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At best, the broad stock market’s 15.8% drop since its peak only three months ago on September 20 has been disconcerting. The deeper 23% plunge in small cap stocks, as measured by the Russell 2000 index: startling. For the weakest 9% of S&P500 stocks – often those with some type of unfavorable macro exposure – their average loss of 40% in such a brief time has been simply jaw-dropping.
No natural buyers of stocks right now
What is behind the sharp fall-off in share prices? Given the broad list of issues facing investors, there don’t appear to be any natural buyers of stocks right now.
The top two issues weighing on the market: slowing economic growth and a central bank that is determined to raise interest rates.
Economic growth in the U.S. is slowing. Its torrid 4.2% pace in the second quarter is estimated to taper to a 2.9% rate in the 4th quarter. Growth outside of the US, particularly in Europe and likely in China, remains positive but is clearly weakening, as well. Slowing economic growth reduces corporate earnings growth and increases the risks of lower-quality stocks.
Our central bank appears determined to raise interest rates. Investors worry that either the Fed is making a policy blunder by raising rates in a weakening economy (risking over-tightening which could produce a recession), or it is no longer supportive of stock prices. Neither of these would be good news for stock prices. Wednesday’s comments by Fed Chairman Powell did nothing to deter these worries.
Compounding these two core issues are the unknown depths to which the temporarily-deferred trade war with China will plumb, the possibility of further rancor in Washington as the House shifts to a Democratic majority, high levels of debt across companies and governments, and a litany of other worries including the speculation in bitcoin, marijuana stocks and profitless private equity-backed unicorns.
Who wants to buy stocks these days? Almost no one.
Mutual fund and other institutional managers have little interest in buying risky new stocks this late in the calendar year. Given the issues described earlier, they want to de-risk their portfolios by selling cyclical, lower-quality or otherwise higher risk names. Since these investors are graded on their calendar-year returns relative to a benchmark, selling sharply falling stocks can help their performance while reducing their portfolio and career risk. Similarly, few managers are willing to show uncomfortable positions in their year-end holdings lists, prompting more selling of already weak stocks.
For individual investors, who focus on absolute performance (straightforward profits and losses), the mood is one of preserving the gains over the past decade and avoiding further losses. Like institutional managers, their concerns about the slowing economy and unsettling Fed policy incentivize them to sell, particularly to lighten the frustration and disappointment from owning money-losers. Pain relief right before the holidays is a powerful motivator. For already-weak stocks, tax-loss harvesting before year-end drags these stocks lower. Most individual investors have little to no interest in putting money to work in the falling market right now.
Similarly, most hedge funds aren’t likely to be meaningful stock buyers. Like other institutional managers, their performance is based on year-end (or, more commonly, monthly or quarterly) results, so de-risking is their plan, too. Several large hedge funds have decided to shut down recently, so their entire portfolio is being liquidated. Others clearly want to avoid this fate – and with the average hedge fund in a loss position this year1, they have an urgency to sell (or add to their short positions). For hedge funds, a down-year or two could result in business failure. Selling stocks aggressively regardless of investment merit can make good business sense.
It’s not only human investors that have no interest in buying. Computer-driven quant funds tend to be momentum-oriented. When stocks are falling, they are selling. Another factor comes into play: quant funds typically use volatility as a risk measure, so when markets jump around more than usual, the models adjust by selling stocks.
Déjà vu, all over again, but in reverse
Just as investors ended 2017 by extrapolating the accelerating economy and booming stock market well into the future, they are closing out 2018 with the opposite emotion: extrapolating a slowing economy and weakening stock market into a sharp downturn. Dormant (or, for any investor under 32 years of age, non-existent) memories of the 2008-09 financial crisis have been re-awakened: no one wants to be holding stocks if it looks like we will have a repeat of the S&P500’s 58% peak-to-trough plunge.
With Mr. Market’s investing horizon essentially terminating at year-end, the imperative is “just get me out” in the next five trading days. This leaves little room for considering a stock’s underlying valuation or longer-term fundamentals.
After New Year’s, valuation and fundamentals will begin to matter again. Some stocks might bounce sharply upward, others might take several quarters or more to begin to recover. Successful investing involves a tolerance for risk and patience. The market has neither right now.
Bruce W. Kaser
Head of Equity Research
New Generation Research and The Turnaround Letter
- According to hedge fund research firm HFR, based on results through November, 2018, the average hedge fund has lost 2%.