Jittery stocks should settle down, rally after midterms

Many investors expected a pickup in volatility heading into the U.S. midterm elections, but the disproportionate and extended selling in equities relative to other risk assets leaves us optimistic.

As of Oct. 24, the S&P 500 sold off by 9.4 percent since its peak in late September, with selling pressure picking up again after an initial downdraft earlier in the month. While some pointed to rising U.S. interest rates and trade war tensions to explain this drawdown, sell-offs typically do not have a single catalyst.

{mosads}Those catalysts may be unclear, but the move in equities appears disproportionate to the moves in other risk assets: While fixed-income credit spreads have widened, the magnitude has been smaller than what might be expected given equity declines.

Typically, when risk heightens in the market, investors seek safety in government bonds and may also sell riskier high-yield bonds, causing the yields between these types of bonds to widen — yields rise when bond prices fall.

Despite blame for the sell-off being attributed to fears of slowing global growth, we maintain confidence in the U.S. expansion. The ClearBridge Recession Risk Dashboard remains unchanged, and we continue to view this increased period of volatility as a buying opportunity.

One potential culprit for the recent surge in volatility is higher long-term interest rates. Rising rates make bonds more attractive compared to stocks and also signal higher financing costs across the economy, which lowers liquidity or available capital for some companies.

Higher U.S. Treasury yields have been linked with the current pullback, as well as the correction in January/February.

Although we believe the longer-term trajectory for yields will be higher in coming years due to expectations of higher inflation, near-term investor positioning should keep interest rates in check. Since the initial bout of selling this month, 10-Year Treasury yields have remained relatively flat, giving the market time to digest this new reality.

Treasury futures positioning is at record short levels. Historically, when positioning moves to an extreme, there is typically an unwind in the other direction. That would result in investors buying Treasuries to cover short futures positions, pushing yields modestly lower.

As we look ahead toward the end of the year and into 2019, we remain optimistic about equities. Historically, markets have traded largely flat ahead of midterm elections. After the most recent pullback, 2018 is following this pattern with the S&P 500 down slightly year-to-date.

The silver lining is that midterm election years tend to be back-loaded, with strong returns in the final months. The fourth quarter returned 5.1 percent on average over the past 17 midterm election years. We believe stocks will ultimately follow the typical pattern and rally into year-end.

A second positive catalyst for stocks is the large gap between buyback authorizations and executions. While $716 billion of buybacks have been authorized so far this year, just $392 billion have been executed — leaving $324 billion left to come.

With earnings season at its busiest, companies will soon exit their blackout periods. We expect indiscriminate buying to occur, as companies execute announced buyback plans with many stocks cheaper by 10 percent or more.

We believe that many corporate management teams will be very excited, and the additional capital should provide strong support for equities over the next several months.

While pullbacks can be frightening, it is important to distinguish between signal and noise. Recessionary risk remains dormant. The negative stock market action, which may not be over quite yet, may represent an attractive entry point for longer-term investors. As monetary policy normalizes, and the economic cycle matures, months like October may become more common.

Yet the end of the cycle appears to remain in the distant future, allowing investors plenty of opportunities to take advantage of these periods of market anxiety.

Jeffrey Schulze is is director and investment strategist at ClearBridge Investments.