October Volatility Not Atypical

Equity Selloff

October Volatility Not Atypical

As monetary policy normalizes and the economic cycle matures, volatile days like those just experienced may become more common. However, the end of the cycle appears to remain in the distant future, allowing investors to find opportunity amid market anxiety.

  • Many investors expected a pickup in volatility heading into midterm elections, but the disproportionate move in equities relative to other risk assets leaves us optimistic about the market.
  • Recessionary risks currently remain dormant and we believe the pullback this week represents an attractive entry point for longer-term investors. 
  • The market’s historically positive pattern following midterm elections and a potential uptick in share buybacks due to more attractive valuations could drive stocks higher into year-end.
 

Growth Fears, Higher Interest Rates Spur Latest Equity Drawdown

The S&P 500 has sold off by -9.4% since its peak in late September, with the selling pressure picking up again this week after an initial downdraft earlier in the month.   While some have pointed to rising interest rates and trade war tensions as an explanation for this drawdown, sell-offs typically do not have one single catalyst. While the catalyst may be unclear, we do know that many investors expected a pickup in volatility as the midterm elections drew nearer. 

However, the move in equities appears disproportionate relative to the moves in other risk assets. For example, while credit spreads have modestly widened, the magnitude has been much smaller than what might be expected given the decline in equities. 

Importantly, despite some blame for the sell-off being attributed to fears of slowing global growth, we still maintain confidence in the current U.S. expansion. The ClearBridge Recession Risk Dashboard remains unchanged, and we continue to view this increased period of volatility as a buying opportunity.

The market experienced a -3.1% decline on October 24, representing the second largest pullback for a single trading day since February and the fourth daily decline of 3% or more this year.  This exceeds the total number of days with -3% or greater declines from 2012 through 2017. Historically, when these large drawdowns have occurred during market uptrends (S&P 500 above its 200-day moving average), they have represented buying opportunities. More specifically, the market has risen over the following one, three and six months by an average of 1.7%, 6.6% and 10.7%, respectively when these instances have occurred going back to 1950.

 

Treasury Positioning

As of Sept. 25, 2018; most recent data available as of September 30, 2018. Source: CFTC and Bloomberg.

One potential culprit for the recent surge in volatility is higher long-term interest rates. Higher Treasury yields have been linked with both the current pullback (10-year yield +30 bps in six weeks) as well as the correction in January/February (10-year yield + 55bps in two months). Although we believe the longer-term trajectory for yields will be higher in coming years, investor positioning should keep interest rates in check in the near term.  In fact, since the initial bout of selling earlier this month, 10-year yields have remained relatively flat. This is important as the market has time to digest this new reality. At present, Treasury futures positioning is at record short levels. Historically, when positioning moves to an extreme, there is typically an unwind in the other direction. Such a scenario would result in investors buying Treasuries to cover their short futures positions, pushing yields modestly lower.  

As we look ahead toward the end of the year and into 2019, we remain optimistic about equities and see two important catalysts for equities as we move forward from here, many of which we highlighted in our recent article "One for the Record Books".  Additionally, we see two important catalysts for equities as we move forward from here. 

 

Midterm Election Year Performance

Source: Strategas Research Partners. Averages based on S&P 500 return data from the following years: 1950, 1954, 1958, 1962, 1966, 1970, 1974, 1978, 1982, 1986, 1990, 1994, 1998, 2002, 2006, 2010, 2014.

The first is the market’s typical behavior in midterm election years. Historically, markets have traded largely flat ahead of midterm elections. After the recent pullback, 2018 is following this pattern with the S&P 500 now up just 2% year-to-date. The silver lining is that midterm election years tend to be back-loaded, with strong returns in the final few months of the year. In fact, the fourth quarter has returned 5.1% on average over the past 17 midterm election years. As we gain greater certainty around the outcome of the midterms and the market refocuses on the strong fundamental backdrop, we believe stocks will ultimately follow the typical pattern and rally into year-end.

The second positive catalyst for stocks is the large gap between buyback authorizations and executions. While $716 billion of buybacks have been authorized so far this year, just $392 billion have been executed, a gap of $324 billion. With earnings season in its busiest period this week, companies will soon be exiting their blackout periods. As a result, this gap should begin to shrink as we expect indiscriminate buying to occur as companies execute their announced buyback plans with many of their stocks cheaper by 10% or more. We believe many corporate management teams will be very excited about this development, and given the large amount of available dry powder for corporate buyers, this should provide strong support for equities over the next several months.

 

Buybacks Should Drive Markets Into Year-End

Data as of September 30, 2018. Source: JPMorgan.

While the series of pullbacks we are experiencing this month can be frightening for investors, we believe it is important to distinguish between signal and noise.  For the time being, recessionary risk remains dormant which is why we believe the negative October stock market action —  which may not be over quite yet — represents an attractive entry point for longer term investors. 

As monetary policy continues to normalize, and the economic cycle matures, months like October may become more common.  However, the end of the cycle appears to remain in the distant future, whcih we believe allows investors plenty of opportunities to take advantage of these periods of market anxiety.

 

Forecast are inherently limited and should not be relied upon as indicators of actual or future performance.

 

Top

Important Information

 

All investments involve risk, including possible loss of principal.

The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested. 

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.

International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

Past performance is no guarantee of future results.  Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.

The information in this material is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason or its affiliates or any of their officer or employee of Legg Mason accepts any liability whatsoever for any loss arising from any use of this material or its contents. This material may not be reproduced, distributed or published without prior written permission from Legg Mason. Distribution of this material may be restricted in certain jurisdictions. Any persons coming into possession of this material should seek advice for details of, and observe such restrictions (if any).

This material may have been prepared by an advisor or entity affiliated with an entity mentioned below through common control and ownership by Legg Mason, Inc.  Unless otherwise noted the “$” (dollar sign) represents U.S. Dollars.

This material is only for distribution in those countries and to those recipients listed.

All investors and eligible counterparties in Europe, the UK, Switzerland:

In Europe (excluding UK & Switzerland) this financial promotion is issued by Legg Mason Investments (Ireland) Limited, registered office 6th Floor, Building Three, Number One Ballsbridge, 126 Pembroke Road, Ballsbridge, Dublin 4, D04 EP27, Ireland. Registered in Ireland, Company No. 271887. Authorised and regulated by the Central Bank of Ireland.

In the UK this financial promotion is issued by Legg Mason Investments (Europe) Limited, registered office 201 Bishopsgate, London, EC2M 3AB. Registered in England and Wales, Company No. 1732037. Authorised and regulated by the UK Financial Conduct Authority.

In Switzerland, this financial promotion is issued by Legg Mason Investments (Switzerland) GmbH, authorised by the Swiss Financial Market Supervisory Authority FINMA.

Investors in Switzerland: The representative in Switzerland is FIRST INDEPENDENT FUND SERVICES LTD., Klausstrasse 33, 8008 Zurich, Switzerland and the paying agent in Switzerland is NPB Neue Privat Bank AG, Limmatquai 1, 8024 Zurich, Switzerland. Copies of the Articles of Association, the Prospectus, the Key Investor Information Documents and the annual and semi-annual reports of the Company may be obtained free of charge from the representative in Switzerland.

All Investors in Hong Kong and Singapore:

This material is provided by Legg Mason Asset Management Hong Kong Limited in Hong Kong and Legg Mason Asset Management Singapore Pte. Limited (Registration Number (UEN): 200007942R) in Singapore.

This material has not been reviewed by any regulatory authority in Hong Kong or Singapore.

All Investors in the People’s Republic of China ("PRC"):

This material is provided by Legg Mason Asset Management Hong Kong Limited to intended recipients in the PRC.  The content of this document is only for Press or the PRC investors investing in the QDII Product offered by PRC’s commercial bank in accordance with the regulation of China Banking Regulatory Commission.  Investors should read the offering document prior to any subscription.  Please seek advice from PRC’s commercial banks and/or other professional advisors, if necessary. Please note that Legg Mason and its affiliates are the Managers of the offshore funds invested by QDII Products only.  Legg Mason and its affiliates are not authorized by any regulatory authority to conduct business or investment activities in China.

This material has not been reviewed by any regulatory authority in the PRC.

Distributors and existing investors in Korea and Distributors in Taiwan:

This material is provided by Legg Mason Asset Management Hong Kong Limited to eligible recipients in Korea and by Legg Mason Investments (Taiwan) Limited (Registration Number: (98) Jin Guan Tou Gu Xin Zi Di 001; Address: Suite E, 55F, Taipei 101 Tower, 7, Xin Yi Road, Section 5, Taipei 110, Taiwan, R.O.C.; Tel: (886) 2-8722 1666) in Taiwan. Legg Mason Investments (Taiwan) Limited operates and manages its business independently.

This material has not been reviewed by any regulatory authority in Korea or Taiwan.

All Investors in the Americas:

This material is provided by Legg Mason Investor Services LLC, a U.S. registered Broker-Dealer, which includes Legg Mason Americas International. Legg Mason Investor Services, LLC, Member FINRA/SIPC, and all entities mentioned are subsidiaries of Legg Mason, Inc.

All Investors in Australia:

This material is issued by Legg Mason Asset Management Australia Limited (ABN 76 004 835 839, AFSL 204827) (“Legg Mason”). The contents are proprietary and confidential and intended solely for the use of Legg Mason and the clients or prospective clients to whom it has been delivered. It is not to be reproduced or distributed to any other person except to the client’s professional advisers.