The Haunt of Red October: Fears of Stalling Growth, Slowing Earnings Spook Stocks

By Victor Zhang - November 2, 2018

The month of October has historically had its share of steep stock market slides. In October 2018, a combination of factors frightened investors and broad U.S. and global stock market indices suffered their worst monthly declines in several years.

The S&P 500® Index was down nearly seven percent in October, its worst one-month drop in more than seven years. The downward slide was even scarier for the technology-heavy NASDAQ Index, which fell more than nine percent. Further highlighting the month’s hauntings, the S&P 500® Index had 15 down days in October. The last time there were that many daily declines in a single month was October 2008.

What’s more, the large moves (two percent or more in either direction) downward outnumbered the up days. So far in 2018, there have been five times as many down days as up days for the S&P 500® Index.

Number of Days S&P 500® Index Return Above / Below 2%

Data from 1/1/1990 to 10/31/2018.  Source: FactSet.

Rising Yields Eclipse Economic Gains

The month began on a tricky note, with stock prices dropping despite upbeat economic data. Positive news, including a new North American free trade agreement and steady U.S. jobs and wage growth, sent U.S. Treasury yields soaring in the first week of October. As Treasury yields reached multi-year highs, stock prices struggled. The rapid rise in Treasury yields, combined with the Federal Reserve’s (Fed’s) ongoing rate-hike campaign, led to concerns that sustained higher interest rates may trigger a slowdown in the economy.

In addition to higher borrowing costs, companies are facing higher labor and materials expenses, slowing demand from China and the still-strong U.S. dollar. All of these influences may cut into operating results. Investors fear these factors, combined with escalating trade tensions and other geopolitical issues, may have implications for a broader range of global companies.

Spirits Slump Despite Robust Results

A similar scenario unfolded later in the month. The first look at third-quarter economic growth showed the U.S. economy expanded at a better-than-expected annualized rate of 3.5%. With that gain, the economy posted its strongest back-to-back quarters in four years. Meanwhile, consumers boosted their spending, incomes inched higher and inflation remained muted.

Third-quarter earnings results also represented an October “treat” for investors. As of Oct. 26, approximately half of the companies in the S&P 500® Index had reported their third-quarter results. According to FactSet , 77 percent beat analysts’ earnings expectations. FactSet also indicated companies were on track to deliver an overall earnings growth rate of more than 20 percent for the third quarter in a row.

Yet, investors generally overlooked these stellar results, looking for more certainty on companies’ sales and revenues outlooks. The stock prices of companies that beat their earnings estimates fell 1.5 percent, on average, according to FactSet. This contrasts sharply with the previous five years, when companies with positive earnings surprises experienced a 1 percent average price increase, FactSet noted.

High-Profile Sell-Offs Highlight Market’s Narrow Focus

Recent performance among prominent technology-related companies, particularly Amazon and Alphabet (Google), illustrates this phenomenon. Despite reporting solid results, these companies were notable laggards for the month and contributed significantly to the broad market sell-off.

Late in October, Amazon recorded its second-straight quarter of record profitability. But after releasing its third-quarter results, Amazon’s stock plunged nearly eight percent in a single day—primarily due to a slowdown in revenue growth.

As American Century portfolio manager Jeff Bourke discussed in a recent video  that recapped his meeting with Amazon founder and CEO Jeff Bezos, the company remains an excellent fundamental business with a sterling track record of growth and innovation. Although the company is known as a retail giant, retail is the lowest-margin component of its business. Amazon’s higher-margin advertising and cloud computing segments are growing rapidly. Considering these positive factors, one or even a few quarters of slower-than-expected revenue growth is unlikely to change our expected outcomes.

It was a similar story for Alphabet (Google). Earnings were strong, but the company’s stock sold off because Alphabet narrowly missed analysts’ revenue projections.

In our view, Alphabet remains a strong fundamental business producing massive free cash flow, which the company is reinvesting to drive future growth. And this quarter’s earnings report underscores that fact—earnings surged on contributions from the company’s investments and other business units. Generally, the market has viewed some of these investments as a drag on the company, because they historically have produced little revenue and come at high expense. But we continue to believe they will add value to the company over time.

Short-Term Swings Merit Longer-Term Focus

In our view, the U.S. economy remains on solid ground. Employment and growth data are strong, corporate fundamentals remain sound, and we believe over time the market will continue to reward companies exhibiting earnings growth.

We expect Treasury yields to eventually stabilize near current levels. However, a combination of less bond buying from the Fed (due to its balance sheet cuts) and a sharp increase in Treasury issuance should keep yields on the upswing, as long as economic data remain robust. This influence, combined with tariffs, a slowdown in China and other factors weighing on stocks, likely will contribute to heightened volatility in the near term.

As always, we encourage investors to stick to their long-term investment programs rather than react to short-term market volatility.

Victor Zhang
Victor Zhang
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      References to specific securities are for illustrative purposes only, and are not intended as recommendations to purchase or sell securities. Opinions and estimates offered constitute our judgment and, along with other portfolio data, are subject to change without notice.

      Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

      The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.