Declining S&P revenues and profits driving equity market stress

The primary story of the third quarter was the August / September volatility event, which coincided with a period of global economic weakness and uncertainty.  The below chart from Yardeni Research illustrates the challenge faced by the U.S. economy, and therefore the U.S. equity market, in 2015.  The OECD index of U.S. leading economic indicators (the blue line) has been predicting a slowdown for most of 2015.  At the same time, S&P 500 revenues per share (the red line) have declined in 2015 from their year-ago levels and are on track to do so again in the third quarter, according to Factset Research’s most recent Earnings Insight report.



In late August, these factors plus a host of others – concern over a potential Federal Reserve interest rate increase, a stock market selloff in China and the Chinese government’s resulting surprise currency devaluation, persistent declines in commodity prices – all contributed to a burst of volatility in U.S. equities. 

The chart below shows that our Market Stress Indicator switched to Defense at market close Friday August 21.At the time, the S&P 500 was in the throes of its steepest decline since August 2011. In fact at market open August 24th, when our portfolios repositioned, equity indices were already down substantially from Friday’s close. Our Indicator remained in the Defense state for 30 trading days, the longest such period since we introduced our system four years ago. This period represented a classic investor sentiment regime shift from one of optimism to a regime of pessimism and fear, characterized by much higher than average daily volatility and abrupt reversals in equity market direction.

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During this 30-day period, the S&P 500’s daily volatility more than doubled to 1.83%, from 0.75% in 2015 through August 20th.  Over the past ten years, this level of volatility has only been seen during the market selloff of 2008-9, and the steep S&P 500 corrections of 2010 and 2011. 

Market downside volatility abruptly ceased on October 2nd, protecting the S&P 500 from further declines past its 12.4% peak-to-trough decline reached at the start of the volatility event in August.  The catalyst was most likely that morning’s disappointing Non-Farm Payrolls (NFP) report, which convinced investors that the Federal Reserve was unlikely to raise interest rates before its December meeting. 

In our view, this last point illustrates the U.S. equity market’s ongoing dependency on stimulus measures, and the risk of further volatility once these measures are unwound.  The October 2nd NFP report was disappointing in several areas: job creation was shown to be slowing, hourly wages declined, and average hours worked declined.  Such a report would normally depress equities due to its implications for future economic growth.  However, by making it difficult for the Federal Reserve to justify raising rates, in this instance it quieted volatility and ignited a recovery in U.S. equities that has continued through October, a continuation of the “bad-news-is-good-news” equity cycle induced by ongoing stimulus.

At the end of the third quarter of 2015, the Russell 2000 stood at 1100.69, a level it first reached nearly two years before, on October 17th 2013.Sideways trading in U.S. equities continues, without a meaningful break one way or the other.We wait along with you for the return of a trend.