The Ghouls Don’t Disappoint

Investopedia says, “October has a special place in finance, known as the October effect, and is one of the most feared months in the financial calendar.” The financial web site goes on to explain that October gets a bad rap because some of history’s most storied market crashes occurred during the month, most notably the Panic of 1907, Black Tuesday in 1929, and Black Monday in 1987. But while it’s true that these traumatic events all happened in October, the month has actually yielded an average return of 0.40% over the past 100 years, with positive returns in 62% of those years*. Not the best month in the calendar, but not the worst either.
This year October has lived up to its unsubstantiated billing. Thus far in the month we’ve seen the major market averages drop 9%-12%. The selling has been aggressive at times, reminiscent of the dark days of the Financial Crisis. Some days it has felt like there was no place to hide. But concurrent with the broad market weakness we’ve also seen a fairly dramatic and telling rotation from the cyclical sectors into the more defensive sectors. A rotation like this would make most sense if investors were fearful of an economic slowdown or some other impediment to corporate earnings growth.
In the chart below, we show the performance of two indices we created using data from Standard & Poor’s. The first index, which we call the Cyclical Index, includes the performance of four S&P 500 sectors most dependent on a positive economic backdrop – Consumer Discretionary, Industrials, Information Technology and Materials. The second index, which we called the Defensive Index, includes the three S&P 500 sectors considered to be least economically sensitive – Consumer Staples, Health Care and Utilities. As expected, the Cyclical Index produced far greater returns through the month of September. However, once we moved into October, the Defensive Index closed the gap with a vengeance. As I write, the Defensive Index is now outperforming the Cyclical Index by nearly 2% for the year – a reversal few thought likely (or possible) in such a short period of time.
Source: Bloomberg

In last week’s Market Commentary, we discussed the rising cost pressures that may negatively impact corporate margins in the months to come. These pressures include rising wages, higher interest rates, higher transportation/freight costs, a stronger dollar, higher energy costs, and tariff-induced spikes in the cost of inputs, like steel. Are we beginning to see reality setting in with regard to the earnings growth expectations for next year? We think the answer is quite possibly yes. Though the economy could (and likely will) continue growing in 2019, the lofty expectation for 10% earnings growth in the face of so many rising cost pressures may simply not be realistic anymore. If we add into the mix a growing number of ancillary investor concerns – the mid-term elections, Brexit, the Italian debt crisis, the trade standoff with China, North Korea, Iran, Saudi Arabia, etc. – it’s also quite possible that a deterioration in business and consumer confidence could begin to affect top-line results as well.
The rotation into defensive makes sense to us. In fact, we think it’s overdue. Sure, it’s quite possible that we sign a trade agreement with China by the end of the year and the markets are off to the races again. It’s also possible that with the passing of the elections we gain more policy visibility, which the markets always crave. But it’s also possible that growth expectations, especially for the high-flying FANG stocks and other pricey “growth” stocks, will continue to moderate, in the process taking more froth out of the lofty valuations that prevailed for so long.
Stocks are down but most indices remain slightly positive for the year. After a string of nine straight positive years for the S&P 500, nobody should be surprised that the gains are becoming a little harder to come by. We are actively looking for opportunities to add positions in high-quality and relatively defensive names.
*Data from Bespoke Investment Group, taken from an October 1, 2018 article on by Barry Ritholtz entitled “October Is the Scariest Month for Investors, Along With All the Others.”