Even with several tailwinds, stocks were down Tuesday and pressured in general. Meanwhile, strategists on Wall Street point to reasons the correction could get a bit worse in the near-term.
How Stocks Have Recently Traded:
First off, U.S. stocks — excluding the mega-cap tech stocks — were down a fair bit Tuesday even as the House proposed a $2.2 trillion fiscal spending bill. Investors were looking to more fiscal stimulus to uphold the current V-shaped economic and market recovery, but the bill has come far later than hoped for, while many small businesses and households are moving closer and closer to insolvency. Also, virus cases are picking up as the weather gets cold again and investors will — again — grapple with the relatively unquantifiable tug-and-pull of the positives of stimulus against the negatives of potential lockdowns. Earnings per share on the S&P 500 for 2021 are expected to reach 2019 levels, but these events — which have already caused a broad correction that has moved the S&P 500 down 6.5% since September 2 — have begun to reflect potential lowered earnings expectations for 2021.
Short-term interest rates are also already at 0% and the Federal Reserve is buying bonds across the risk-ladder, keeping borrowing costs low. Fiscal spending in general may be important throughout the pandemic, but even if Democrats control Congress after the election, they aren’t likely to control by wide margin, leaving only a few centrist Democrats to potentially vote against large spending programs.
Now, the average stock on the S&P 500 is trading at just about 20 times next year’s earnings, a multiple that has been higher this year with rates where they are as of the end of September. Tech stocks have corrected substantially and are a part of that, but others sectors have certainly participated.
“While September has been rough for U.S. equity markets,” Morgan Stanley’s Chief U.S. Equity Strategist Mike Wilson wrote in a note, “We expect it to bleed into October.” Many strategist agree. "The correction phase should continue for a few more weeks,” wrote Steven Ricchiuto, chief U.S. economist at Mizuho Securities in a note.
Here are some signals that investors may view negatively.
Far more dollars in the stock market are positioned for upside potential rather than downside, according to Wilson’s team at Morgan Stanley. Net long equity positions (long as a ratio to short positions) among institutional investors are at 70%. That 70% long position is net of the short positions. Since 2005, that has sat at around 50% to 60%. “What this tells us is that if volatility stays high and markets remain fairly trendless, these exposures are likely to fall over the next month, Wilson said. “That means lower equity prices before the correction is over.”
This statistic, though, must be weighed against another stat. Global investors, broadly speaking, are holding a relatively high percentage of their portfolios in cash. A bit over 4% of total portfolios of diverse assets is in cash, according to Bank of America Global Research. Historically, that sits a bit below 4%. So, if institutional investors specifically are net long by a wide margin, it is short-sellers that are not likely coming out to party. “There is not really a lot of institutional money that is really short,” Tim Anderson, managing director of TJM Brokerage told TheStreet. "It doesn’t feel to me that short exposure is excessive,” he added, noting that a lot of short exposure may be concentrated in a few names.
So some investors have decent long exposure, but many investors are not over invested by historical standards. Bank of America clients only just recently just reached 60% equities in their portfolio — full exposure by historical or recommended standards.
But there’s more to say that the stock market correction is ongoing.
Real Yields Are Rising:
The 10-Year treasury yield did dip to 0.64% from 0.66% Tuesday, but the real yield has indeed bounced a bit of late. Real yield is interest rate, or just rate of return, minus the expected rate of inflation.
In today’s incredibly bearish environment on long-term economic growth, the real has been below negative 1% for some moments this year. This makes stocks incredibly attractive against safe investments and lowers the rate at which corporate cash flows are discounted, boosting valuations. Now, the real yield is inching in the direction of positive territory, at 0.9%, according to Morgan Stanley.
Positively, this may be reflective of an incremental increase in expectations for inflation and economic growth ahead, although that hasn’t been the tone of the market of late. Plus, while the directional trend in inflation expectations matters, the recent improvement is marginal. “I just don’t see how that affects the economy at all,” Anderson sad. "The nominal difference is so small that if businesses can’t make money with a 0.65% ten-year [yield[, is a 0.68% going to make that much difference to them?”
Case in point: near-term upside to stocks may be a bit limited, but many strategists do think the U.S. is in the beginning of a larger new bull market.
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