Are Fundamentals Back In Play? Keep Eye On Price-To-Earnings Values

Instability and impulsiveness—synonyms for volatility—appear to be at work again today in the early going as the major benchmarks dropped sharply but made a big comeback into positive territory. With rocky starts and rollercoaster trading days so far this week, this market fickleness doesn’t appear to be one and done.

Early on, the benchmarks took a deep dive, only to recover moderately, then fall again—sometimes within a minute. Some of that activity might have been tied to earnings reports that came out ahead of the bell.

The Dow Jones Industrials ($DJI) was off as much as 160 points early on before bouncing lower than 100 points, and then looking at an implied open in positive territory. The S&P 500 (SPX) slipped just below the flat line before heading into the green. The Nasdaq Composite (COMP) mostly bounced in and out of positive territory ahead of the bell. In early trading, all three were in the red.

Shares of Twitter Inc TWTR jumped as much as 25% in the early going. The social media messenger reported better-than-expected revenues and sales. TWTR also surprised Wall Street with a 4% year-over-year climb in active monthly users and a 12% increase in daily users, which could be behind why some analysts noted that the business has turned around.

Let’s take a walk down yesterday’s Volatility Lane, which was marked by the bungee jumps of the three benchmarks. The Dow swung in a jaw-dropping 500-point range before closing with a slight loss. The Dow started the session off dropping by 127 points, only to zip into the green by 381 points, before tumbling again to finish off 19.42 points, or 0.1%. At one high level, headlines noted that the Dow was having its best two-day gain since 2016.

There was also a similar headline for the SPX, which registered solid gains early on, climbing back above 2,700, before settling 0.5% lower at the close. Energy and tech sectors led the declines. The tech-heavy Nasdaq also fell nearly 1% amid info tech sector struggles. 

Many Wall Street analysts have been talking a lot about a return to fundamentals, with some blaming much of the wild trading Monday on computer models that had to balance their risk and the deep drops amid high volumes of exchange-traded products betting against the Volatility Index (VIX). (See below.)

Brian Belski, chief investment strategist of Bank of Montreal Capital Markets, said on CNBC this morning that this market activity is “reminiscent of what we saw in the mid ‘90s,” noting that “we have this period of condensed craziness. Perspective-wise, this has been a pullback, not a correction.”

It’s important to note again that the fundamentals of many of these companies haven’t changed over the last week. What has changed is how investors value the price-to-earnings (PE) ratios, what might be considered bare-bones investing strategy. When investment momentum starts to fade, as it clearly has, investors tend to be willing to pay less on a PE basis; when momentum is rocketing, they’re willing to pay more on a PE basis.

Bond yields were mixed in the early going. The 10-year yields raced back to 2.86% but still short of the 2.88% four-year peak they tapped Monday. Some of Wednesday’s climb might have been tied to a key 10-year Treasury auction that was met with what some analysts said was lukewarm demand. Also, Senate leaders reached a bipartisan $300 billion budget agreement that is heavy on military spending and could thwart a government shutdown before the midnight deadline. But the pact faces hurdles in both the House and the Senate. If it passes, it will add another $300 billion to the deficit, which could be a source of inflation.

As noted yesterday, the pressure on bonds continued as many investors seem to believe higher rates are coming no matter what.

Crude oil prices were lower again this morning, trading in the $61 range, wiping out all the gains made in the last month. As noted here before, falling oil prices also illustrated something that’s occurring more broadly here at mid-week, namely that markets seem to be acting more the way you might expect them to. Relationships to fundamentals might be coming back a little.

The dollar index, which had dipped below 89 earlier this week, rode a wave of buying all the way up to 90.34 by the time the stock market closed and was hanging around there in the early going. Keep an eye on the dollar index to see if it keeps gaining strength amid these rising bond yields. Typically, investors buy the dollar when they’re optimistic about the U.S. economy, and fundamentals do continue to look strong.

The European Central Bank held its interest rates steady but seemed to imply in a statement that when they raise them, they might have to do it quickly and aggressively. The pound was up more than 1%, with the euro and the yen also trending to the upside in the early going.

Earnings news managed to get a little attention Wednesday. Tesla Inc TSLA, which awed many space lovers Tuesday with the SpaceX launch of the Falcon Heavy rocket that put the Starman mannequin behind the wheel of a Tesla roadster, got another stock boost with a better-than-expected earnings report late Wednesday. TSLA reported a deep quarterly loss that was narrower than forecasts, though it was still the biggest loss it ever posted. Its Model 3 production goals are still on target, the automaker said. In the early going. TSLA shares lost yesterday’s post-market gains, off marginally in early trading.

Meanwhile, Steve Wynn’s resignation from the casino empire he founded amid allegations of harassing female employees and a growing number of shareholder lawsuits, appeared to help shares of Wynn Resorts, Limited WYNN rebound by 8.6% yesterday. Early on, WYNN shares were moderately higher.

FIGURE 1: BENCHMARK BREAKDOWN. As if watching the minute-by-minute market activity as it happens isn’t dramatic enough, here’s what it looks like in pictures, starting with Thursday, Feb. 1, activity through Wednesday’s close. All three indices charted above—the Dow with bars, the SPX in purple, the Nasdaq in blue—are still positive since the start of the year. Data sources: CME Group, Standard & Poor’s. Chart source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.

About those ETFs and ETNs

Exchange-traded funds and notes are relatively new products that include some tied to the VIX with short or long positions. Many analysts and investors, including billionaire investor and money manager Leon Cooperman, attributed much of this week’s deep selloff to the explosion of certain ETFs and ETNs that are considered inverse volatility-linked products, or those that seek to profit from opposite movements of the VIX.

Investors who shorted the VIX lost billions of dollars when the index rallied; on the flip side, those with a long exposure surged, according to the Wall Street Journal. At one point on Monday, ETF volume equaled 40% of the total stock market value, well above the typical 25%, the Journal reported. The VIX’s swing from 50 back to 25 triggered price volatility halts.

Eye on the Fundamentals

All this talk about a return to fundamentals is based on what the market volatility is crowding out: Earnings are still looking pretty good; the economy is still on the upside and climbing; and interest rate increases aren’t necessarily a bad thing for the stock market.

“I think the fundamentals are intact,” Cooperman said on CNBC yesterday. “I think the S&P is a fairly priced index,” he said, adding that the growing economy and earnings will continue to support it. “The S&P does not deserve to trade up or down 100 points in a half hour. It's crazy. It creates casino mentality.” It's important to note that not all ETF and ETN structures are the same, and that there are many benefits to investing in ETFs. However, like all investments, investors should read a fund's prospectus and understand the product's structure before investing.

Fed on Volatility

New York Federal Reserve President William Dudley said Wednesday that the Fed worries about financial stability risk, including inverse-volatility linked products, according to Reuters.

“Some of these VIX products, I think, people now are going to look at this with the benefit of hindsight and say, ‘Were these really well designed?’,” he said at an event about banking culture, co-sponsored by Reuters. “This wasn’t that big a bump in the equity market and these products actually blew up.”

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