February 5, 2018

Stocks fell sharply on Friday accelerating the decline that began earlier in the week. By the closing bell, the Dow experienced its 9th biggest drop on record in terms of points. But it was hardly a decline accented by any real signs of panic. Given the record levels the Dow reached just a week ago, the drop of 2 ½% was hardly one that could cause undue worry. Volatility indexes rose sharply by week’s end, but were still only at moderate historic levels.

The obvious question is whether this is or was the big correction virtually everyone has been looking for. So far, despite Friday’s loss, the averages are down less than 4%. That is more a blip than a correction. Clearly there are signs that Friday is likely more than a one-day affair. The employment report last week showed an acceleration in the rate of wage increases. The January increase was 0.3%. January may have been affected by the corporate reaction to the recent tax bill. Some gave bonuses. Some promised higher wages. January is also the biggest month for government mandated annual minimum wage increases. Government data is always “seasonally adjusted”, but with all that is going on at the moment relative to the law changes, it is unclear how those changes were reflected in the seasonally adjusted data. But with that said, other data has been suggesting rising wage pressure for months, and I expect modest further rises in wages in the coming months.

As we approach full employment, wage inflation will naturally increase. But history shows that it will most likely increase at a very moderate pace, excluding the one-time impacts I just mentioned above related to new laws. Second, if heightened investment can produce some improvement in productivity, then the effects of higher wages on overall inflation should remain reasonably moderate. With that said, the impact of rising investment won’t likely impact productivity for quite a few months.

Aside from wage increases, the upward inflationary pressures are moderate, at least for now. That is important because, in normal times, it is rising inflation expectations that push long-term interest rates higher. The reason for the sharp drop last week is that 10-year Treasury rates have moved from 2.45% to 2.85% in a short period of time. In January, when stocks went up about 7.5% in three weeks, equities reacted to a very sharp rise in earnings expectations, mostly the result of the new tax law, but also due to a consciousness that global growth was accelerating. As markets finished the process of reacting to the change in earnings expectations, interest rate increases began to accelerate. Thus, the tailwinds of rising earnings forecasts started to taper off a bit as the headwinds of rising interest rates started to increase. Rates increased not only because of inflation fears, but because Treasury announced the need to borrow close to $2 trillion over the next two years. This is a consequence of the tax law changes we have discussed many times.

Throughout the bull market of the past nine years, every time stocks fell, bond yields also fell. I had noted each time that a correction would not be sustained if stocks fell while rates fell at the same time. But last week, for the first time, rates moved higher (and bond prices fell) at the same time stocks moved lower. Even cryptocurrencies fell sharply. Last week, there was no place to hide and that left traders struggling. As leveraged traders lose money in one market, they have to look elsewhere to sell in order to raise capital.

The other factor to consider is that while inflationary pressures are only rising at a modest pace, one that shouldn’t disrupt economic growth, and one that the Fed should be able to adapt to with 3-4 interest rate increases over the next 12 months, markets have to also adjust to the fact that central banks are in the process of rotating from being net buyers of bonds (putting downward pressure on rates) to being net sellers, helping to restore rates to normal levels. It is unlikely at this time that central banks will become remotely aggressive enough to stall the world economic growth rate. Hints of rising inflationary pressures are far different than a state of high inflation. But the process of normalization is going to be a headwind to all markets. At times, like last week, the hints of rising inflationary expectations and coincident rising interest rates will serve to move all financial asset prices lower. At other times, the benefits of growth, mainly through higher earnings, will push them higher.

Central banks are closing the cookie jar and we all have to adjust. While this process began months ago, Friday was a wake-up call. Values will seek normal levels. That is a process that will take time. Central banks want to close the lid slowly enough to avoid disrupting markets too much. But virtually no transitions can be timed perfectly to avoid all speed bumps. That is why we have written often to expect much more volatility as the process takes place. That isn’t a bad thing, and it doesn’t mean the stock market is ready for a big fall. Even with last week’s losses, markets are still up over 3% year-to-date and over 25% since the start of 2016. In 2018, we should expect more volatility. The market’s accompanying emotions could well accentuate the interim ups and downs. Today could see bargain hunting and a net gain or it could just as easily see an acceleration of Friday’s losses. Futures overnight suggest the latter. The fundamentals today are no different than Friday but the emotions are almost impossible to predict.

If you remember back to the start of 2016, stocks fell 10%+ in the first six weeks before finishing the year with very healthy gains. I wouldn’t be surprised if this correction mirrors that one in scope, but history rarely repeats exactly. I had noted previously how far most stocks had risen in the January spike, well above their 50 and 200-day trend lines. After Friday’s losses, most are still above those lines. That suggests to me Friday wasn’t the end. Most bull market corrections last 3-6 weeks. This one is only one week old so far. But I also don’t want you to panic. This is a correction, not the end of the bull market. Yield curves are actually steepening once again. Leading economic indicators are positive. Adding 200,000 jobs per month, as was reported on Friday, is never bad news. Earnings are surging. Markets were extended and, with rising interest rates, prices needed adjusting. Mid-course corrections rarely provide long term pain, but they can feel a bit scary as they occur. Emotions are an investor’s worst enemy. A 25%+ rise followed by a 4% or even 10% pullback is not a cause for distress. Bull market corrections can be sharp, but are rarely long lasting.

Lastly, take comfort in the fact that when an original NFC team wins the Super Bowl, odds are high that the year will finish positively. So, to all you Patriot fans, all you Giants fans and all you Cowboy fans, how about those Eagles!!

Today, Hank Aaron is 84.

James M. Meyer, CFA 610-260-2220

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