The Bear Thread

Defense Outperforms
Mon, Aug 5, 2024

Losses are accelerating as the S&P 500 (SPY) has, as of this writing, fallen 8% since the July 16th high. That move has occurred on a rotation out of former market leaders like the mega caps as markets contend with a number of factors ranging from recession fears to rising geopolitical tensions abroad. While breadth has been rough in that time, it hasn't been a total wash with roughly a third of the index having risen since July 16th. On a sector level, the groups with the largest share of stocks rising since 7/16 come from defensive sectors like Utilities (83.9%), Consumer Staples (63%), Real Estate (61%), and Health Care (57%).



What is impressive is that in looking only at the S&P 500's 20 best performing stocks since the 7/16 high, the two sectors with the largest representation are Health Care and Industrials. However, looking more closely, a number of those Industrial stocks are also in the Aerospace & Defense industry with stocks like Lockheed Martin (LMT), Northrop Grumman (NOC), and RTX (RTX) all posting double digit gains.



As a result, the S&P 500 Aerospace and Defense Industry index has risen 1.4% since the July 16th high compared to the high single-digit percentage decline in the broader market. Looking at the 14-trading day performance spread of the industry and the broader market, that 9.5 percentage point difference is a 99th percentile reading dating back to 1990. While not every spike in this spread is due to geopolitical tensions (for example in the spring of 2020 it surged as equities recovered from the Covid Crash), this spread has tended to rise sharply around tense periods for geopolitics. This current spike surpasses that from when Hamas attacked Israel on October 7th and is now the most elevated reading since November 2022 (North Korea missile launches and Russia/Ukraine war was underway) and when Russia invaded Ukraine in early 2022 before that. Prior to 2020, the only other time defense stocks outperformed the S&P 500 by such a wide margin was in the late 19990s and early 2000s. More specifically, the current reading would be the highest since February 2002 in the early days of the War on Terror when these companies began to receive large contracts from the US government.



While the industry as a whole has outperformed the S&P 500 by a decent margin, under the hood it actually hasn't seen the best breadth. Of the dozen stocks belonging to the industry, just four defense names are higher since 7/16, and each one has earnings to thank. As shown in the charts below, those four stocks all rose sharply in late July in the wake of their latest earnings reports. Impressively, the reaction to earnings for Northrop Grumman (NOC) and RTX (RTX) were both the best on record for their respective earnings histories based on data from our Earnings Explorer tool. Howmet Aerospace's (HWM) gain after reporting the most recent quarter also ranks highly as their third best reaction on record, however, it has not been immune from selling over the past few sessions meaning that gap has since nearly been filled. Lockheed Martin's (LMT) saw its sixth best reaction to date. In other words, while some are arguing that the defense group is up due to geopolitics, it has really been a few strong reactions to Q2 earnings reports.

 

Open Field Election Year Pattern Rears Its Head



Looks like we’re getting that mean reversion correction we’ve been talking about. Election years have historically been bullish with above average performance in June, July, and August. But, over the past few months, we’ve warned that the market has gotten well ahead of itself and ahead of all the average election year patterns.

After the usual midyear NASDAQ rally tech stocks have been prone to mid-July selloffs. And “Hot July” markets for DJIA have notoriously preceded market declines. Now August appears to be ditching its election year bullishness for its usual seasonal weakness.

All this on the backdrop of President Biden bowing out 2 weeks ago, a more heightened geopolitical arena, some awful earnings and a weak jobs report have cranked up recession fears and market volatility. This is the volatility we warned of. Expect it to continue for the next few months.

While the market is likely overreacting, this sort of pullback is overdue and likely not over. August-October seasonal weakness is clearly in play and the action over the past two weeks brings our Open Field Election Year Pattern back in play as well. This does not necessarily mean we are heading into the red for the year, but it does suggest the market is likely to struggle over the next few months with a correction low in late October just ahead of the election.

 

No Escaping Historically Miserable August



So much for a positive election-year August for the market. A combination of stretched valuations, weak/tepid earnings, a disappointing July jobs report, a late-cycle change in presidential candidates, currency market volatility and geopolitics has put the major indexes in a deep hole to climb back out of. As of today’s close, losses in August range from -5.1% from DJIA to 9.7% by Russell 2000.

These sharp declines have drawn comparisons to past difficult Augusts such as 1990 (Iraq invaded Kuwait), 1997 (Asian currency contagion), 1998 (Russian debt/currency), 2010 (European debt), 2011 (U.S. debt downgrade) and 2015 (China growth scare & yuan devalue). But August weakness does not always need a crisis or trigger with sizable S&P 500 declines also occurring in 1988 (-3.9%), 2001 (-6.4%), 2013 (-3.1%), and 2022 (-4.2%). All of this weakness is why August has been the worst DJIA month and second worst month of the year for S&P 500, NASDAQ, and Russell 2000 from 1988 to 2023.

Looking at the chart of 2024 through the close today (August 7) compared to the seasonal patterns using the last 36 years of data, more chop and volatility is likely in store for the market in the near-term. After an early August selloff, the market has tended to spend the balance of August bouncing around on average with little meaningful progress. The tightening of the presidential election and elevated geopolitical tensions are likely to keep a lid on markets through the rest of the “Worst Months.”

 

DJIA Down 13 of Last 17 August Monthly Option Expiration Weeks



Mid-August has historically better performing than the beginning and the end of the month. This strength is punctuated with a cluster of bullish days this next week beginning on August 15 and ending on August 21. Four out of five days are bullish. In the annual Stock Trader’s Almanac, a bullish day is defined as a trading day in which the S&P 500 has risen greater than or equal to 60% of the time over the last 21 years.

Unfortunately, this bullish cluster has not always resulted in full-week gains during August’s monthly option expiration nor does this daily bullish streak guarantee market gains on each day. S&P 500 has declined on August monthly option expiration day nine times in the last fourteen years. Full-week performance has been mixed over the longer-term but has been notably weaker since 2010. The week after monthly options expiration has been bullish with average gains ranging from 0.32% by DJIA to 0.66% by NASDAQ.

 

1968 Analog Resonates Not 1987



The mid-July pullback we expected arrived right on cue. This pullback and the market’s steep trajectory bring into consideration the unsettling parallel to 1987 as you can see in the chart below. This is not to say we expect a 1987-style crash or market action in 2024. We don’t. It can’t happen with the circuit breakers now in place.

As illustrated in the chart below the 1987 market was much more extended than 2024. Q1 1987 S&P was up 20.5% while up 10.2% in Q1 2024. At this juncture in 1987 S&P was up over 35% year-to-date. At the high this year S&P was up 18.8%. Plus, in 1987 the market took off from mid-July to late August unlike 2024.



The 1968 analog is the one that resonates now. Both are election years with a democratic sitting president that dropped out of the race and democratic convention in August in Chicago. There are a plethora of other economic, market, political and geopolitical comparisons we can draw, but most important to us is that the market in 2024 is now closely tracking the 1968 trend, especially after the recent selloff. We’ll be keeping a close eye on this.

 

Election Year Drawdowns Happen



Considering the heightened market volatility last week and the bounce back rally let’s take a step back and calmly evaluate market conditions. Election year drawdowns happen. In the table below the average election drawdown for S&P 500 is 13.4% since 1952 and 21.2% for NASDAQ. At the August 5 lows S&P was down 8.5% and NASDAQ was off 13.1%. This is well within the range of historic election year drawdowns and less than the average drawdowns of 13.4% for S&P and 21.2% for NASDAQ.

We’ve been warning of a mean reversion pullback for this overextended market running on AI-boom fumes. The selloff may have been a little faster and more furious than we anticipated, but nevertheless high-flying stocks and the market got their comeuppance. While the market has staged a bit of a bounce back, we suspect the correction is not over.

The support levels we highlighted in the August Outlook two weeks ago for the S&P 500 of 5190 and NASDAQ of 16500 have been breached, which suggests we could test the April lows (S&P 4954/NASDAQ15223), which would be a 12.6% correction for S&P and 18.4% for NASDAQ. This is just shy of the average election year drawdowns in the table above.

 

Yen Stalls After Historic Rally
Mon, Aug 19, 2024

While the moves in US equities in recent weeks have been extreme, the currency markets have been even crazier, especially in the Japanese yen. In early July, the yen was trading at its weakest levels in over 30 years (higher values in the chart below), and shorting the yen was ‘easy money”. Those rumors of the yen’s death proved to be exaggerated. Just like that, the decline in the yen stalled out, unleashing a stampede of shorts looking to cover causing one of the most extreme movements in the currency ever recorded. From its weakest point in early July to early August, the yen rallied a practically unheard-of 10%+. While the rally stalled in the short term, the USD/JPY cross remains down nearly 10% from its peak in early July.



To illustrate the gravity of this move, the chart below shows the rolling five-week (25-trading day) change in the USDJPY cross going back to the early 1970s. The current move ranks as the most extreme since the Financial Crisis and before that the Russian Debt default in 1998. While the recent chaos in the currency markets reverberated throughout financial markets, including equities, so far at least, the impact this time around has been downright tame relative to the two most recent periods of similar volatility.

 

Bespoke's MORTGAS Misery Index
Thu, Aug 22, 2024

Last year when mortgage rates and gas prices were rising steadily day in and day out to multi-decade highs, we created our MORTGAS Misery Index that is simply the sum of the 30-year fixed mortgage rate and the cost of a gallon of gas.

Below is an updated look at both gas prices and mortgage rates.

The national average 30-year fixed mortgage rate according to Bankrate.com is currently down to 6.86%, which is the lowest level seen since seen May 11th, 2023. As shown below, the peak for mortgage rates during the current cycle was 8.09% on October 25th, 2023.



Longer term, of course, mortgage rates remain very elevated. They would need to fall another 40 basis points down to 6.45% to get back to the peak readings seen in the mid-2000s prior to the Financial Crisis.



Gas prices have also been falling steadily since peaking in the spring (which is usually the case from a seasonal perspective). Using AAA's national average for a gallon of regular unleaded, gas prices are currently at $3.387/gallon. That's down about 30 cents from the peak price seen so far in 2024 of $3.679 on April 18th. Prices are down about 50 cents from their September 2023 peak of $3.88/gallon.



Longer-term, gas prices are currently about 50 cents above the 20-year average of $2.89/gallon. The low-point of the current decade came on April 28th, 2020 when the national average hit $1.768/gallon. The high point came on June 13th, 2022 when prices ticked just above $5/gallon ($5.016).



Combined, our MORTGAS Index currently sits at 10.2. As shown below, the index is down 1.46 points from its record high of 11.66 seen in late 2023, but it's still extremely elevated relative to the last 20 years. Looking on the bright side, the index is now back below its peak seen in 2008 during the Financial Crisis, but we're going to need to see significant further easing to get back to the 20-year average of 7.62. A drop like that would likely mean mortgage rates falling at least into the 4-5% range and gas prices remaining closer to a 2-handle than a 4-handle.

 

First Trading Day of September Weaker Last 16 Years


S&P 500 has been up in 18 of the last 29 years on the first trading day of September, but this trend appears to be fading as the S&P 500 has been down nine of the last sixteen first trading days. DJIA’s first trading day performance has experienced a similar trend reversal, also down nine times since 2008. NASDAQ has been modestly stronger recently, but is still mixed, up eight and down eight. Proximity to the three-day Labor Day holiday weekend can dampen trading activity, which could be a factor this year with the first day falling on Tuesday.

 

DJIA, S&P 500 & Russell 2000 Down Seven Straight Day After Labor Day



In the last 21 years, DJIA has registered an average loss of 0.09% on the Tuesday after the long Labor Day weekend while S&P 500, NASDAQ and Russell 2000 have eked out fractional average gains. DJIA, S&P 500 and Russell 2000 have all declined for the last seven years on Tuesday. On Wednesday the market’s performance has been varied. DJIA has performed the best (based upon frequency of gains), up 66.7% of the time with an average gain of 0.25%. S&P 500 is weakest, up only 47.6% of the time with an average gain of 0.26%. NASDAQ has a slightly better record up 52.4% of the time on Wednesday with an average gain of 0.24%.

 

Even in Election Years, September Still a Problematic Month



Portfolio managers back after Labor Day tend to clean house in September. Since 1950, September has been the worst performing month of the year for DJIA, S&P 500, NASDAQ (since 1971), Russell 1000 and Russell 2000 (since 1979). September was creamed four years straight from 1999-2002 after four solid years from 1995-1998 during the dot.com madness. More recently, DJIA, S&P 500, NASDAQ, Russell 1000 and 2000 have been down seven of the last ten Septembers and the last four straight. Average losses over the last ten years range from –1.5% by DJIA to –2.9% from NASDAQ.

Even though election years have historically been solid years, this tendency appears to have little to no impact on September’s abysmal performance. September’s ranking in election years does improve slightly but remains in the bottom third. Average performance remains negative with the exception of Russell 2000 gaining +0.4% on average since 1980.

 

Here Comes the Worst Month of the Year


“Summer has come and passed, the innocent can never last, wake me up when September ends.” -Wake Me Up When September Ends by Green Day

August was quite the rollercoaster, but in the end the S&P 500 added 2.3% for its fourth consecutive monthly gain. On top of that, all four months gained at least 1%. As we noted many times the past few months, the best three months of the year during an election year have been June, July, and August. Well, that played out nicely once again, with the S&P 500 up 7.0% in the summer months this year, right in line with the 7.3% average. Many told us to be fearful and expect summer weakness, but we held firm and expected a nice rally and that fortunately has happened.



Are we still bullish? Yes, we remain overweight equities, which is where we have been since December 2022. But we can’t ignore the potential for some pre-election jitters and seasonal weakness over the coming two months. September has been the worst month of the year the past 10 years, 20 years, and since 1950. In election years it is the third worst month (February and October have been worse).



Here’s a better look at election years and monthly returns. August bucked early month weakness this year and turned in a solid gain, but the next two months are notorious for weakness in election years. The good news? Year-end rallies are quite normal after the election is out of the way.



What happened recently after a long monthly win streak heading into September? There was a five-month win streak heading into September in 2020 and stocks fell nearly 4%. There was also a seven-month win streak last year at this time that ended with a nearly 5% drop in September.

Here’s a nice way of showing that election years tend to rally in the usually weak summer months (like we saw in 2024), but also tend to peak right around now with weakness into late October perfectly normal.



Lastly, this year and last year look a lot alike. This is a sample size of one, but it’s worth noting last year saw weakness into late October before a furious end of year rally.



One more. Think about the last two elections. 2016 and 2020 both saw stock weakness ahead of contentious elections, only to see stocks soar at the end of the year once the election uncertainty was behind us. So buckle up, as we wouldn’t be surprised at all to see that pattern play out once again this year.

 

JOLTS: Job Openings Fall as Firings Edge Up
Fri, Sep 6, 2024

The following charts were included in our daily Closer report on 9/4/24. You can receive our Closer in your inbox with a two-week trial to Bespoke Institutional.

July data on job openings and labor market turnover (JOLTS) showed a larger-than-expected drop in job openings, which came in 5% lower than estimated with a 3% downward revision to June data. The JOLTS data has been very consistent for some time in terms of showing a slowdown in hiring. Hires were over 4.5% of the labor force at the peak in late 2021 but have been trending lower for almost three years now; the same goes for the quits rate. Both those metrics improved this month despite weaker openings, but the weaker trend is very clear. One final note that is arguably the most concerning: while layoffs are still low, gross job terminations were 1.68mm in July. That’s not unusually high compared to pre-COVID levels, but firings may be starting to pick up. If slow hiring is now being matched by outright firings, problems could mount.

 

Horrible Small Business Earnings
Tue, Sep 10, 2024

This morning's NFIB Small Business Optimism Index showed disappointing results. The index was expected to show small businesses had less optimism with the index forecasted to fall 0.1 points month over month down to 93.6. Instead, the decline was much more dramatic as it fell down to 91.2; erasing all of the summer gains. One factor likely at play that we have noted in the past is political sensitivities.

Historically speaking, NFIB data has tended to hold a positive bias during Republican administrations and vice versa. Put differently, optimism rises when Republicans are in power or are expected to be voted in, and optimism falls when Democrats are in power or are expected to win an election. In reaction to last month's report, we discussed how the recent surge in optimism earlier this summer was concurrent with the rising odds of former President Trump winning back the presidency. This latest data, on the other hand, would capture that the Presidential race is looking tighter than it did previously, and optimism seems to have moved lower in turn.



Looking under the hood of the report, there wasn't much to like. Of the inputs to the Optimism Index, only two rose month over month: Plans to Make Capital Outlays and Job Openings as Hard to Fill. The latter of those is by far the strongest category of the report with the August reading in the 92nd percentile of all months. Outside of that, there are four inputs to the optimism index and another three non-input categories that now rank in the bottom decile of readings. Some of those like Actual Earnings Changes and Expectations for Higher Real Sales also fell significantly month over month with bottom decile monthly moves.



As noted above, one of the weaker inputs to optimism was actual earnings changes and other "actual" categories are similarly weak. In August, that index fell 7 points month over month. That is the largest decline in a single month since last October when it fell 8 points. More impressively, that drop results in the index falling below the spring 2020 lows for the worst reading since March 2010. Among other categories for observed (rather than expected) conditions, employment change reached a new near term low of -6. That is the weakest reading in this index in two years. As we showed in the Morning Lineup, combined with other labor market categories, the report is consistent with a further weakening labor market.



Circling back on the weak change to earnings, the report details a handful of reasons that small businesses are reporting lower earnings. As shown below, the most common response in August was increased costs; up 2 percentage points to 16%. The next most common reason was sales volumes which was unchanged sequentially at 13%.



While those responses would indicate that an uptick in inflation has been hurting the bottom line of small businesses, the report's inflation gauge was somewhat contradictory. There continues to be more companies reporting that prices are higher versus lower than they were three months ago. However, that higher prices index has been improving dramatically. The index dropped to a new low of 20 in August which is the lowest level since January 2021. While that is also still elevated ranking in the 81st percentile of all months on record, that is well below the peak from two and a half years ago and is consistent with decelerating inflation. Additionally, the share of businesses reporting inflation as their biggest problem ticked down modestly to 24% from 25% and is well below the highs near 35%.

 

Volatility Anyone?
Wed, Sep 11, 2024

It’s anyone’s guess where the S&P 500 finishes the day. What we do know is that the S&P 500 once again found itself trading down more than 1% on the day this morning. Today’s move continues an emerging trend from the last two months where the market increasingly finds itself in a 1% hole early in the trading session. To illustrate, the chart below shows the 50-day moving average of the number of trading days when the S&P 500 was down at least 1% relative to the prior day's close at some point before noon easter. After dropping as low as zero in mid-July just as the S&P 500 was hitting record highs, the frequency of 1%+ declines in the morning has quickly shot up to eight. That's the highest level since April 2023 coming out of the stress in the regional banks.



From a longer-term perspective, the current frequency of 1%+ declines in the morning is nowhere near extreme levels. During the 2022 bear market, the moving average spiked as high as 22, and during Covid it exceeded 24. During both the Financial Crisis and the bursting of the dot-com bubble, there were periods where the S&P 500 was down at least 1% in the morning on over 60% of all trading days! Despite these periods of extreme readings, the long-term average number of days that the S&P 500 was down 1%+ in the morning over 50 days is much lower at just 6.2

What is notable about the current period, however, is that up until a few days ago, the recent period (338 trading days) was the seventh longest on record of below-average readings in the number of 1%+ morning declines. It was also the longest since the 471 trading day streak ending in March 2018. With the yield curve uninverting, the Fed set to cut rates, and an election on the horizon, the relative calm of the last 16 months has faded like a summer fling.

 

Sentiment Goes According to Seasonality
Thu, Sep 12, 2024

The typical seasonal September slump for stocks has left the S&P 500 down 1.5% month-to-date. Regardless of the rebound in the past few sessions, the weak start to the month has put a dampener on investor sentiment. In the final two weeks of August, the percentage of respondents reporting as bullish to the AAII Investor Sentiment Survey came in above 50%. Since peaking the week of August 22nd at 51.6%, bullish sentiment has now slid for 3 straight weeks and is down to 39.8%. That is the lowest level of bullish sentiment and the first sub-40% reading since the first week of June.



With the drop in bulls, bearish sentiment has been on the rise. Bears came in at 31% today which is the highest level in five weeks and right in line with the historical average for that reading since the start of the survey in 1987.



Bulls falling and bears rising would mean that the survey's bull-bear spread has pivoted lower. The spread fell from a reading above 20 last week down to 8.8. While that is a significant drop, bulls still outnumber bears as has been the case for the past 20 weeks. Through the history of the survey, there have only been 13 other streaks of 20+ weeks of positive bull-bear readings, the most recent of which ended this past April at 24 weeks.



September has historically been a rough month for equities from a seasonal perspective. As such, sentiment has also tended to be weak. The charts below show the average bull-bear spread reading by month for all years since 1987 and so far in 2024. Sentiment is usually strongest at the bookends of the year (January and February) and tends to fall in the late-Summer with September marking the annual low.

This year has to some degree followed that pattern. Sentiment was strong in the first two months of the year and unusually carried through into March. Sentiment slumped in April but began to pick up through July before reversing lower in the past two months.



The AAII survey hasn't been the only measure of sentiment to moderate lately. This week's bull-bear spread in the Investors Intelligence survey similarly dropped with the weakest reading since last November. The NAAIM Exposure index was modestly higher but continues to show equity exposure was significantly higher a couple of weeks ago. All combined into our sentiment composite, sentiment favors bullishness, but to the weakest level in a month.



Like the AAII survey, although investor outlooks are not as rosy as they were previously, it has been an impressive streak of net bullish readings. Our sentiment composite has now come in with a positive reading for 20 straight weeks. That immediately follows a 24-week long streak that ended in April with only one week of bearish sentiment in between the two. Before that, there were only seven other streaks that lasted at least 20 weeks. In other words, it has been an impressively long stretch of bullish investor sentiment.