the “normal” September-October selloff?

why an October selloff?

the old days

Before the rise of the mutual fund industry in the 1980s, big investing institutions–banks and insurance companies–used to do annual tax planning in November-December–because their tax year ended in December.  They’d reshape their investment portfolios and dump unsuccessful holdings so that realized losses could be used to offset otherwise taxable income.  The key word here is “selling,” made more intense by the end-of-year timing.  The exact starting day of the resulting market downturn was the subject of intense jockeying by the major players.  Once someone started selling, though, everyone else jumped in.

mutual funds

For mutual funds, which today dwarf the activities of those former giants, the crucial months are September-October (more detail on why).  In most years since the late 1980s there has been a several-week, tax-related selloff during this time, triggered by mutual fund tax planning.  It’s typically been followed by a significant bounceback as selling pressure abates.

I think this is what has been going on in domestic markets for the past week or so.  If I’m correct, selling will abate at worst in about two weeks–if for no other reason than that firms will try not to do trading during the final week of their fiscal year (to avoid having unsettled transactions hanging over into the new fiscal year).  At best, I think, selling pressure will begin to ease up by the end of this week.

the role of IT 

As I see it, the selling so far has been the most intense in the IT sector.  Within tech, medium-sized companies that have been sharp outperformers so far in 2018 have been hurt the worst.  Again, if my diagnosis of what’s going on now is correct, this last group is where the best buying opportunities will lie.

An unusual twist:  a main goal of the selling this year seems to be for funds to reduce their exposure to IT and to the new Communication Services sector.  Typical selling is more across the board.  Two factors are likely at work:  managers think their IT overweights have grown too large and are trimming them back; and they perceive greater relative value in other sectors.  My guess is that the first is the larger influence.

bonds

Long-term Treasury bond yields have risen by about 70 basis points so far this year (10bp of that during the past week).  The 10-year yield now stands at 3.19%; the 30-year is at 3.35%.  At some point such yields will provide competition for stocks, particularly in the minds of Baby Boomers seeking steady income.  This is a very important issue, especially since the US market hasn’t been in a position where this might matter since the mid-1980s.  Nevertheless, I don’t see this as the main force behind current selling.

 

what to do

My experience is that most people, including many (most?) professional money managers, either turn off their quote machines or hide under their desks during market declines.  Financially, a better strategy is to try to upgrade portfolio holdings.  Clunkers that have never gone up will likely be temporary pillars of strength.  On the other hand, stocks with much stronger fundamentals will be sold off mostly for tax or internal portfolio structure reasons.  Trend-following short-term traders will magnify this difference.  Anyone with a longer investment horizon should sell inhabitants of the portfolio dustbin and buy stocks they’ve wanted to own but which always seemed too expensive or to have had too much short-term upward momentum.

In my case, I’m mostly     rearranging my holdings within tech   …but that’s just me.

 

the new S&P 500 sector arrangement

Keeping Score tomorrow

a new S&P 500 sector breakout

Announced last November, a new S&P sector arrangement went into effect last Friday.

Telecom, with only three constituents and about a 2% market weighting, disappeared and was replaced by the new Communication Services sector.

The latter contains former telecom names + enough heavyweights from IT (e.g., Facebook, Alphabet, Activision, Electronic Arts) and Consumer discretionary (e.g., Disney, 21st Century Fox, Comcast, Netflix) to give the new sector a total of 26 constituents and about a 10% market weighting–clipping a total of eight percentage points from IT + Consumer discretionary.

 

revised overall sector weightings:

IT .    21%

Healthcare .    15%

Financials .         13.3%

Consumer discretionary .         10.3%

Communication services .         10%

Industrials .         9.7%

Staples .         6.7%

Energy          6.0%

Utilities .         2.8%

Real estate .         2.7%

Materials .         2.4%.

 

my thoughts

–Telecom was a mature sector–if sector is the right word for three stocks–with large, high-dividend companies in it.  So it had defensive characteristics.  Not Communication, though, which contains a bunch of high-multiple, low/no yield components.

–The old Wall Street saw is that any sector is in for big trouble when it breaches 25% of the S&P 500’s weight.  That’s no longer the case with IT, but the change is obviously artificial.

–Splitting the index  sectors into highly cyclical, somewhat cyclical and defensive comes out like this:

Highly:  Materials, Industrials .  ~12% of the S&P

Defensive:  Real Estate, Utilities, Staples .   ~12% of the S&P

Somewhat cyclical:  everything else.      ~76% of the S&P.

Nothing has really changed, but parsing it out like that makes the index look like it has almost no defensive characteristics.  The lower weight for IT makes the index look less risky: this does the opposite–if only by about 2 percentage points.

–There’ll be new passive ways to bet on the Communication sector

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