t get delivery before 2023. Then Morgan Stanley (MS) put out a bearish call saying the market is heading into a bear market. MS stands alone in that call on Wall Street. Trust me, while MS is saying this, their brokers are calling up clients to buy stocks and mutual funds. Finally, there was news that another round of tariffs would be imposed on China if a trade deal is not agreed upon by the G20 meeting (that takes place on November 30).
We fell into a technical black hole with a low volume fast market driving stocks down dramatically till about 3:45. Then when all looked bleak, buyers stepped up and the markets rallied, closing well off their lows, albeit in the red for the session.
Can we call this a capitulation? It certainly has the makings of one.
Stocks have gone from fair valuation to cheap in October. As I mentioned before, the worst hit stocks are the biotech, growth and technology stocks.
Through last Friday, third quarter earnings have been strong with about 77% of stocks in the Standard & Poor’s 500 (SPX) beating earnings expectations, 13% meeting expectations and just 8% missing estimates.
The SPX earned $124.51 in 2017 and is expected to earn $157.38 in 2018, on a bottoms-up basis. Concerns are that earnings which are expected to rise 26.4% in 2018 will slow down in 2019. That is a fair concern, especially in the light of a dogmatic Federal Reserve.
However, let’s be objective. The SPX closed at 2,641.24 yesterday, implying a trailing P/E of 16.8. I can accept that earnings will not grow as fast in 2019, but earnings will not shrink, which is what happens in a recession. An overpriced SPX will sell for 21 or more times earnings. The SPX topped out at 18.7 times earnings within the last month.
Even if earnings growth slows down to 5% in 2019, then the SPX will remain undervalued. I think that earnings grow a bit more, likely 10-12%.
Here are the risks to the bears’ case:
- The Federal Reserve becomes less hawkish – I give that a 25% chance.
- China and the US come to a trade agreement, or halt to tariff hostilities by the end of the G20 meeting – 75 % chance.
- The Republicans hold both the house and Senate in the mid-term elections – 25% chance
Right now, all three are being priced at 0%.
While it looks darn ugly out there and all those hard-earned gains for 2018 have been given back, I will likely make a few portfolio changes, but will not throw in the towel because of what appears to be a normal correction. I do not see much more downside to the market. However, we will have to learn to accept a higher degree of volatility than has existed the past few years. As a result, the next few weeks or months will be a bit rocky. I expect that we can easily recoup half of the October losses by Thanksgiving. If 2 out of those 3 bearish risks become reality, the markets can make a run at the 2018 highs.
Disclosure: At the time of this commentary Scott Rothbort, his family and/or clients of LakeView AssetManagement, LLC was long BA, IBM, SPY, SSO & SPLX although positions can change at any time.
Scott Rothbort is the President & Founder of LakeView Asset Management, LLC, a registered investment advisor specializing in high net worth private wealth management. For more information on investing with LakeView Asset Management, LLC call us at 888-9LAKEVIEW or request more information by clicking on the contact button on the top right hand corner of the website. LakeView Management, LLC is a Nevada LLC, with its principal office located in Henderson, NV and branch office located in Millburn, NJ
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