Dog Days of Fall: Covenant’s Weekly Market Synopsis

September 30, 2019

In this week’s edition:

  • Last Week Today – A summary of the most impactful news on financial markets and the economy.
  • Dog Days – Investors are becoming desensitized to news headlines, promises, and threats. They want action as we enter a favorable season for the stock market.
  • Financial Plumbing II – Repo madness from last week has died down temporarily, but below are suggestions on what the Fed can do to prevent a real calamity in the next recession.
  • Behavioral Finance – I encourage you to listen to my colleague’s podcast, where I was a guest the past two weeks discussing the investment implications of Loss Aversion and Overconfidence.

Last Week Today. Germany’s manufacturing Purchasing Managers Index (PMI) fell to its lowest level since the Financial Crisis, and the services PMI declined as well, indicating Germany is on the cusp of a recession. | U.S. Consumer Confidence dropped in September as trade tensions “rattled” consumers. In contrast, Consumer Sentiment (a different survey) rose as consumers anticipate higher incomes, particularly in the middle-income brackets. | U.S. Durable Goods orders in August rose for the third consecutive month. | The third, and final estimate of Q2 GDP was unchanged at 2.0%, and the Atlanta Fed’s GDPNow forecast for Q3 rose to 2.1% (from 1.9% last week). | Political theater in the U.S. and Britain reached new peaks as politicians from each side of impeachment and Brexit, respectively, squared off in session and the media.

Dog Days. Typically reserved for summer, we feel like market-wise this September (and last week in particular) represent the dog days of Fall. Usually, the summer is pretty dull as traders hit pause and head out on vacation, but this year trade tensions and the Federal Reserve cutting interest rates (for the first time in more than ten years) kept things pretty lively. Now we find ourselves entering the Fall, and while trade remains an issue, the impact of trade news (good and bad) and the news de jour (impeaching President Donald Trump) are less impactful. Indeed, it feels like the market is in a “show me state.” In other words, investors are somewhat desensitized from what has become the norm in the tit-for-tat sniping between the U.S. and Chinese trade delegations, and yet a new front for the Democrats and Republican politicians to find a reason to disagree. Investors want results, not promises and threats, and the market’s muted reaction function reflects that thinking.

This past week the market was listless. Domestic equities seemed to want to move higher as overnight futures on the major indices often indicated higher opens, but those paper gains were typically given up as the day wore on. This is partly due to a vacuum of economic and corporate news. The Fed is not scheduled to meet until the end of October, economic data has been light, and the Q3 earnings season is a couple of weeks away.

Seasonally, September marks the transition from Summer to Fall; a point in time when the leaves change color, the weather gets colder (except apparently in Texas this year), and investors begin to look forward to a more promising environment for risk assets. Over the last 30 years, September has, on average, produced slightly negative returns for the S&P 500. The market may give back the monthly gains today, but thus far the S&P 500 is up more than 1% and near record highs. For a summary of weekly, month-to-date, and year-to-date financial market performance, please click here.

With Q4 2018 fresh in many investors’ minds, and some notably difficult Octobers historically, it’s worth noting that over the last 30 years the fourth quarter is the strongest season (on average) for the stock market with the S&P 500 averaging monthly gains of greater than 1.25% in each of October, November, and December. The heat map below shows monthly performance for the S&P 500 over the last 30 years. Click on the chart for a larger, clearer view.


Financial Plumbing II. The previous week’s issue with interest rates on overnight bank lending continued to garner headlines, even as the Fed stepped in with funding to alleviate the squeeze. Indeed, towards the end of the week, banks stopped taking down the full capacity of the Fed’s largesse each day, indicating the liquidity squeeze was abating. However, the problem has not been resolved. As JP Morgan CEO Jamie Dimon explained, last week’s disruption was small and nothing of real concern. However, in the next recession, the disruptions will not be small. Dimon went on to say that banks have tremendous liquidity, but they are also under tremendous constraints in how they can use their liquidity.

It’s as if you have $5,000 in your checking account, $50,000 in your savings account, and write a check for $6,000. Easy, you think, I’ll transfer $1,000 to cover the shortfall in my checking account.  Unfortunately, that can’t happen because (in this analogy) the Fed disallows the transfer because they mandate you maintain a $50,000 balance in your savings account. You’re not insolvent, but you are facing a liquidity squeeze because you are unable to access a portion of your assets.  Banks are facing a similar situation.

The Fed needs to solve the problem, and FTN Financial suggests three potential solutions to avoid a funding squeeze in a tougher economic environment:

  • Begin increasing the size of the Fed’s balance sheet. The Fed always knew they would need to grow the balance sheet because the demand for cash in circulation is continually increasing; they just didn’t think they would need to address this so soon.
  • Cut the Fed Funds rate. Because of the inverted yield curve, currently, interest earned on bank reserves is higher than what banks can earn by investing in U.S. Treasuries. Banks are thus incentivized to earn riskless interest on reserves, vs. purchasing more liquid U.S. Treasuries and taking on interest rate risk. If the interest paid on reserves was lower, the situation would be reversed.
  • Reduce capital and liquidity restraints on banks to free-up more of their reserves. This would require an act of Congress, and our Senators and Representatives are focused on the impeachment currently.

The issue is a minor consideration for now, but it needs to be addressed before the next recession to avoid a technical glitch from becoming a financial crisis.

Behavioral Finance. Rather than detail another behavioral finance bias this week in our ongoing series, please listen to my colleague’s podcast on Karl Eggerss has had me on as a guest the last two weeks to discuss the investment implications of two important biases: Loss Aversion and Overconfidence.

Be well,