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VIX

Mish Mash

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

Managing Partner

Populism and Uncertainty

Stocks began 2017 with an undercurrent of optimism as prices touched new intra-day and all-time highs. The total return for stocks, measured by the S&P 500, was 1.9% for the month of January. The month was notable, if for anything other than competing events in Washington DC, in that it was both positive and dull. There were no trading days when the market moved up or down by more than 1% since the 1.11% move on November 9th, the day after the election. Often, when markets hit new highs, it clears the path to further price strength.

The shadow to this optimism is uncertainty. This is often measured by the VIX, or the volatility index. The VIX is the Chicago Board of Options Exchange Volatility Index, showing the implied volatility of the market using S&P 500 index options.   The figure has been skulking in the 10% range since the start of the year. For some context, just prior to the election it was around 20% (its historical average), and during the financial crisis back in 2008, the VIX spiked into the 80% range. The implications of a high VIX are that options traders are actively attempting to position themselves for what they anticipate will be a turbulent market.

The VIX is frequently referred to as the fear index. It often happens that when investors are at their emotional limit, the VIX measure is high. Today’s measure is historically low. Yet, more and more well-known and vocal investors have begun to express discomfort with the US’s lack of direction, protectionist tendencies and militaristic posturing. The market appears to be discounting the rhetoric. There is a curious air of complacency among investors empowering them to make substantial bets on tough talk.

The tough talk, or bombast, has lulled market participants and created a high expectation. The rub is all the pro-business talk may or may not bring forth change. It will be quite a task to double GDP growth to the 4% level, as promised, on the back of an economic expansion now more than seven years old. The economy is at full-employment, and the outcome of certain proposals (tax reform, reduced environmental and financial regulations, fiscal spending on military and infrastructure projects) may ironically lead to inflation and other unintended consequences – but not growth. I suspect the complacency may have allowed investor and corporate confidence to run ahead of itself.

The most important measure of future stock prices, corporate earnings, are now being released for the period 4Q2016. According to FactSet Research, the growth rate for Q4 S&P 500 EPS currently stands at 4.2%, better than the 3.1% expected at the end of the quarter and of the 34% of S&P 500 companies that have now reported for Q4, 65% have beat consensus. If the 500 companies that make up the S&P 500 are going to generate the current consensus earnings of $130.76 for 2017 and $146.11 for 2018, they are going to have to get a move on. On the plus side, the resolution of the damaging oil price shock of 2014-15 will help, as will a more normal and steeper yield curve, and the addition of some fiscal stimulus the market has been begging for since 2008.

None of this will be clear, until it is. In a market such as this, we could cautiously step out of the car anticipating its imminent breakdown, only for it to rumble on down the road, without us. My impression of the way forward is to proceed, with a foot on both the gas and the break – a two footed driver. As expected, the big theme thus far has been the post-election landscape, though also as expected, companies are unable to quantify potential policy implications given lack of details. So, we wait.

My expectations remain somewhat guarded. I think average returns from stocks and bonds for the year ahead can be attained. My concern is that these average returns will be delivered on the back of greater than average volatility and unrest in the financial markets. We of course, cannot see this at the moment. With this in mind, I am happy to speak with you if we have not been in touch recently. My goal is to check-in, in order to reaffirm your asset allocation and near and long term investment goals.

 

Bruce Hotaling, CFA

Managing Partner