February 12, 2018

Stocks rebounded Friday afternoon recovering part of last week’s sharp losses. Overnight, futures point to further recovery this morning. But rallies that last hours have very little longer term meaning. For anyone to think about sounding the all clear siren, the rally indicated by the overnight futures has to carry through at least until the end of today’s session. With volatility still high, that would be a guess rather than a prediction. While the volatility extremes of last week might not become the new norm, the tranquility of last year is not likely to return very soon. And even if relative quiet is restored, the market’s behavior over the past two weeks is a clear indication that times are going to be a lot different in 2018 than they were in 2017.

Let me give you a numerical example to start with this morning. At the market’s close on Friday, the S&P 500 traded to a dividend yield of 2.07%. If I make two assumptions, first that dividends will rise 10% over the rest of this year, and second, that higher inflation expectations will push the S&P dividend yield to 2.25% by December 31, then the average would rise 1% over the next 10 ½ months.

There is nothing sacrosanct about those numbers. Some might call it garbage in, garbage out. But these numbers weren’t pulled out of thin air. 10% dividend growth isn’t going to be far from reality, assuming that part of the tax cuts show up in higher dividends, and that the economy continues to grow at a healthy pace. Dividend increases were close to 10% last year without the benefit of lower taxes. As for a yield of 2.25%, that is simply an educated guess. It presumes some rising inflationary pressure, and some earnings growth acceleration. The faster earnings grow longer term, the less dividends have to contribute to total return. While 2018 will be an extraordinary year for earnings growth simply due to the tax cuts, that year-over-year benefit won’t reoccur after 2018. In fact, longer term, as certain tax cut provisions expire, rates may actually start to creep up a bit.

But the 2.25% yield does make a good point. That yield, combined with 10% dividend growth, only generates a mere 1% increase in the average and a total return of just a bit over 3%. Should the S&P 500 be priced to a higher dividend yield by the end of 2018, then the odds of a down market for the year become significant.

As I have mentioned in different ways many times in recent months, tell me where the 10-year Treasury yield will be at the end of 2018, and I will tell you how the stock market will perform. Over the weekend, The Wall Street Journal had an editorial talking about the aftermath of the Bernanke inspired policy of persistently low interest rates for almost a decade. But it missed the point a bit tying “free” money and short term rates the Fed sets to the performance of the stock market. Stock market valuations are determined by a combination of earnings and long term rates, not short term. With that said, the Journal isn’t entirely wrong either. While easy money was intended to drive economic growth and raise inflation expectations, it did neither, at least not until recently when the excess slack in world economies finally got absorbed. In the meantime, excess money in the market, combined with very low interest rates all along the curve, ended up inflating the value of financial assets. That includes not only stocks, but bonds, real estate and, yes, even bitcoin.

The Fed has begun the process of withdrawing that excess liquidity. It started in late 2016. By the end of this year, other central banks will follow. The Fed is on a road never traveled before. It wants to raise rates and withdraw liquidity at such a slow pace that markets can adjust without severe dislocation. Last week, the markets demonstrated that won’t be an easy task. Even as bond and currency markets remained stable, stocks shuddered. Hopefully, the current correction won’t be that long or deep but when you head into new territory, outcomes are uncertain and uncertainty creates volatility.

With all that said, the economic underpinnings of our economy remain strong. Employment growth continues at a healthy pace. Jobless claims are historically very low. While inflation fears are rising, inflation itself is hardly budging. Don’t forget that the Fed and other central banks consider 2% an ideal target, and with the slight increases we have seen to date, we are right around 2%. This is not a world of runaway inflation; at the moment, it is a world of near ideal inflation. Leading economic indicators are rising (although they might take a temporary hit in February unless the stock market recovers sharply real soon). Worldwide growth is strong and accelerating. So are earnings, the most important underpinning for stock prices.

But with all that said, remember that last year stocks enjoyed a perfect trio of accelerating earnings, lower than expected interest rates and a weak dollar. These were all tailwinds. This year, while earnings are actually accelerating, the path of the dollar is uncertain and interest rates are rising. Thus, we have cross winds rather than a strong tailwind. Crosswinds create volatility. We have to accept that. After rising 40% in 21 months, stocks should logically give back some gains. A correction is healthy. Everyone would probably prefer not to see 1000-point drops in a single day but that just may be the norm for the market going forward, i.e. weeks or months of relative calm punctuated with brief and scary short term corrections. One way to deal with volatility is to rebalance more frequently. After strong gains, like we saw in January, taking a little money off the table would create some buying power for the next correction. But these are nuanced moves. Long term investors should stay the course even recognizing the near term risk should interest rates adjust quicker than we or the Federal Reserve expects.

As for this week, nothing would surprise me. We may have seen the lows for this correction last week, or after a brief rally another leg down could extend the decline. One argument for the more negative view is that we haven’t seen any classic panic or capitulation yet. But while such behavior almost always marks the end of bear markets, it doesn’t have to occur at the bottom of every mid-course correction. Indeed, normally there are several 10% corrections within bull markets. One or more per year are not uncommon. Thus, even if the lows for this correction were set last week, I doubt that will be the last we see in 2018.

Although stock futures are up this morning, so is the 10-year Treasury yield. Stocks won’t move sharply higher while that rate is rising. It started the year near 2.45% and this morning is pushing 2.90%. I don’t expect that pace of change to continue without evidence of true inflation acceleration. While the Fed has started to unwind its balance sheet, other major central banks remain net bond buyers. Inflation is creeping back into worldwide economies, but inflation rarely moves suddenly, particularly early in an inflation cycle. I would be very surprised to see inflation sustained at anywhere near 3%, for instance, any time soon. And if that were to happen, the Fed would react and accelerate the pace of short term rate increases.

Perhaps the best advice I can give after a week like last week is to take a deep breath, relax and focus once again on the bigger picture. Make sure the companies represented in your portfolio are performing to expectations, keep the proper balance, and don’t overreact to short term market fluctuations. This is not a bear market and there is no recession in sight. On the other hand, the 30% move over the past two years isn’t sustainable. Future returns will be less and they won’t occur in a straight line. Normality is lower returns achieved in a saw-toothed manner. Accept it and relax.

Today, Christina Ricci is 38. Josh Brolin is 50. Arsenio Hall is 62. Abraham Lincoln was born on this day in 1809.

James M. Meyer, CFA 610-260-2220

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