October Pullback: A scary start to Q4 trading

15 October 2018

By Mike Coffey

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As I walked into the office on October 4th, I received a text message from a long-time friend with the following graph. The top line represents the S&P 500. The bottom line is interest rates.

 

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My response to the text was of course, “it’s different this time?” But 1,300 points on the Dow and 150 handles lower in the S&P 500 would indicate that it wasn’t. Back in February, I wrote about the market drop, when the Dow slumped 1,600 points in 10 minutes. This time, it took us two days to amass similar totals, but the reasons were pretty similar: higher interest rates, program trading and those index funds that everyone loves (until they don’t). Since February’s article, we have also introduced a new villain to the bull run-tariffs.

 

Interest Rates

Last week, the yield on the 10-year Treasury note hit a seven-year high, after Federal Reserve Chairman Jerome Powell said the federal-funds rate target could still go higher. The FOMC’s “dot plots” of future fed-funds rates anticipate four more quarter-point increases by the end of 2019. This is hardly a view shared by President Trump, “I think the Fed is making a mistake. It’s so tight, I think the Fed has gone crazy. The Fed is going loco and there’s no reason for them to do it.”

 

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4th Quarter Earnings: How will tariffs impact your business?

Earnings season kicked off last week, and suddenly people started paying attention to companies that usually go unnoticed. PPG shares slumped 10%, after the paints and coatings company announced they would miss 3rd quarter estimates. This was based on their 4th quarter views about tariff-related margin squeeze and diminished demand from China. Fastenal, an industrial distributor, followed suit. Despite posting top-and-bottom-line upside, analysts became increasingly cautious. The gross margin softness was concerning, because tariffs were starting to pressure the cost of goods sold. Fastenal indicated that there is limited visibility into the impact this will have over the next number of quarters.

Back in February, we looked at the 200-day moving average as the key line of support. The market held serve then and went on to make new highs. This week we dipped below the level for a while, but managed to close back above the 200-day on Friday.

 

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The October Effect

With the volume of pumpkins sold, spooky decorations and endless Halloween movies, it is not lost on me what time of the year it is. A few events that have given October a bad name include The Panic of 1907, The Crash of 1929 and Black Monday (October 1987). While these events were certainly painful for investors, historically, September is actually the worst month for the markets. According to Investopedia, October has traditionally marked the end of more bear markets than the beginning.

 

What to Watch 

Earnings

Traders will be looking for clues as to how tariffs are impacting results. According to FactSet as of 10/11, twelve S&P 500 companies have reported and half indicated that tariffs had a negative impact on results. This is up from just one company at this time last quarter.

 

Interest Rates

Equities have had very little competition over the last 9 years, as interest rates have remained very low. With rates ticking higher here, will we see a fund re-allocation into fixed income?

 

Trade War

The market reacts, or should I say the market Algos react, to any headline regarding a potential meeting between China and the U.S. Look for a major bounce, if a deal can be worked out.

 

It ain’t over ’til it’s over

As we get closer to crowning a World Series Champion, I am reminded of the quote from Yankee Great Yogi Berra. The markets have battled several headwinds this year and still managed to hit new highs. While there is plenty to be concerned about, there are also reasons to believe the bull run is not over. The economy remains strong. Factset indicates that the S&P 500 is expected to post earnings growth above 20%, for the 3rd straight quarter.

Corporate buybacks roll on. According to CNBC, over the last 12 months, the companies in the S&P 500 have purchased $646 billion of their own stock, nearly 30% more than the previous 12 months. One firm estimates that at least $350 billion of buybacks scheduled are just waiting to be put to work. While companies historically were buying back stock during blackout periods, CNBC reports that nearly 80 percent of companies have altered programs; so they can automatically buy back their shares even during blackout periods.

Buy the dip investors have been rewarded very nicely during this incredible bull run. We will see if this trend continues.

 

Mike Coffey is Head of Business Development for Intelligence at Q4. He has 20+ years of experience in the capital markets.

 

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