- February ended a record streak of 15 consecutive monthly gains for the S&P500.
- Volatility returned to the market with historic moves in the CBOE Volatility Index (VIX).
- Economic and market measures of inflation are on the rise, increasing the chance of a fourth rate hike in 2018.
- Cyclical stocks led by technology and financials were the outperformers, suffering the smallest declines, while Energy was once again a laggard.
All good things must come to an end and that certainly was the case for markets in February. On a total return basis the S&P 500 Index declined 3.7% in February and with it ended a record streak of fifteen consecutive months in the green. All major equity indices registered double digit declines marking their largest correction in two years. And the VIX index, which only weeks earlier in January retested its all-time lows made two months earlier in November, saw a month over month rise of more than 450% which included an all-time record gain of 116% in a single trading session. Interest rates which typically move lower during risk-off / flight-to-safety type moves, actually saw weekly gains throughout the equity correction which may have contributed to the widespread fear. All in all it is was quite the welcoming for Jerome Powell who took office as Chairman of the Board of Governors of the Federal Reserve System on February 5, 2018
For the month all of the major equity indices saw high-to-low declines ranging between 11% and 12.2%. The selloff was fast yet the recovery was nearly as quick. By month-end the Dow Jones and S&P 500 indices registered monthly declines of "only" (4.3%) and (3.9%). The small and midcap Russell 2000 and S&P 400 indices were the worst performers with declines (4%) and (4.6%). And the Nasdaq Composite outperformed the lot with a relatively modest decline of (1.9%).
The sharp declines in early February could partly be attributed to accelerated inflation concerns and thus explains why "safe haven" treasuries also sold off. On Friday 2/2, the S&P 500 dropped more than 2% following the disclosure that January average hourly earnings rose 2.9% YoY, the largest increase since 2009 (see "Inflation" below). When the markets opened the following Monday, the downside accelerated to the tune of (4.1%) trapping "weak hands" holding recent long positions. The selling did not discriminate as all sectors and market cap-sizes experienced precipitous declines.
The equity rebound off the early February lows was positive in the sense that the pro cyclical groups -
technology, financials, and industrials - led the way, as opposed to the defensive sectors like staples and utilities. As such the cyclicals finished the month with the best relative performance with the top performer technology declining a modest (0.1%), followed by financials (3%), and consumer discretionary (3.7%). Conversely energy was by far the worst performer with a decline of (11.3%).
The Energy sector took it on the chin last month with an 11% decline, its worst decline since September 2011. Lower crude oil prices and weak earnings get the blame. Brent and WTO crude oil fell about 4.8% in February after five monthly gains. Analyst see progress in working down the global supply glut, but ten weekly declines in crude stockpiles have given way to builds in four of the past five weeks. Earnings were another factor despite the sector showing double-digit earnings growth. According to Factset the sector saw the most deviation between earnings estimates and actual earnings. Bellwethers Exxon and Chevron for instance missed expectations and declined 14.6% and 10.3% respectively in the days following their results.
Technology rallied back 14.8% from its 2/9 low, and is the only sector to make a new high in early Mach, as the S&P Info Technology Index closed out the month with a marginal decline of (0.11%). The top gainers were CSRA +23.3% (to be acquired by General Dynamics), Micron Tech +17% (raised guidance), Qorvo +14% (Apple contract win), and Skyworks Solutions +13% (reported revenue +15% and$1b buyback). Since the start of 2017, technology has been the top performing sector and has outpaced the S&P 500 in ten of the past 14 months.
Financials continue to benefit from the tailwind of rising rates, particularly on the short end of the curve, driven by solid economic data, rising inflation, and the expectation of three rate hikes in 2018. Over the last five months alone the US Treasury 2-year yield has spiked more than 100bps from 1.25% at the September lows to the February high of 2.28%.
The calendar had barely turned to February when investors reacted negatively to the 2/2 hourly earnings report that raised concerns of wage inflation and caused the Dow to shed 666 points. The following Monday, volatility returned in force, with stocks down 1,175 Dow points on the day (-4.6%) after flirting with greater losses that had traders dusting off their circuit breaker notes. The narrative for February has centered around interest rates - specifically a focus on whether the 10-year Treasury would move above 3% and the increased chances for a fourth Fed rate hike this year. Some have pointed out the low correlation between the 10-year and the S&P 500 as evidence the market is reacting to something else, but the chances for rising consumer prices is something traders have not contended with for many years.
A weakening dollar (which seemingly goes against rising interest rates relative to other currencies), would also allow for more import inflation. One factor that might explain renewed inflation expectations and the weaker dollar is the budget deal announced on February 8 th . The deal adds hundreds of billions of dollars to projected future deficits and the prospect of papering over trillion dollar deficits each year going forward weighed on stock and bond market sentiment.
A Bloomberg survey of economists sees the Fed allowing inflation to rise in an effort to extend the current nine-year economic expansion. And former Fed governor Laurence Meyer said some hawks on the committee told him "they wouldn't be worried about a modest overshoot" as long as it is below 2.5%. This suggests investor fears of an aggressive rate hike path on signs of inflation may be misplaced, although Meyer does not expect a fourth rate hike in 2018.
While the economy remains on solid footing, recently there has been a clear trend of releases coming in below expectations. The second estimate of Q4 GDP was revised down to 2.5%, modestly below the initial 2.6% announced in late January which then fell short expectations of 3% GDP. Consumer spending remained unchanged at 3.8% with weak durables offset by an increase in service spending. Meanwhile pending home sales declined 4.7% which fell well below forecasts of a 0.5% increase, however the miss was attributed to low inventories. The solid yet "underperforming" economic data is best visualized by the below chart of the Citigroup Economic Surprise Index which peaked in December and has since been in decline.
After being absent for nearly all of 2017 and into January 2018, volatility returned with a vengeance in February. Whether it is the disappointing economic data, dramatic spike in yields, fear of increased rate hikes, or some other, the lull seen over the prior twelve plus months is a thing of the past. The VIX Index spiked more than 450% from the January lows to February highs which included a record daily gain of 116%. For the month the VIX averaged a daily close of 22.46, more than double that of the 11.06 average in January. Viewed another way, twelve of the 19 trading sessions (63%) saw a daily percentage move greater more than 1%, up or down. This compares to a total of eight in all of 2017. The more detailed high-low range saw 17 of 19 trading sessions (90%) with a range greater than 1%, nearly double the ten occurrences in all of 2017. As in past bouts of volatility, Exchanges gained market share at the expense of alternative trading systems as investors pursued liquidity.
Earnings season for large cap names neared an end in February with nearly all S&P 500 members reporting. Posting an average upside beat of over 3.8%, the S&P 500 membership leadership came from Consumer Discretionary & Materials names, both outperforming by over 9%. Underperformers included the Energy and Utilities sectors - both missing to the downside. The quarterly earnings growth rate for the index popped over 14% while the sales growth rate increased 7.7%. Of the 97% of S&P 500 companies that have now reported for Q4, 74% have beaten consensus EPS expectations, better than the 72% one-year average. In addition, a record 77% have surpassed consensus sales expectations, above the 64% one-year average.
The wild swings in US equities correlated with the ETF flows during February and for the first time since early 2015 ETF's experienced their first negative outflow. From 2/1 through 2/9 more than $25b was taken out of the SPDR S&P 500 Trust (SPY). As markets then rebounded, investors piled back into the large-cap ETF, partially offset the initial outflows while finishing February down -$19.6B. Conversely, International ETFs saw net inflows including the iShares Core MSCI EAFE (IXUS) which finished the month +$6.9B. High yield bond ETFs experienced outflows, including the SPDR Bloomberg Barclays High Yield Bond ETF (-$2.36B) and iShares iBoxx Investment Grade Corporate Bond ETF (-$3.3B).
As noted above inflation expectations are creeping back into the market. The surprise wage gains in late January kicked off concerns that rising labor costs and inflation expectations themselves could begin to ripple through the economy. This seemingly was confirmed by rising treasury yields during the stock market selloff in February. Also, market expectations for a fourth rate hike in 2018 have moved to above 25% from below 10% at the beginning of the year, and three likes are now fully priced in. Stock valuations remain near historic highs and would be pressured if expected earnings growth is outweighed by rising yields. Earlier this month Reuters reported that US corporate profits are expected to increase by nearly 20% this year. Whether investors are willing to pay more for future earnings in light of tariff talk and potentially higher rates is an open question. Traders will be closely watching employment and other economic reports for more clarity on the inflation picture.
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Michael Sokoll, CFA is a Senior Managing Director on the Market Intelligence Desk (MID) at Nasdaq with over 25 years of equity market experience. In this role, he manages a team of professionals responsible for providing NASDAQ-listed companies with real-time trading analysis and objective market information.
Jeffrey LaRocque is a Director on the Market Intelligence Desk (MID) at Nasdaq, covering U.S. equities with over 10 years of experience having learned market structure while working on institutional trading desks and as a stock surveillance analyst. Jeff's diverse professional knowledge includes IPOs, Technical Analysis and Options Trading.
Steven Brown is a Managing Director on the Market Intelligence Desk (MID) at Nasdaq with over twenty years of experience in equities. With a focus on client retention he currently covers the Financial, Energy and Media sectors.
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