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Oct 11, 2018

Bear market? 1987 redux? Market selloff has investors spooked

A technical take on the North American selloff

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Big drops in the stock market like we saw this week, with the S&P 500 Index plunging as much as 5.90 per cent over the course of Wednesday and Thursday, naturally spark a lot of angst. Is this the start of a bear market? Is this a repeat of 1987? (Yes, there are those comparisons going around.) Buy the dip or sell the bounce? Are stocks cheap or are they still expensive? Spoiler alert: you can find credible measures to support whatever bias you may have. 

Cutting through all the noise, the thing to know is that such sell-offs, while painful, are normal and that it pays to hang on. After the S&P 500 plunged 4.10 per cent on Feb. 5, DataTrek Research crunched the numbers and found that declines of 4 per cent or more on a single day have happened 41 times in 59 years. That's an average of about 0.7 times a year. So while Wednesday's drop of 3.29 per cent and Thursday’s 2.06 per cent drawdown each fell a bit short of the bogey, taken together they are enough to say it has happened twice this year — and we can take a look at what usually follows. According to DataTrek, although the S&P 500 is generally flat in the month following a big plunge, over the next year it has been up an average 20.1 per cent. The point here is that the stock market is extremely resilient. Yes, there currently seems to be an abundance of headwinds facing equities, from trade wars and rising interest rates to US$1 trillion budget deficits, but there are always plenty of obstacles facing equities.

"One-year forward returns after big drops are typically very good," DataTrek co-founder Nicholas Colas wrote in a research note. "Having a roadmap/plan to live through the volatility helps." The bull market in stocks that began in March 2009 is now the second-longest on record. About the only thing that ends a bull market is a recession, and economists aren't forecasting one of those until 2020.

SAVING THE BEST (AUCTION) FOR LAST 

This week's first two auctions of coupon-bearing notes by the U.S. Treasury Department were kind of a dud. Demand for teh three- and 10-year notes were below the average of recent auctions based on the amount of bids investors submitted relative to the amount offered. That’s despite yields being at the highest in 11 years. Suffice it say, there was not a lot of optimism heading into Thursday's sale by the government of US$15 billion in 30-year bonds. But, rather unexpectedly, it was a hit. Investors submitted bids for 2.41 times the amount offered, the most for that maturity since January. That helped pushed yields lower for the third straight day, the longest such streak since August. To be sure, this is unlikely to mark a turning point for the bond market. For one, there's more talk among traders about the U.S. government's bulging debt and budget deficits, which is becoming more expensive to service as the Federal Reserve continues to shrink its balance sheet. Treasury Department data show the U.S spent a record US$523 billion on interest expense in fiscal 2018 ended Sept. 30, up from US$458.5 billion in fiscal 2017. As recently as fiscal 2015, the amount spent was just US$402.4 billion.

MORTGAGES ARE GETTING EXPENSIVE

The recent move higher in bonds yields is starting to have a big impact on the real world. Freddie Mac said Thursday that the average rate on a 30-year mortgage jump to 4.90 per cent in the latest week from 4.71 per cent in the prior period. That's the biggest jump since November 2016 and puts home loan rates at their highest since early 2011. A year ago, they were below 4 per cent. The jump in rates will test the thesis among those in the real estate business that plentiful jobs and high consumer confidence matter more in the decision to buy a home than borrowing rates. Investors aren’t so sure. The Bloomberg Americas Home Builders Index has dropped 33 per cent this year to its lowest since February 2017. Then there's lumber. Lumber futures tumbled by the exchange maximum of US$15, or 4.4 per cent, to US$324.20 per 1,000 board feet Thursday on the Chicago Mercantile Exchange. That’s the lowest since January 2017 and 50 per cent below the record US$648.50 reached May 18. Canadian lumber shipment data shows monthly volumes to the U.S. fell 16 per cent in September, potentially pointing to softer demand, CIBC analyst Hamir Patel said Wednesday in a note. U.S. tariffs on Canadian imports of softwood lumber, strong housing demand and transport bottlenecks had spurred the rally earlier this year, according to Bloomberg News's Jen Skerritt.

OIL GETS SMACKED

Traders seem to think that the tumble in stocks may have an impact on the economy and demand for such commodities as oil. Crude prices tumbled by as much as 3.64 per cent a barrel Thursday, the steepest decline since July. At the same time, domestic crude stockpiles rose for a third straight week as refineries conducted seasonal maintenance, processing less oil, according to Bloomberg News's Jessica Summers. “The enhanced volatility in the market in general is spilling over into energy, as investors are reducing risk,” Rob Thummel, a managing director at Tortoise, which manages US$16 billion in energy-related assets, told Bloomberg News. “When you have volatile equity markets, the risk-off trade is happening and you’ve got a third consecutive build, that’s generally not a good recipe for crude oil prices.” OPEC cut its estimate for global demand for its crude next year due to weakening economic growth and higher output from rivals, such as U.S. shale drillers. OPEC’s outlook comes amid pressure on the cartel to pump more to offset any impact from Iranian sanctions and calls from U.S. President Donald Trump to boost output.

A TURKISH DETENTE?

The Turkish lira was the big winner in the foreign-exchange market Wednesday, strengthening as much as 2.81 per cent. The lira jumped following a report by NBC that the Trump administration expects American pastor Andrew Brunson, who’s been held for almost two years over what Turkey says was his role in a failed 2016 coup, to be released in days. Brunson denies any wrongdoing. Separately, the Washington Post reports the U.S. has agreed to lift sanctions against Turkey, which will allow Brunson to be sentenced to time already served or serve any remaining sentence in the U.S. The U.S. has imposed sanctions over Brunson’s detention, which has contributed to the lira's 37.5 per cent depreciation this year through Wednesday. One benefit of a weaker currency was that it made Turkey's exports more competitive. Turkey’s current-account balance posted its biggest monthly surplus on record in August, the first month since September 2015 that there was no deficit, according to central bank data published on Thursday. Even so, many investors and strategists say there's still too much uncertainty regarding Brunson, the central bank, and risks surrounding lenders’ foreign-currency debt rollovers to take a large position in the lira, according to Bloomberg News's Constantine Courcoulas.

TEA LEAVES

Finance ministers and central bankers from the International Monetary Fund’s 189 member nations are gathering in Bali, Indonesia, on Friday, but don't expect it to be a joyous affair. Economic policies are diverging more so now than at any time since the financial crisis a decade ago. The Fed is away ahead of its counterparts in major economies in returning interest rates to more normal levels. That's helped bolster the dollar, sparking criticism from officials in emerging markets that the U.S. central bank is moving too fast and causing havoc in their economies. Also, the U.S. and China are locked in an escalating trade war. The European Union worries that it may be the Trump administration's next target. As such, tensions are likely to be higher than usual, as are the odds that some officials may inadvertently say something that moves markets or causes even more bad blood.

DON'T MISS

Stop Panicking About Stock-Bond Correlations: Brian Chappatta A Fresh Look at Stocks Shows They’re Cheap: Stephen Gandel How to Think About the U.S. Market Sell-Off: Mohamed A. El-Erian U.S. Economy Can Take Bad News, Just Not All at Once: Conor Sen Italy Just Put a Price on Its Own Desperation: Marcus Ashworth

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