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« Q4 2018 Commentary | Main | Q2 2018 Commentary »

Q3 2018 Commentary

It was a strong quarter for stocks, with major indices setting aside their first half malaise and working back to the January highs.  The moves come against a backdrop of continued strong economic data and corporate earnings growth. 

Though stock prices are back at their highs, it is a very different environment from the January peak. 

Gone is the euphoric fervor that erupted at the start of the year, when sentiment measures across the board were at extreme highs.  That peak in optimism also came with a peak in price multiples.  At the January highs, the S&P 500 was trading at a trailing P/E ratio over 25.  The only other time in history that multiples climbed that high was in the early days of the tech bubble.

Even if you tried to factor in the benefit of tax cuts, the trailing P/E multiple was over 24 – still a tech bubble era valuation. 

Today, stocks are cheaper by most measures. Year to date, domestic stocks are up nearly 9%, but earnings are up even more.  This has allowed P/E multiples to fall nearly 8%.  Many are casting this price action as “normalization,” but the moves have been rather extreme by historical standards.  The last time stocks were able to advance this much in nine months with price/peak earnings multiples contracting as much as they have (all adjusted for tax cuts) was over a century ago (1916).

The only modern periods that come close to this performance: the end of 2006 (less than a year from the financial bubble peak) and mid-2000 (near the tech bubble peak).  In both cases, stock prices were rising, but earnings were rising faster – a combination that many interpreted as a “goldilocks” scenario. In each case, however, stocks would soon fall more than 45% – evidence that “normalizing multiples” do not tend to end in soft landings.  Looking at all past instances of rising real prices and falling multiples, future risks have been highly elevated.

Contrary to the popular interpretations, this type of multiple compression is likely to mark the beginning of the end of bull markets.

While this type of multiple erosion fits our broad view that the market is overpriced (no price/peak earnings multiple over 19 has been sustainable), there were reasons to be optimistic in the third quarter.  As we regained new highs, sentiment was nowhere near the euphoric levels from the start of the year.  More moderate sentiment tends to correlate with lower downside risks.

Among the most positive developments in the third quarter was a healthy rotation in market leadership.  Momentum stocks, which had led the market since 2016, took a back seat in the third quarter. As stocks reclaimed new highs, several other sectors had their turn with impressive relative strength.  From our standpoint, the most important shift in relative strength was a rotation into higher quality companies, which showed signs of outperformance for the first time since 2016.

This shift in market leadership was encouraging, but the trend had eroded by the end of the quarter.  At the end of September, major indices were hitting record highs, but only half of those stocks on our Master List of quality companies were up in the month. 

Further undercutting the record highs was the performance from financials.  The sector has lagged most of the year, but that underperformance accelerated as financials fell over 4% during the final week of the quarter.

Financials can be volatile and their lack of participation alone is not necessarily a poor omen, but over the past decade, these divergences have been concerning. On average, when the S&P 500 is near its recent high while financials are more than 4% off their recent highs, future risks are elevated across all time periods.  Average S&P 500 declines within the next quarter have exceeded 10%. This number is a bit skewed by peak financial crisis losses, but even median losses within the next have carried eight times the typical downside risk.

Even the economic picture, which has been rather unblemished, has been showing cracks.  Most notable is an emerging weakness in housing data – most of which seems to have peaked at the end of 2017.  Similarly, auto sales are well off of their levels from one year ago.  When both housing starts and auto sales are this far off their one-year highs, coincident equity losses have generally been larger than average, as have future drawdowns.  The last time we saw these two post such weakness (in 2010) stocks corrected more than 10%

It is important to keep perspective here.  Stocks closed the quarter near all-time highs, and most economic data is indicative of a strong underlying economy.  The small cracks, however, mean the future is perhaps the most uncertain it has been at any point since at least early 2016.

The rotation into quality stocks meant that core-strategy Time Overlay accounts posted their strongest quarter since the election.  All Time Overlay strategies, however, maintained large cash allocations, meaning that returns remain somewhat muted while we avoid the volatility of the market.

The options-enhanced version of our traditional approach managed to outperform for a third consecutive quarter. 

All strategies enter the fourth quarter at our most conservative positioning since the start of the year.


Robert B. Drach

Drach Advisors LLC

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