Identifying market surprises is an important element of our investment process. The goal is always to understand not only what the market believes, but also where an outcome could be counter to that belief and how the market may react. At the beginning of this year, we discussed 2018 SURPRISES WE WOULDN’T BE SURPRISED BY. Now that we have half of the year behind us, we lay out the five surprises we identified and where they stand today.
SURPRISE #1: AMAZON UNDERPERFORMS THE RETAILERS
Our surprise prediction for the retail sector is so far, wrong...and right!
This surprise was formulated on the belief that at some point, Amazon’s lofty valuation will become a deterrent to investors and as other retailers focus on their distinct competitive advantages, they’ll be able to successfully compete against Amazon. This year, however, Amazon is again outperforming the retail index.
But surprisingly, Amazon is not the best performer. Dillard’s and Macy’s are performing better thus far (Display 1).
By most accounts, the future of traditional retail is facing major headwinds. That’s why it’s a bit surprising that some traditional retailers, like 160-year-old Macy’s, are gaining share and their stocks are the top performers this year.
Success at traditional retailers shows that while Amazon, and e-commerce in general, is a game changer, it is not limitless. But what’s too often lost in the “future of retail” discussion is that many will survive. The survivors will be those whose value proposition includes some combination of unique products, service, shopping experience, convenience, or price leadership. Any retailer who can embody more than one of these consumer values, has the ability to gain market share.
SURPRISE #2: QUANT FUNDS CAUSE THE 2018 VOLATILITY SPIKE…NOT GEOPOLITICS
Volatility did return this year, and it was not a function of geopolitics. It was driven by fundamentals and exaggerated by quant funds.
2017 featured some of the calmest equity markets on record. So as we entered 2018, we believed that, like other investors, volatility would likely return to the markets. However, our “surprise” was that volatility-targeting quantitative funds, rather than geopolitical tension, could be the cause. And that’s basically what happened.
Wage data released on February 2 triggered fears that inflation was on the horizon. This increase surprised investors, causing the market to fall 10% in two weeks, while the Volatility Index (VIX) rose over 116%. (Display 2). But did the change in fundamentals justify the magnitude and volatility of the sell-off? We don’t think so.
In our opinion, the drastic swings that defined February’s equity market sell-off appeared out of sync with the economic data on wages. Like several similar events, the extremeness of this decline appeared to be the result of a positioning unwind among large quantitative and volatility-focused investors, exacerbating the downward market move.
Events like these are generally transitory, but often induce nervousness and test investment discipline. Unfortunately, there will probably be others, so understanding the reasoning behind such large market moves is important to reduce irrational behavior and an emotional response.
SURPRISE #3: TAX BENEFIT DOES NOT INCREASE CORPORATE PROFITS
While corporate profits did benefit from the tax bill, the full benefit did not fall to earnings as companies increased capital spending to defend market share and grow, and paid one-time employee bonuses.
Following the passage of the 2017 tax bill, many investors assumed the full benefit of the corporate tax cuts would fall to the bottom line for all or most companies. But we postulated that most companies are in competitive industries and would choose to spend much of the savings to defend their positions.
Now six months later, we see that many companies did spend a portion of the savings to strengthen their position. Capital spending swelled in the first quarter as companies defended their market share and drove growth. They also rewarded shareholders. Dividend increases averaged 14% in the first quarter while share buybacks rose over 15%. And recent reports identified over 400 companies who paid more than $4 billion in bonuses because of their tax savings.
Earnings also grew, by an average of 22% from a year ago, while revenues increased nearly 10%. Moreover, earnings forecasts for the full year are rising, in part because analysts continue to expect an approximate 10% boost to EPS from tax relief.
SURPRISE #4: US REGULATORS CRACK DOWN ON INDUSTRY DOMINANCE
Industry dominance has largely continued in 2018.
European regulators have been pressuring large tech companies for years. At the beginning of the year, we thought it was possible for these companies to face similar issues in the US. This surprise, we believed, would have caught most investors off guard as most assumed a favorable US stance would continue.
While the year started out as any other, from a scrutiny standpoint it took a turn when the news related to Facebook and Cambridge Analytica came to light. The privacy issues surrounding this event underscore concerns among some that these companies have too much power and raise the possibility that regulators may target them more formally. While these things take time to play out, so far that has not been the case.
SURPRISE #5: BITCOIN FINISHES THE YEAR AT $50,000…OR $0
We were not trying to speculate on the price of Bitcoin, nor were we making any recommendations regarding its value. Rather this was our way of suggesting that there is great uncertainty around Bitcoin, and cryptocurrencies in general.
After a frenzied second half of 2017 when Bitcoin rose over 700%, euphoric investors saw no end in sight. For us, the surprise was less about the vertical ride, but more about the uncertainty around its use as a currency, its value as an asset, and its future.
As we said in January, the valuation of Bitcoin and other cryptocurrencies do not appear grounded in fundamentals. That’s why there is such a debate around the use of cryptocurrencies as a global currency. Conversely, the technology behind Bitcoin—blockchain—continues to show benefits for many sectors, potentially transforming the way transactions occur and data is stored.
EXPECT THE UNEXPECTED
As we mentioned in our initial note, these surprises, other than Surprise #3, are not our base case. But we consider the impact that these and many other unanticipated events could have on our forecasts. By expecting the unexpected, we prepare for the unforeseen, so we will not be left flat-footed.
For more on trends in the economy, markets and asset allocation for long term investors, explore The Pulse, a Bernstein podcast series, and for additional thought leadership, check out the related blogs here.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.