Everyone is saying that the correction this past week was way overdue. Few claim to be surprised by the selling. Yet if “everyone” (the majority) was prepared for the sharp sell-off we got, it seems curious that the S&P 500 still managed to drop over -6%. News this past week was light – no big macroeconomic data, no earnings warnings from a big company, no sensational Trump tweets (other than calling his choice for Federal Reserve chairman “crazy” and “loco” for raising interest rates). If there was a “culprit” for the selling in risk assets this week, we can cite the jump in U.S. yields. Last week the 10-Year yield broke to a new high since 2011, crossing above 3.20%. Perhaps it took investors one week to recognize that rates are rising? Or the flattening of the yield curve over the past week frightened investors (10-Year/2-Year spread at 34 bp last Friday vs. 29 bp this Friday)? In any case, some big institution decided that the “pump” phase had gone long enough and it was time for the “dump” phase. With the algos turning into sell programs, we see just how fragile this market is.
Inflation data was the highlight of macroeconomic news this week. Producer prices slowed to 2.6% y/y in September from 2.8% y/y the prior month. Consumer prices also slowed in September, 2.3% y/y after 2.7% y/y in August. Finally, import prices also slowed in September, completing the tableau (3.5% y/y from 3.8% y/y). Markets should have appreciated the easing of inflation pressures, in so far as slowing inflation may factor into Federal Reserve’s pace of rate hikes. We also learned that the University of Michigan Consumer Sentiment ticked down to 99.0 for the preliminary October reading. Recall that both this measure and that of the Conference Board are at the highest levels since 2000 and the peak of the Tech Bubble.
When Momentum Breaks Down
What happened this week? We can’t really believe that the Trade War or rising interest rates – clearly old news that should be price into stocks – suddenly caused investors to sell. What happened was a classic failure of key indexes to break out to new highs, coupled with overbought conditions, triggering high frequency trading algos to begin selling as soon as the first support levels were breached. A snowball effect took hold as more and more support levels were taken out. The first chart below of the S&P 500 demonstrates the technical sequence.
The next chart shows the Nasdaq-100. Exact same “mini” double top as on the S&P 500 which stopped the advance of the index. When traders are buying assets (Amazon, Google, Netflix, etc) for the single reason that price is rising, it is not hard to understand why selling came fast and furious when price stopped rising. We see no fundamental justification to be holding most of these Nasdaq tech stocks at current valuations.
The prize for the worst index this past week does not go to the Nasdaq-100, however, which “only” fell -3.27% (thanks to Friday’s rebound). Among the laggards were the Russell 2000 (-5.23%), Financials (XLF down -5.61%), and the Euro Stoxx 50 (-4.52%). China’s CSI 300 fell -7.80%, but the Chinese exchange was closed the prior week, so there was some catching up in this week’s fall.
What is most instructive in a rapid correction like this is to note what fell the least. And this week it was the Emerging Markets equities. The MSCI Emerging Markets Index (EEM) only dropped -1.35%. It is indeed in the Emerging Markets that we’ll look to deploy our cash once the world leading U.S. indexes settle out.
One asset finally caught a bid in this week of risk-off trading. Gold broke out of its tight one-month congestion zone, returning to levels at the end of July. In last week’s Commentary, “Gold: So Ugly It’s a Buy”, we concluded:
Gold has been a horrible trade since 2011. Investing in physical gold, a non-yielding asset, has left perma-gold bulls with nothing but a hole in their portfolio. However, we are seeing signs of light at the end of the tunnel. It is not a far stretch to imagine the macro environment becoming more favorable for gold investors within the next few quarters as Fed rate hikes choke off economic growth but inflation continues to run higher. In the near-term, Gold is unloved and unwanted – the typical characteristics of an asset near a major price bottom.
The break-out in the Gold price would appear to be a clear invitation to move back into Gold Miners. We did not hesitate, increasing the weight of Gold/Silver Miners to 34% in our Natural Resources portfolio.
Given the break-down in equities and break-out in Gold, it is not surprising to see our WMA U.S. Composite Risk Indicator drop sharply. The indicator is back to levels seen after last February’s correction. We’ll keep holding lots of cash in hopes that our indicator will drop into Risk-Off mode. We prefer to get fully invested only after the indicator bottoms in the Capitulation zone and begins moving up.
Trade Recommendation
This week we added Centerra Gold (CAGDF on N.Y. / CG on Toronto) to our portfolios. Centerra Gold acquires, explores, develops, and operates gold properties primarily in Central Asia, the former Soviet Union, and other emerging markets. The Company currently operates the Kumtor mine in the Kyrgyz Republic and the Boroo mine in Mongolia.
We choose Centerra to play the break-out in Gold. While we are holding Wesdome Gold Mines and Kirkland Lake Gold as “Growth” plays (both have positive Growth, EPS revisions, and Sales revisions score in our rankings), a Deep Value Gold Miner such as Centerra has much more “catch-up potential”. Here is what we like with Centerra.
1.) Valuation, P/E, MV/EBITDA, and Book Value/Average 5-Year Book Value score are all well above the 50 median level. Among the Materials sector, Centerra is one of the more attractively valued stocks. We also like the solid balance sheet (score of 81.5).
2.) The Street has set a $7.94 12-month price target (47.3% return potential). While we don’t use price target spreads in our ranking methodology (they have not proven to be good useful in our back-testing), the fact that the PT is above current price is a good sign that the stock will draw institutional fund allocation.
3.) Insiders are buying. Company officers are putting their own money in Centerra’s stock this year. They are investing in the company only if they believe something good is on the horizon.
4.) Finally, on the chart of Centerra, it looks like the down-cycle is trying to form a base. A higher Gold price could get Centerra’s price above the September high, opening a return to $8.00. We also see a small positive divergence as the October price made a new low relative to the September low, yet the RSI (bottom clip below) and Stochastic (second clip below) made a pair of higher highs – often a sign of a trend reversal.
We got into Centerra (CAGDF) on Friday’s open at $4.04. If the stock fails to take off right here, we will stop out at $3.75 on the U.S. shares or C$4.80 on the Canadian shares.
