October 18, 2018

Stocks gapped down at the open today (Dow -280 pts; SPX -1.27%). Tech, telecom and consumer discretionary sectors are all down more than 1.5%. Utilities and real estate sectors are up slightly. So today’s risk-off trading session flips the switch from yesterday’s risk-on bent. Th VIX Index bounced back up to 18.7 today. European markets will close a bit lower and most of Asia was down overnight. The dollar is strengthening a bit on China concerns (see below). Commodities are mostly lower in early trading, with WTI crude oil pulling back under $70/barrel. Bonds are trading modestly higher as you would expect on a risk-off day. The 5-year and 10-year Treasury note yields edged down to 3.03% and 3.17%, respectively.

China’s Shanghai Composite Index fell nearly 3% last night. And in local currency terms, the index is now down nearly 30% on the year. China’s stock is by far the world’s worst-performing in 2018. According to Bloomberg, investors are concerned about slowing economic growth and rising margin debt in China. Margin refers to borrowing money for the purpose of investing in stocks. Taken too far, it always ends badly. That’s because the stock shares become loan collateral, so when the market falls the lender demands additional collateral to keep the loan active. That, in turn, causes investors to sell shares into a falling market, compounding volatility.

Famed investor Lee Cooperman was interviewed on CNBC yesterday and his comments deserve to be quoted at length. “Things I look at indicate the market is OK.” He says the S&P Index is in a range of fair value and there’s no reason to panic about interest rates or inflation. “All this fixation on interest rates I think is misplaced.” The market can easily handle rising interest rates as long “as the rise is gradual.” It is true, he acknowledges, that “every business cycle [downturn] has been preceded by high real interest rates and accelerating inflation.” But, he points out, “we don’t have that now.” Real (that is, adjusted for inflation) interest rates are hovering around zero. And that means rates are not poised to kill the stock rally…yet. “Somewhere in the next 12-18 months, inflation and the Fed will catch the market, but not now.”

In Cooperman’s view, bonds are the asset bubble to worry about, not stocks. He discussed valuation on the US stock market at length. Over the last 50 years, the P/E multiple on the S&P 500 has averaged 15. But at the same time, the 10-year Treasury Note yield has averaged 6.65% and 90-day T-bill has been about 4.95%. At the moment, the stock market P/E multiple is about 16.5 and 10-year yield is only 3.1%. The 90-day T-Bill is yielding a little over 2%. In other words, the current P/E multiple is reasonable and could even handle higher interest rates. Also, “There’s no sign of recession.” The conditions leading to a large decline just aren’t present. But understand that we’re in the “process of normalization.” With real GDP growth of 2% and inflation at 2%, nominal economic growth is about 4%. Referring to an old rule of thumb, Cooperman says the 10-year Treasury yield should be 4% and the short-term Fed-funds rate should be at 3%. That would be normal, and that’s where we’re headed.

Finally, Mr. Cooperman directly addressed the stock market volatility we’re seeing. “Quantitative trading systems are destroying the structure of the market.” These automated systems are trend followers and are “really exaggerating the trend, up and down.” Whereas human investors try to buy low and sell high, electronic trading algorithms are usually designed to sell on weakness and buy on strength. “Selling begets selling because [of] these quantitative trading systems.”


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