In perhaps a massive understatement, volatility in the global financial markets picked up during the third quarter. Equity, fixed-income, and commodity markets all around the world were disrupted to varying degrees.
Of course, the renewed volatility unsettled investors, and bears roared loudly while bulls pulled in their horns. To paraphrase Clement Clarke Moore, visions of 2008 danced in their heads.
The key question for investors is whether the secular bull market remains intact or whether a bear market and recession are looming.
We think the secular bull market remains intact. Fear continues to overwhelm greed in most segments of the financial markets.
Waiting for an entry point?
For the past year or more, many investors suggested that fundamentals were improving, but that the equity market was overvalued at current levels and investors should use pullbacks in the market as entry points to invest.
Investors have gotten their pullback, but it doesn’t look as though they are using the opportunity to buy equities. Rather, it appears that investors were too scared to invest as the stock market rose and are too scared to invest as the stock market corrects. One might say that one is waiting for the market to bottom; however, history suggests that the stock market bottoms at the point of maximum fear and not at a perceived point of maximum opportunity.
Whether one looks at ETF flows, mutual fund flows, Wall Street strategist recommended asset allocations, institutional portfolio allocations, or hedge fund positioning, the simple fact remains that investors are generally scared of equities. See Chart 1.
Why volatility now?
We pointed out last month that perhaps the main reason for the markets’ volatility is the odd combination of the Fed hiking interest rates when the profits cycle was decelerating. Chart 2 shows the historical positive correlation between changes in the Fed Funds rate and the profits cycle.
Historically, profits were revving up when the Fed started increasing rates, and the positive of accelerating earnings would overwhelm the incremental negative of the Fed raising interest rates.
However, this cycle appears unique in that the Fed is “threatening” to raise interest rates when the US is in a profits recession. Rather than a traditional offsetting relationship at this early point of the tightening cycle, the near-term interest rate outlook and the near-term profits outlook are both negative.
Is the secular bull market intact?
Our proprietary research suggests that the profits cycle is likely to trough either in the third or fourth quarter depending on the level of write-offs toward year-end (See Chart 3). That would imply that the relationship between Fed Funds and the profits cycle might return to a more normal one and, if that is the case, we think the equity market can continue advancing as it would during a mid/late-cycle environment.
Is the sky really falling?
Volatility is always unsettling for investors. However, one has to assess whether the volatility is forecasting an end to the profits, economic, and market cycles or whether the volatility is a correction within the context of a longer bull market.
Our corporate motto is “Uncertainty = Opportunity®” and our portfolios are positioned accordingly.
