The Big Short
The S&P 500 Index fell 1.2% Tuesday, snapping a two-session win streak. The tech-heavy Nasdaq 100 Index dropped 2.1%. Defensive sectors were the biggest outperformers, with healthcare stocks and consumer staples both gaining. Technology stocks were the biggest underperformers, sliding 2.3%, while the S&P 500 Equal-Weighted Index fell only 0.3%. Investors bought the dip on Wednesday following election results that scored a win for Democrats in Virginia, New Jersey and New York City. Frustration with the government shutdown and affordability issues were clearly on the minds of the electorate this week.
Even though corporate earnings are strong, valuations are still challenging. US stocks tumbled on Tuesday as some technology earnings reports were not well received. We also had warnings from a few Wall Street executives that the equity market was due for a pullback. Hedge fund manager Michael Burry, who wrote “The Big Short” book, disclosed bearish wagers on some high-flying technology stocks. Burry recently posted a warning to investors about market exuberance as well, suggesting he was betting heavily on a market decline ahead. Burry successfully bet on a housing market crash and the underlying mortgage-backed securities in 2008. Lightning may or may not strike twice, but Burry joins the chorus of investors noting high valuations in some stocks.
The Signal is Noisy
The trick is whether these warnings are the signal or just noise. The signal is a clear radio broadcast (for those of us that still tune in to the radio). Or it can be a sustained economic trend, like rising unemployment over several months. Noise refers to the irrelevant, distracting, or random data that obscures the signal, like the static, interference, or other background sounds on the radio. Or it could be minor, short-term market fluctuations that don’t change a long-term economic trend. Right now, the signal we are receiving is that market valuations are indeed well above historic levels, but continue to march higher due to an underpinning of solid earnings. The underlying economy is chugging along at a slow and steady pace, but with a few cracks forming. Meanwhile, stocks are up 8% on average this year per the equal-weighted S&P 500 index and up 17% for the regular weighted S&P500 Index. Higher income consumers are driving most of the spending in the economy while lower income consumers are feeling pinched. Visa# is doing well. Chipotle# is not. Further noise comes from tariff turmoil, geopolitical dealings, election year posturing, and government shutdown impacts. While these are important issues, many times the underlying signal gets lost with all of the daily noise.
To filter out some of the noise, we look to The Pareto Principle. This is the 80/20 rule that states that for many phenomena 80% of the result comes from 20% of the effort. The principle was named after Vilfredo Pareto, an Italian economist, who noticed back in 1895 that about 80% of Italy’s land belonged to 20% of the country’s population. Sound familiar? This principle highlights that a large proportion of outputs is typically due to a smaller concentration of factors or inputs. We see this today in taxation where the top 25% of taxpayers pay 87% of Federal income taxes. The top 20% of income earners account for over 60% of consumer spending in the U.S. The top 10% of households in the U.S. own 87% of stocks. The top 10 stocks in the S&P 500 account for 40% of returns this year. Concentration is king in many areas.
Reading the Tea Leaves
While the government shutdown has now set a new record at 36 days, and the shutdown has created somewhat of a data vacuum near term, there are some signals to consider. October ADP private payrolls increased by 42,000, above expectations. The bulk of job creation came in services industries and from large firms, while medium and small companies shed jobs. The October ISM Services Index came in at 52.5, ahead of expectations and in expansion territory. The trends are up but the path is muddy. Interestingly, about 80% of earnings reports this quarter have been better than expectations, and about 20% have been less than stellar, thanks Pareto. The Magnificent 7 companies (including Apple#, Amazon#, and Alphabet#) reported earnings overall that increased by about 14% in the third quarter, but well below the average 30% growth rate over past year. The Magnificent 7 stocks still account for about one-third of the weighting of the S&P 500 index and about 40% of returns, so still have an outsized impact.
McDonald’s reported earnings this week slightly below expectations, but noted that same-store sales grew 2-4% domestically and overseas. McDonald’s reported that lower-income consumer traffic fell by a double-digits percentage. However, higher-income traffic was up nearly double-digits. The trend is positive, but the data is noisy. McDonalds is still expanding its restaurant base globally, which is a positive signal. This compares to Chipotle, which guided same store sales down for the third quarter in a row, toward a low single-digit percentage decline. Traffic trends are worsening for Chipotle and margin compression lies ahead. The takeaway is that the economy rests upon a concentrated number of consumers spending due to rising wealth, which is partly based on a concentrated number of companies driving markets to higher valuations. Signal meet noise.
It’s an actors field day today: Emma Stone turns 37, Ethan Hawke turns 55, and Sally Field turns 79.
Christopher Crooks, CFA®, CFP® 610-260-2219