Having grown up in New Jersey, and attended school in Boston, I absolutely love a good thunderstorm. There’s a sense of tranquility amidst the thunder and lightning in which time seems to slow, providing a place for reflection and appreciation. Living in San Diego now, I can count on one hand the number of thunderstorms we’ve had the last decade. However, whenever the dark, stormy-looking clouds roll into town, I still can’t help but wonder if in fact this time is different…and it’s actually going to thunderstorm.
I share this is because it perfectly summarizes the climate for the S&P 500 at the moment. Generally speaking, the market climate for the S&P 500 is nothing but sunny skies, just like San Diego. However, October’s sharp decline and 2018’s collective price action leaves a dark cloud hovering over the S&P 500 at the moment. History does set a precedent that far more often than not these dark clouds will clear with time, and we don’t actually witness a storm unfold. The dark clouds give way to the sunshine, and prove to ultimately be corrective, which means they’re temporary downturns that only interrupt primary uptrends for the S&P 500, they don’t end them. However, these dark clouds always possess the chance to unleash a nasty storm, a la 2008, and even if it’s not probable, we all can’t help but wonder if in fact this time is different…and it’s actually going to thunderstorm. There’s a fascination with market tops, and the trillion dollar question at the moment is whether or not 2,940.91 is going to be remembered alongside 1,576.09 or 1,553.11, no matter how unlikely it is.
Interestingly, the last two times the storm clouds rolled into town in a similar manner, it did go on to storm over the forward 1 year. October’s monthly decline of -6.94% recorded a two-month pattern of a monthly decline of -4% or worse immediately following an all-time high monthly close. Behaviorally, the pattern reeks of distribution, as if all-time high prices for the S&P 500 and its constituents were “too good to be true” given the forward outlook. And that’s exactly what we saw following the last two calendar months in which this pattern occurred, November of 2007 and September of 2000. The S&P 500 would trade lower by at least -34.23% at some point over the forward 1 year in each of these instances.
We’d be remiss in not pointing out that in aggregate this two-month pattern contains no significance - not only is it a crime of small numbers, but the S&P 500’s forward 1-year price action, both in terms of returns and maximum drawups and drawdowns, isn’t much different than the forward price action from all calendar months since 1950. While it is perhaps a reason to pack your umbrella (i.e., to make sure you have an investment plan designed to manage the possibility of a thunderstorm), it most certainly doesn’t guarantee a thunderstorm. The third time could very well be the charm.
November’s price action then saw the S&P 500 oscillate wildly, as if it’s sprinting in place. Trendless market climates are notoriously difficult to forecast, and November’s price action was a great example of that. We opened the month rising by 3.76% over the first 5 trading days and closing back at 2,813.89. We went on to give it all back and then some, declining to our monthly low at 2,631.09 a mere 9 trading days later. November then left a big ray of sunshine through the clouds, rising 4.84% the final 5 days of the month. Behaviorally, there isn’t much conviction we can take from November as there was no range expansion relative to the prior month's high or low. If you view the glass half full, you focus on November’s upside pivot above October’s low, the double bottom off of October’s closing low, and find comfort in Mr. Powell’s ability to buoy the market this past week. If you view the glass half empty, you focus on November’s downside pivot from a confluence of resistance in the ~2,815 region (100-day simple moving average and 61.8% Fibonacci retracement level), and believe the Fed’s potential pause is an indictment regarding the future health of the economy. You might also view Mr. Navarro’s seat at the dinner table this weekend as an impending food fight, with meaningful negative consequences come Monday morning. All in all, November gained 1.78% and recorded as an “inside month”, which then defines the trailing three-month pattern as follows:
T-2: All-time high monthly close
T-1: -4% decline or worse
T: Inside month
The last time that occurred was December of 2007. This marks the trailing 3-month period as a price action twin to that of final quarter of 2007, and given the “double top” trendless characteristics of 2007, there’s an eerie similarity to what’s transpired in 2018 thus far. Again, this isn’t predictive of what lies ahead, it’s just an acknowledgement that collectively the behavior of market participants over the past three months is basically the same as their behavior over the fourth quarter of 2007. It’s just another reason to make sure you’ve packed your umbrella.
We can also find a warning sign in the tremendous disparity between market participants collective desire to own a recession- proof stock like Procter & Gamble (PG), and a more economically sensitive stock like Apple (AAPL). PG beat AAPL by 30.16% in November, and that’s not a typo. Collectively, the actions and behaviors of market participants in the present reveal their expectations for the future. Right now, participants are showing a salacious appetite to own PG, and are treating AAPL like it’s a piece of garbage. That tells us that economic pundits and talking heads are perhaps underestimating the threat of recession in 2019, at least according to the collective actions and behaviors of market participants in the present. Here are all calendar months where PG beat AAPL by 20% or more with the S&P 500 closing no more than 5% above its 12-month simple moving average, which is what just occurred in November. Collectively, the S&P 500’s average forward returns over all time periods measured are bloody red. Again, this isn’t consistently predictive of what lies ahead as it’s a crime of small numbers and the future over any meaningful semblance of time is random. For all we know, we’re one trade deal with China away from market participants collectively loving AAPL, and throwing PG in the trash. However, that’s pure speculation, and all that’s known and knowable at the moment is that historically when the market collectively loves PG, and hates AAPL, it’s almost always been a bad omen forward looking. Once again, it’s just another reason to make sure you’ve packed your umbrella.
If we prefer to focus on a time frame beyond 1 calendar month, and avoid the company-specific comparison to AAPL, we can compare PG to the entirety of the consumer discretionary sector (ticker symbol XLY). PG has beaten XLY by 24.19% the last three months. Here are all rolling 3-month periods where PG beat XLY by 20% or more. Overlapping samples makes this study appear more dramatic than it is, but the takeaway is this type of relative strength for PG has only occurred during and in advance of bear markets for the S&P 500.
Finally, long-term investors are generally rewarded by investing (in the most traditional sense of the word) during primary uptrends for the S&P 500. The big money is mostly made by being right and sitting tight when the chart’s moving from the lower left to the upper right. I define a primary uptrend as a sequence of higher highs, higher lows, and higher closes over any period of time, whether you’re dealing in minute charts or monthly charts. The issue at the moment is that a top is a top until it’s not, and a primary uptrend can’t reassert itself until we make fresh new all-time highs for the S&P 500, or until the chart is once again moving from the lower left to the upper right. Therefore, the best we can say at the moment is that the S&P 500’s primary trend is neutral, or sideways, and will sustain between ~2532 and ~2,940. The worst we can say is 2018 is the market’s way of transitioning between a decade old “bull market” and a newly established cyclical “bear market”. What I can’t say is that our primary trend is still up, or “bullish”. For me, we can’t reestablished a primary uptrend until we close a day above 2,930.75, a week above 2,929.67, or a month above 2,913.98. Until such time, I believe it’s prudent for long-term investors to proceed with caution. For tactical investors, it’s imperative you adhere to your sell discipline with ferocity. If your rules suggest you underweight or eliminate equities, then you underweight or eliminate equities at the time the signal occurs. For more strategic investors, it’s imperative you ensure your asset allocation is robust, and stress test your asset allocation to make sure you can behave in the event you’re asked to tolerate substantial portfolio drawdown. It’s imperative long-term investors are prepared to follow the rules of their long-term investment plan. Like they teach us in kindergarten, when you follow the rules you stay out of trouble. Lastly, for advisers and investment managers, it’s vital you reset your clients’ expectations, and have conversations about risk and the impact portfolio drawdown could have on your clients financial well-being. In a service-based business, it’s always important to under-promise and over-deliver. Don’t consider the strong end to November as a reason to go silent, as if it’s nothing but sunny skies. The sunny skies may actually be right around the corner, but it’s best to lead your clients to expect otherwise.
Looking ahead to December, should the S&P 500 Total Return Index finish the year in the green, it will record the 10th consecutive calendar year of positive returns - a first in the history of the index. Alternatively, should the S&P 500 finish the year in the red, it will mark the first calendar year to drawup by 10% or more from the prior year’s close, only to then finish the year in negative territory. The final narrative for 2018 lies in December’s hands and since I like to gamble, I’ll bet on the former.