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Six Things We Learned In Q1

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Authored by Nicholas Colas via DataTrekResearch.com,

One of the best things about writing daily reports is that I can look back in time and see what topics and themes dominated capital markets every single trading day. In fact, I just did that with all the DataTrek notes for the first quarter of 2018. There are several ideas that fit together neatly to give us some perspective on what may come in Q2.

#1. Too many equity investors are overweight Technology. This was today’s central lesson, so it is a good place to start. Tech has been a one-way ticket to outperformance for the last five years, and that clearly sucked too much capital into the sector.

With the end of Q1 almost here, today’s selloff is a sign many portfolio managers no longer want to show dramatic overexposure to the group. We doubt they finished selling down these positions today. If you are looking for a short-term trade into Q2, you should get your chance in large cap Tech over the next two days. The selling will likely continue.

What it means for Q2: Tech will return to its roots as a high risk/high return sector. That is where fundamentals say it should be. The critical question for the quarter will be how investors absorb that punch.

On the plus side, remember that Facebook/Google/Twitter and others are in the dog house for running businesses that are too good at what they do. Even with a dialed-back commercial model, they still have something akin to the only game in town. Slim comfort at the moment, to be sure. But the important one over the longer term.

#2. Big Tech is no longer a sleek, elegant black box; it is a jumble of wires that requires the constant intervention of an increasing number of humans to keep it on the rails. This is the other Tech-related theme that started in Q1 but will cast a shadow on the rest of 2018. It isn’t just Facebook, either. Google’s YouTube is hiring thousands of monitors to keep its platform safe. Uber’s tragic accident shows technology cannot deliver the magic bullet of self-driving cars any time soon. Tesla can’t seem to produce vehicles at scale.

In short, the bloom is off the tech rose.

What it means for Q2: equity prices are already adjusting to the spectacle of Mark Zuckerberg and other tech leaders doing their public penance in Washington. The more important issue is how much Facebook and its peers will have to spend in labor and capital to remediate their business models into compliance with user expectations.

More broadly, investors will have to adjust to a world where they still drive themselves to work in five years and wonder if the 2020 US presidential elections will be free and fair. All this is a large shift from a year ago and we doubt the adjustment process is over.

#3. Volatility may be an absolute measure, but humans perceive it in relative terms. Shifting to a behavioral finance point, equity price volatility in Q1 may have seemed exceptionally high. That, combined with lofty valuations, has sparked concerns that US equities are poised to drop materially.

The truth is US equities are currently exhibiting normal volatility.

Take the VIX as one proof point: today’s close was 22.5, about 10% above its long run average. But did today feel like a typical day? No – not by a long shot. That’s because we have had a long period of low volatility, only recently broken by more typical price churn. Like it or not, today is closer to a “Normal” US equity market than last year.

What it means for Q2: we expect similar volatility in Q2 as in Q1. In fact, it should continue for the balance of the year. US equities can still return their typical 6-8% in such an environment. They have, after all, done so many times in the past.

#4. What President Trump giveth, he can also taketh away. Last year’s dominant investment theme centered around tax reform. In the first quarter of 2018, that shifted to trade policy. The first was very helpful to US equities prices. The second has not.

What this means for Q2: the list of potential equity market risks is long, but what happens inside the Beltway clearly tops the list. First quarter 2018 showed that President Trump is not afraid to generate headlines that hit stock prices over the near term. There is no reason to think next quarter will be any different.

#5. Equity sector correlations tighten up at the first sign of trouble and stay there. The most underappreciated market dynamic of 2017 was the drop in sector price correlations to the US equity market as a whole. From an average +80% correlation, they dropped to 50% right after Election Day 2016 and remained low all last year. With the spike in volatility in Q1, however, they returned to their pre-election levels.

What this means for Q2: we expect correlations to remain elevated while investors piece through the other themes in this note. Also worth noting: there is a mathematical relationship between correlations and market-wide volatility. Until correlations decline, day-to-day market-wide price moves will remain higher than 2017.

#6. Stock investors will have to keep a weather eye on fixed income markets. This trend started with the move higher for Treasury yields at the start of 2018. Now, the list of rate markets to watch includes Libor, breakeven rates on Treasuries/TIPS, the shape of the yield curve, and commercial paper markets. None of this is comfortable for equity investors, who feel much happier looking at earnings releases and talking to managements.

What this means for Q2: We believe two statistics will drive equity valuations in the second quarter.

  • The first is the chance the Federal Reserve moves three more times this year, as measured by Fed Funds Futures. Given the selloff in stocks today, the odds there fell to 29.8% from 33.4% yesterday. If that number goes to 50% quickly on the back of stronger economic news, equities will likely falter. 

    You can track this here: http://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html
  • The second is the shape of the 2-10 Year Treasury spread. Currently at 50.5, this is the easiest way to see if debt capital markets believe the Federal Reserve is stumbling into a policy mistake. 

    If the Fed is right and the US economy is still strong, inflation expectations should take long-term rates higher and increase the 2-10 spread. So far in 2018, debt markets aren’t so sure the Fed is on the correct course – the 2-10 spread is essentially where it was at the start of the year.

    The data here: https://fred.stlouisfed.org/series/T10Y2Y

To sum up: we aren’t throwing in the towel on US stocks. We understand how we got to a down Q1 for US stocks, and why Tech is under pressure. Our central point is that there is nothing unusual about either. After many years of artificially low interest rates and liquidity, capital markets are returning to a more normal level of volatility. Yes, the transition isn’t easy. But there’s no reason to think it must end badly.

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