Investor behavior has been by and large complacent. The market commentary has been Pollyannaish. The combined effect has been an extended period of positive returns and low volatility. Stock prices, measured by the S&P 500, rose for 15 consecutive months, something they had not done in over 20 years. Then, in February, stock prices fell by an uncomfortable 3.69%. Sharp price drops, 4.1% on the 5th and 3.75% on the 8th, echoed swings felt prior to the onset of the financial crisis.
The market backdrop looks to have shifted. A trend change cannot be extrapolated from one month’s returns. Just the same, it may be that the majority of the market friendly changes (tax cuts, regulatory roll-back, loose spending) are baked in. If this is the case, the return/risk profile stocks offer may have begun to seesaw. Here are some observations worth your consideration.
The dominant factor influencing stock prices is earnings. 4Q 2017 was one of the strongest earnings seasons in the last 20 years, according to Bespoke Research. The “inflection” in earnings is remarkable, as they had been flat. We tend to extrapolate data forward, and expectations going forward may be too high.
The surge in US corporate earnings has been bolstered by an up-swell in economic growth around the world. Manufacturing PMI’s around the world are simultaneously rising, and although Europe’s emergence from the global debt crisis lagged, it’s now the catalyst for a full-fledged global economic revival.
Another boost to earnings has been a weakening US$. This allows for a currency translation bump, when earnings from abroad are repatriated. This tailwind has been in effect since November 2016, as the US$ has fallen roughly 15% against the Euro.
The current administration’s weak US$ policy is apparently intended to cure the trade deficit. Curiously, the trade gap widened in January to the highest level since October 2008. The recent imposition of tariffs on various imports may help offset the trade deficit but the true economic result will more likely be a decline in domestic growth – the opposite effect from the intended goal of making America great (protecting US industry).
The recent emphasis on fiscal policy and deficit spending is a significant concern at this point in the economic cycle. It’s inflationary by definition, and the budget deficit may well exceed $1TN in 2018, something last accomplished in the dismal recovery from the financial crisis. The looming cost of financing increased government debt levels is a large reason for the sharp increase in longer term interest rates.
Wages are also going up, which is good for workers earning the $7.25 federal minimum wage, but this too is a source of inflation. Last month’s inflation data was the spark that ignited the February stock market sell-off. The Fed has signaled it will raise rates three to four times in 2018. Long term, there is a good likelihood the Fed (rising interest rates) will take the blame for triggering the next recession – not the ambitious policies that catalyzed the need for higher rates.
Finally, volatility is back. This is a reflection of these disparate factors. Stock prices move up and down and this normally tempers investor behavior. When price volatility is low, investing in stocks becomes too easy. The spike in volatility in February was only the second time the “fear” index hit those levels since the 2008 financial crisis.
Often times the stock market is not reacting to an event, as many TV commentators attempt to explain, rather it is signaling. Stock prices are a leading indicator. Along these lines, the sudden jump in price volatility (the VIX) may well be foreshadowing change. The stock market may be telling us inflation is here and the Fed’s response will be to raise interest rates. Four rate hikes may be the equivalent of taking away the punch bowl. In my opinion, a raised level of caution is healthy here. We have to be able to live with the ups and downs, and to do this may require owning less of the risky asset. We have been repositioning portfolios to reduce oversized positions and address our view of the trend going forward. If you would like to review this with us in more detail, please don’t hesitate to check in.
Bruce Hotaling, CFA