The stock market turns cautious

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Good morning. Yesterday, we tried to decipher the message from the September Treasury rout (main conclusion: “higher for longer” monetary policy can’t explain what has happened). Today we attempt a similar diagnosis of the stock market, which has been falling by fits and starts since midsummer. Email us: [email protected] and [email protected]. 

Also, the Financial Times has just launched a new social channel (on WhatsApp) dedicated exclusively to markets news. Check it out.

Stocks look a little nervous   

The S&P 500 peaked on July 31, and has fallen about 7 per cent since. Some basic characteristics of the downturn:  

• It is all down to valuation: earnings estimates for this year have held steady, while the price/earnings ratio on the index has fallen from 21 to 19.5.

• The biggest, baddest stocks in the index — the Magnificent Seven — are no longer providing strong leadership. Only Alphabet is (just barely) in positive territory. Apple, the biggest stock of all, is down 12 per cent. This, too, is a valuation story. Among the salubrious septet, earnings are still expected to crush the rest of the market — a 15 per cent compound annual growth rate through the end of 2025 versus 5 per cent for the S&P 500, calculates Goldman Sachs. Yet recently multiples have come down from 34 times forward earnings to 27.

• Most factor dynamics have not shifted massively since the peak: growth has outperformed value and big caps have outperformed small caps, but not in big, trend-breaking ways.

• Sector performance tells a reasonably consistent story. It makes perfect sense that at a moment when risk-free yields are barrelling upwards, the sectors often thought of as bond substitutes — utilities and real estate — should perform terribly. Putting those aside, and treating energy as an exogenous story driven by the resurgent oil price, the big winners and losers in the chart below are broadly consistent with a growth slowdown: cyclicals, industrials and materials performing relatively badly, while defensive healthcare does relatively well. Don’t be fooled by (cyclical) financials in the middle of the board. Banks have performed terribly, as one would expect in a slowdown, but have been offset by strong performance by insurers.

  

• There are some bothersome anomalies in the sector table, of course. Why has communication services outperformed? Because the sector is weighted massively to Alphabet, which has done well, for reasons that are not totally clear to us. What is consumer staples, generally a defensive group, doing near the bottom? Weak performance by companies such as Coca-Cola, Target, Walgreens Boots, Dollar Tree and Dollar General are a big part of that story — and a trend worth watching, given that the strong consumer is such an important part of the bull narrative.

• Looking at individual stock performance, the slowdown story holds as well. The list of top performers is littered with defensive healthcare names (Eli Lilly, Amgen, Regeneron, McKesson) whereas the worst performers are a who’s who of highly levered economically sensitive stocks (cruise lines, airlines, casinos) mixed in with those weak consumer names. Overall, cyclicals are giving way to defensives:

  

• A cautious mood is also detectable in the options market. Investors want more protection. The put-call ratio, which generally rises if investors are hedging equity exposure with options, was at a 15-month low in July but has since risen noticeably. Our colleague Nicholas Megaw reports that trading activity in Vix derivatives is heading towards a record level, driven by demand for hedges against stock volatility.

• Sentiment is deteriorating, too. The AAII individual investor sentiment survey has turned grim quickly. The bull-bear spread measures the per cent of surveyed investors who are optimistic on equity returns in the next six months minus those who are pessimistic. Between the end of July and last week, the spread flipped, declining from 21 per cent (net bullish) to minus 13 per cent (net bearish). Most of that change happened in the past few weeks.

• Investors are still buying stocks (and bonds) but the bulk of new fund flows are into cash. In the three months through the end of September, $28bn flowed into US equities and $35bn went towards US fixed income, according to Barclays. Both were dwarfed by the $239bn that rushed into money market funds.

• At the same time, equity markets are enjoying fewer tailwinds. Earlier this year, two stable sources of equity demand kept markets from falling. One was share buybacks and the other was volatility control funds, which buy when markets are quiescent. But third-quarter buybacks appear to be happening at the weakest pace in two years, notes Bank of America. And volatility control funds have gone from buying to selling, now that volatility has ticked up. Stuart Kaiser of Citigroup estimates that these funds have sold $25bn worth of S&P 500 stocks since late August.

The key to this whole story — to the degree it makes a coherent whole — is the cyclicals/defensive chart above. Between May and July, it felt like economic growth just kept surprising to the upside and stocks, particularly economically sensitive ones, lapped it up. In the past two months, even as the economic news remains solid, the market has become notably cautious (in contrast, perhaps, to the bond market, which in some aspects looks more soft landing-ish).

There are optimistic and pessimistic ways to read the message from stocks. It could be that, after a nice run, the market is consolidating — a kind of mass analogue to an individual investor locking in some gains. Doing so is attractive when cash pays 5 per cent. The pessimistic read is that stocks are discounting a future in which the good economic news slows or stops. If that’s right, the natural next question is: what are stocks looking at that has them spooked? More on that in tomorrow’s letter. (Armstrong & Wu)

One good read

AQR’s Clifford Asness on Dumb Money, the new movie about GameStop. (In case you missed it, Rob, Ethan and Alphaville’s Alexandra Scaggs talked about this on the Unhedged podcast the other week.)