October is over. Most investors were probably spooked emotionally because markets fell for almost the entire month. But the last two trading sessions of the month saw the S&P 500* gain more than 2%, which was enough to limit October’s overall decline to just 2.2%.
That may seem surprising, given the general sour mood. For us (and probably other investors), October felt much worse than it was. At the broad index level, stocks weakened for most of the month, except those last two days (as we’ll see later, small- and mid-cap equities were most of the pain was).
But during those late-month sessions, stocks generally strengthened. That’s often a precursor to investors de-risking enough for selling to dry up.
Is that the case now? Let’s explore.
Macroeconomics and Technicals
We’ll start with identifying three realities that have passed now that we’re in November:
1. Unprecedented Q3 tax-loss harvesting (i.e., purposeful selling of stocks and bonds).
2. The CBOE Volatility Index (VIX), dubbed the market’s “fear gauge,” hitting its seasonal peak:
3. Stocks often bottoming in October.
Regarding tax-loss harvesting, Bank of America identified stocks likely to benefit from tax-loss harvesting. They fared worse than the market:
This harvest selling appeared to dry up prior to the last two trading days of the quarter. That calmed markets as VIX closed out the month around 18, which is where it was in mid-October, before the capitulation. Based on this trend, the index will likely drift lower in November and December, which is encouraging because a lower VIX is associated with generally rising stock prices, historically.
Furthermore, for technical data to support a bottoming market, we turn to eye-catching research from Bespoke Investments. The firm noted how speculative positioning on the S&P 500 recently flipped to net long from net short for the first time in 70 weeks. We think that’s a significant sign that selling may have exhausted itself:
This flip of fortunes ends the longest period of short speculation on S&P 500 futures ever:
Digging further, thanks to research from Fundstrat, in the previous instances where speculative positioning was short for more than 10 weeks, the win ratios in the following six and 12 months were hugely positive (the same holds when extending consecutive short positioning to 20 weeks):
So, the “flip to net long” is generally constructive for stocks for the rest of this year. But that still leaves a rather large elephant in the room – the bond market.
Stocks could take their cues from the bond market in the near term, as they have for the past couple of months, when both asset classes essentially moved in lockstep. This was also true back from January to March. But it wasn’t the case from April through July, as you can see below. There’s evidence we’re entering another one of those diversionary patterns now.
This is supported by research from Goldman Sachs, which showed the average fair value of the 10-year Treasury to be 3.76%. That implies the actual 10-year yield is about 110 basis points too high:
So, if all of this is correct, it’s further reasoning to think equities can outperform bonds. As the table above shows, the 10-year Treasury could have room to revert to its fair value (which right on cue seems to have begun last weeek).
We’ve said it before about the current situation: none of this means anything without the fundamental support from earnings. It’s still true. As of this writing, we're at the midpoint of the third quarter 2023 earnings season for the S&P 500:
The number of positive earnings per share (EPS) surprises and the magnitude of these surprises are both above their 10-year averages:
Positive earnings surprises were reported in multiple sectors. These surprises were strong enough to even partially offset downward revisions to EPS estimates for the two health care companies we mentioned last week. So far, the blended earnings growth rate for the third quarter is 2.7%:
If that momentum is sustained, it will mark the first year-over-year earnings growth since 2022’s third quarter. In all, these are the beginning signs of the fundamental support needed to align with the macro and technical data already mentioned. Perhaps more importantly, analysts are now expecting year-over-year EPS growth of 5.3% in the fourth quarter, and 2024 growth of 11.9% overall.
Those predictions are important because the current forward 12-month price-earnings ratio of the S&P 500 is now 17.1. That’s below the five-year average of 18.7, the 10-year average of 17.5, and the 17.8 figure recorded at the end of this past quarter. These equity valuations are attractive on their own. But when they’re compared to the potentially inflated market value of the 10-year Treasury, they’re even sweeter.
At Cornerstone, we’re always looking for value. And as equities earnings roll in, we’re seeing value be created.
Our readers know we look to “big money” professional investor activity as a source of data. What’s happening there is of great interest because these investors move markets. For now, the Big Money Index (BMI), a 25-day moving average of “big money” buys versus sells from our friends at MAPsignals, remains heavily oversold:
And exchange-traded funds (ETFs):
But when digging more, we see most of the selling pressure was focused on the more volatile small- and mid-cap stocks. It certainly happened in October, which continued a clear trend going all the way back to August:
The good and bad news is sellers haven’t spared any sectors. Widespread selloffs are miserable, no doubt. But they quickly bring us closer to a market bottom, which is nice because we can then move on.
Daily stock declines like we saw last month are uncomfortable. But the current data picture, along with the historical one, together provide reasons to be grow confidence going forward. It’s likely brighter days are ahead, though you may not feel that way if you invest emotionally instead of using data as a guide.
Historical averages indicated the BMI would lift from oversold on Oct. 24, at the earliest. Obviously, that didn’t happen. But perhaps it’s just a matter of the BMI ascension being a few days late as it appears the BMI bottomed on October 30th, as of this writing. Either way, every time since 2016 the BMI fell to this level, forward prices were higher one, three, six, nine, and 12 months later:
Going back even more, since 1990 there were 129 instances of the BMI being below 19. The one-year returns after were positive 100% of the time. This included instances like 1998, the 2000 tech bubble, 9/11, the 2008 financial crisis, and anything else since 1990. The average return in these 129 instances after one year was 24.7%:
Investing with emotion would work wonderfully if we did the exact opposite of what we feel most of the time. But as proven time and again, superior fundamentals always win.
Investors who ease their fears by bailing out may feel good temporarily, but history shows it’s a long-term opportunity blown. Every investor suffers losing periods. It’s the reaction to those circumstances that matters most.
So, addressing our original question: has there been enough de-risking for selling to dry up? Only time will tell, but the early prognosis is extremely encouraging.
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* The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market.
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