Cracks Appearing

The stock market bucked the historical trend in October, rising 2.7% in one of the worst months for stock market performance (the 1929 crash, the 1987 crash, etc.) However, the market has been unable to maintain the good vibes into November, which is historically one of the best months for stocks. Go figure!

Despite a late Friday recovery, the S&P 500 pulled back from its recent highs this week, trading lower on concerns over the increasing use of leverage to fund the AI buildout and therefore questioning the sustainability of the capital spending, AI stock valuations, as well as weak job data that is hinting that the effect of automation could be beginning to appear in the data. But because of the shut-down, that jobs data is coming from non-typical sources and to an extent is up for debate.

The Nasdaq Composite, which had led gains due to AI momentum, experienced the sharpest decline this week, declining 4.0% from its Oct 30 closing peak. The S&P 500 closed 2.4% off its closing high on Oct 28. And the AI correction is not just in the U.S. The Korean KOSPI Index, an Asian AI bellwether index, is down 6.4% from its closing peak recorded on Nov. 3.

The leaders of the rally this year are also the leaders of the correction this week, as a small number of AI-related mega-cap stocks have driven the stock markets overall performance. Nonetheless, CNBC reported early on Friday that  approximately 80% of S&P 500 stocks were down for the week, so declines were also broadly based.

There is little question that the stock market was expensive at the beginning of the week. Joel Greenblatt, of Gotham Asset Management, wrote in his quarterly letter this week:

“The S&P 500 trades at a 3.2% cash flow yield based on Gotham’s proprietary metrics (“Gotham Yield”), placing it in the first percentile towards expensive over our 30+ year research history. Cumulative two-year forward returns from these valuation levels in the past have averaged 3% -5%… The Russell 2000 is trading at a 0.8% Gotham Yield, the most expensive observation in our data set going back to 1990. Based on that data, two-year forward returns are imputed to be slightly negative. Though small cap stocks have consistently underperformed large caps in recent years they remain much more expensive because cash flow growth has not kept pace.”

The stock market has had a record rally from the April lows and taking a breather is to be expected. Valuations are rarely the impetus for a correction, but when other factors combine with stretched valuations, you have a recipe for a pullback.

Santa Claus Rally Postponed?

Ironically, from a historical basis, November has typically been the best performing month of the year, leading the way to the typical Santa Claus rally into the end of the year. Of course nothing happens with 100% certainty, so it’s possible that Santa came early this year. In any case, it sure would help if the government shutdown ended soon. The pressure to end the stand-off is building on both sides. At some point soon, we expect a deal to be reached. It really doesn’t matter to us which side capitulates, as long as one does. Friday afternoon, Sen. Schumer offered a deal to extend ACA subsidies for one year to end the shut-down, which was quickly rejected by the GOP. What interesting is that when the offer was rejected, stocks did not weaken again. The market appears to sense a deal will arrive soon and that could be a catalyst for the current correction to end.

Welcome to Normal

Markets that go straight up, as the indexes have done since the April low, are not normal. Back in the October 17 edition, Forbes Magazine stated that the current U.S. stock market rally that began in April was the fifth largest rally without a 5% or greater correction in over 55 years. What is normal is a 5%-10% correction. In fact, 10% corrections typically occur every 15-18 months.

Market corrections are a normal part of investing that offset excessive speculation that can build up in bull markets. They are a normal feature of the market and can be a buying opportunity for long-term investors. Although a 10% drop can be frightening, historically, the S&P 500 has ended the year in positive territory in about 73% of the years it has experienced a correction of 10% or more.

Keep calm and carry on!

 

What We’re Reading

 

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The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.

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All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability, or completeness of, nor liability for, decisions based on such information, and it should not be relied on as such.

The views expressed in this commentary are subject to change based on the market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance, and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.

Past performance is no guarantee of future returns.

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General News

By: Adam