Recall that in early February of 2018, there was a brief burst of intense equity market drama. The arrival of a new, potentially more hawkish US Central Bank chairman coincided to the day with an unexpectedly strong US employment report. These circumstances implied that a more aggressive Central Bank interest rate path was in the offing, causing a rapid but limited equity market selloff, and an accompanying increase in daily volatility that lingered for many weeks.
By contrast, the second quarter was relatively quiet for our strategy. In April, due to ongoing volatility from the first quarter, our indicator kept our clients defensively positioned for the first two weeks of the month, incurring some small losses. But in May and June our indicator signaled a return to offensive exposure to equities, driving gains in both months. In the final week of June, a Trump administration announcement of trade tariffs on $200B of imported Chinese goods led to a brief selloff in equities that reduced our gains in the month, but it wasn’t enough to switch our indicator back to defensive.
When geopolitical news or Fed chairman turnover drives short-term stock volatility despite robust company earnings growth, as was the case in the first half of 2018, it generally is due to professional investors’ macroeconomic rules for predicting company valuations. For example, more rapid interest rate increases by a hawkish Federal Reserve can imply that money supply across the economy could decrease, reducing consumer spending and company borrowing. New trade tariffs on Chinese goods can imply that a trade war with China could reduce U.S. company exports, and could increase costs for items manufactured in the U.S. from Chinese components.
This sort of news-driven heuristic is currently competing with the upward stock price pressure of earnings growth. According to Thomson Reuters, S&P 500 earnings grew in the second quarter of 2018 by a remarkable 22.6% from the same quarter a year ago. Another heuristic competing with strong earnings growth is the potential impact of an inverted yield curve:
Source: Charles Schwab & Co.
The plot shown here is of the interest rate difference between 10-year and 2-year US government bonds. As the Federal Reserve raises interest rates during a typical economic expansion, it eventually pushes 2-year interest rates higher than the interest rate on 10-year bonds, causing a negative difference between the two rates, resulting in an ‘inverted’ yield curve.
The chart demonstrates that such a condition has preceded every U.S. recession since the 1970s, albeit with significantly varying time lag in each case. For instance, the 10-year to 2-year yield spread fell below 50 bps in early 1995, a full six years before the 2001 onset of a recession and bear market in U.S. equities. An investor using the yield curve’s breach of this threshold as a signal to get defensive would have missed out on the remarkable returns of the 1995-2000 period and would have waited nearly a decade for the decision to pay off.
While the U.S. economy’s expansion continues to mature and approach an eventual correction, our analyses have shown us that when it comes to identifying periods to be offensively or defensively positioned to U.S. equities, our indicator system is better positioned to do so than any macro-economic heuristics such as those mentioned above. So as various news items continue to drive brief periods of volatility while S&P 500 earnings growth powers on, we’ll continue to use our indicator system to position your assets to benefit from potential equity gains and to protect against potential losses.