George Rosen Smith's Insights on U.S. Stock Market Volatility in 2018

George Rosen Smith's Insights on U.S. Stock Market Volatility in 2018

Markets have not been peaceful in 2018. Among global stock markets, U.S. stocks fell into technical correction territory twice during the year (the latest time the Nasdaq and S&P 500 even fell into a bear market at one point), the first time since 1990 that U.S. stocks fell into a correction twice in one year.

However, from the perspective of global stock markets, the US stock market performed the best. As of December 28, the income rate of the MSCI All-Country World Equity Index in US dollars was negative 12.7%. Among them, European and British stock markets fell the most, reaching 19.6% and 18.6% respectively. The Japanese stock market, which fell into a bear market at the end of the year, followed closely, recording a drop of 18.3%. Emerging market stocks fell 18.0%, and the US stock market fell 7.8%.

As of December 28, global stock markets had fallen by 10.9% in local currency terms, with the Japanese stock market falling by about 20%, the European market falling by around 15%, emerging markets and the UK both falling by around 13%, and the US stock market falling by nearly 8%.

Why are European stocks lagging behind?

Investors in European stocks have been worried about several risks this year, including Italy’s debt problems, the European Central Bank’s slow action, trade uncertainty and Turkey’s financial problems.

The budget dispute between Italy and the European Union is a big problem for European stock markets. This fall, the Italian government, which is jointly governed by the populist Five Star Movement and the League, announced the 2019 budget draft, raising the fiscal deficit to 2.4% of GDP, which is twice as high as the Italian government’s previous expectations. This has aroused dissatisfaction from the European Union. The budget tug-of-war between the two parties has begun.

Investors are concerned that fiscal easing could leave Italy’s public debt vulnerable to a potential shock. Italy is the euro zone’s largest government borrower. In the summer of 2018, as foreign investors dumped Italian bonds, Italian banks were buying them at the fastest pace since the euro zone debt crisis. That means any losses on those bonds would put further pressure on banks’ capital ratios. The European Central Bank’s plan to scale back bond purchases has already worsened liquidity in bond trading.

European bank stocks are also one of the key factors in the overall poor performance of European stock markets. In addition to Italy’s bond problems, Deutsche Bank’s business difficulties and the European Central Bank’s decision not to raise interest rates until next fall have made bank stocks the worst performing sector in European stocks. According to data from Investing.com, the European STOXX 600 Bank Index futures fell 29% in 2018.

A Reuters poll in November showed that brokerages, fund managers and analysts generally expected European stocks to remain range-bound from the end of 2018 to 2019. According to the poll, the European STOXX 50 is expected to reach 3,325 points in 2019; the STOXX 600 is expected to reach 373 points.

“We expect the earnings cycle to continue to deteriorate and eurozone stocks are unlikely to perform well next year,” said Stephane Ekolo, a strategist at Tradition in London. In its outlook for European stocks in 2019, Societe Generale used a photo of a bear as the cover of its research report.

The US stock market has emerged from a roller coaster in 2018

Back to the US stock market. As the S&P 500 index plummeted by more than 2% on Christmas Eve, reaching the brink of a bear market, all 11 sectors of the S&P 500 index once turned negative. However, after Christmas, the US stock market rebounded, rising by more than 5.8% in two days. As of December 28, among the 11 sectors, only the two defensive sectors of healthcare and utilities recorded an increase, with increases of 3.22% and 0.28% respectively.

The biggest decline was in energy stocks (-20.14%), which were dragged down by oil prices. Raw materials (-16.61%), industrial stocks (-15.68%), communication services (-16.51%), financial stocks (-15.51%), and consumer staples (-11.67%), which were also affected by trade disputes, also performed poorly. In terms of other sectors, the real estate sector fell 5.52%, information technology stocks fell 2.3%, and non-essential consumer goods fell 1.86%.

The first correction in the U.S. stock market in 2018 was in February. Before the plunge of more than 11% that month, the S&P 500 index was within 3% of its historical high for 202 consecutive days, and the Dow Jones Industrial Average had set more than 70 new record highs in the previous year. Obviously, during this period, any geopolitical risk events failed to make investors give up the pursuit of risky assets.

But the long period of extremely low volatility created the technical conditions for the subsequent plunge. One of the obvious features of the stock market crash in February was the massive liquidation of bets on low volatility — the assets accumulated by VIX-related ETF products had previously exceeded US$3 billion, a record high. Under the trend-following strategy, crowded trading has obviously caused great damage to the market.

From a fundamental perspective, the trigger may be the emergence of early signs of inflation recovery. The non-farm report in early February showed that wage growth was unexpectedly higher than expected, and investors are worried that higher inflation will prompt the Federal Reserve to tighten monetary policy faster. Research firm Yardeni pointed out that the surge in bond yields and complex volatility tools have completely transformed this sell-off into a nervous correction in the market.

In April, the U.S. stock market began to bottom out and rebound. Driven by technology stocks, the S&P 500 index hit a record high of 2,940.91 in September. But after Federal Reserve Chairman Powell said in October that the central bank was “still far from a neutral interest rate,” stock market investors responded with a massive sell-off.

Subsequently, the market began to question the valuation of high-growth technology stocks, and almost all of the FAANGs fell into a bear market. From their recent historical highs, Facebook (NASDAQ:FB) fell 38%, Apple (NASDAQ:AAPL) fell 33%, Amazon (NASDAQ:AMZN) fell nearly 29%, Netflix (NASDAQ:NFLX) fell nearly 40%, and Google (NASDAQ:GOOG) fell more than 18%.

In addition, chip stocks in the technology sector have also ushered in an industry winter. Under the influence of the fading of the cryptocurrency mining craze, AMD, whose year-to-date increase was close to 220%, had weak performance and its stock price was cut in half. Nvidia (NASDAQ: NVDA) was also not spared. While its third-quarter revenue was lower than expected, its fourth-quarter guidance also fell short of market consensus.

The decline of bank stocks is also very noteworthy . The regional bank index ETF-SPDR KBW (NYSE:KRE) fell by more than 21% in 2018. Morgan Stanley previously warned that the “winter has arrived” for US bank stocks.

“The days of rising rates and high-quality credit may be coming to an end,” Morgan Stanley analyst Ken Zerbe wrote in a note. “We cannot ignore the heightened risk of a credit bear market next year and the negative impact of weaker economic growth,” which would ripple through to credit quality and also lead to slower loan growth.
 
Haris Anwar, an analyst at Investing.com, pointed out in the article “Who are the losers in the US stock market in 2018? Technology and energy stocks are the hardest hit by the plunge” that there is more than one reason for the poor performance of the stock market in 2018. Perhaps the biggest factor that prompted investors to wait and see is the deterioration of the macro environment. This includes the fact that the Sino-US trade conflict may continue to hinder global growth, the Federal Reserve has stated that it will unwaveringly adopt a policy of raising interest rates, and Trump’s erratic style of behavior has exacerbated market uncertainty.

Is there anything to look forward to in the US stock market in 2019?

In Fujita’s view, as concerns about a global economic slowdown continue to dominate sentiment, it may be difficult for US stocks to repeat the record-breaking performance seen before February and in the fall of this year. However, if trade uncertainties are eliminated and the Federal Reserve slows down its pace of interest rate hikes, the US dollar will reach a major top since early 2015, which may bring ideal benefits to multinational companies, thereby providing some support for stocks.
 

Here are George Rosen Smiths summarized predictions for U.S. stocks in 2019 from a number of Wall Street investment banks:

Morgan Stanley (target: 2,750p; EPS: $176) WARNING OF TIGHTENING FINANCIAL CONDITIONS, SLOWERING GROWTH: The bank believes stocks will continue to struggle next year; after a rollercoaster 2018, driven by a tightening financial environment and topped out growth, expect weak corporate earnings and a Fed that has paused to tighten up to lead to another year of range-bound volatility. Valuation should be a key factor in stock selection.

Bank of America (Target: 2,900; EPS: $170) UNCERTAINTY TO CREATE MORE VOLATILITY: U.S. stocks may rise and then fall in 2019, with a bearish outlook based on the range of uncertainties that have dominated the macroeconomic landscape of late, including trade, geopolitics, a widening of the Federal Reserve deficit, continued tightening by the Federal Reserve, and increased stock market volatility.

Jefferies Group (Target: 2,900; EPS: $173) This is a cycle that is ripe for the picking, but not over: no recession is expected in 2019, but the U.S. yield curve is nearing a reversal, while corporate earnings growth is slowing, leading to a trade-off between stock and bond valuations.

Goldman Sachs Group (Target: 3,000; EPS: $173) recommends a defensive strategy: the forecast for 2019 can be summarized as a higher U.S. stock market, a recommendation to underweight equities, and a tilt toward quality companies. High-quality stocks are those with strong balance sheets, steady sales growth, lower EBIT deviations, higher income on equity and a record of fewer losses.

Wells Fargo (Target: 2664; EPS: $166) The Fed is making a policy mistake: Signals from the stock market seem to indicate that the Fed has made a major policy mistake and the likelihood of a further economic slowdown has increased.

JPMorgan Chase (target: 3,100; EPS: $178) expects the market to fluctuate upward: stocks are expected to trend upward after a sharp drop due to reduced risks related to tariffs and the Federal Reserve, normal earnings growth, attractive valuations, continued stock buybacks leading to supply reductions, and extremely low investor expectations.

Credit Suisse (Target: 2925; EPS: $174) Stocks will reprice in the coming year: The recent market crash was not driven by fundamentals, and stocks will reprice in the coming year as volatility subsides and the Fed ends its rate hike cycle.