February 7, 2018

After a record (at least in terms of points) one-day drop in the leading averages on Monday, stocks went on a wild roller coast ride yesterday traveling up and down more than 3000 points before finishing higher and recovering half of Monday’s losses.

While a lot of pundits have tried to explain what has been happening over the past few days, most of the explanations come up at least half empty. Yes, Friday’s employment report showed a slight acceleration in wage inflation but, given the January distortions I talked about Monday, included tax cut related bonuses and wage increases dictated by changes in minimum wage laws. That one data item alone, at best, was a trigger (maybe a better word is excuse) for stocks to tumble, not a reason for a 10% correction.

For the past two years, since a sharp drop in very early 2016, stocks have moved straight up with one brief pause related to Great Britain’s Brexit vote. And that impact only lasted about a day. Gains from mid-February 2016 until the middle of last month totaled 40% or more. It happened without even a 4% intervening correction. That would have the sound of a runaway market except for the fact that earnings pretty much kept pace. Estimates of 2018 earnings alone rose by more than 8% the past two weeks after very strong fourth quarter 2017 earnings and raised 2018 guidance, a combination of expected continuing strong growth and the benefit of the tax cuts recently enacted.

Thus, a correction was due. Many will say overdue. It is extremely rare for stocks to move in such a straight line as they have for the past 21 months. But that begs the questions, why now, why this extreme and what are the market’s forward looking messages? Why now may be the toughest to answer in a factual manner. While I can’t call it a bubble bursting in the sense of prior financial bubbles that burst, the facts that the markets were, politely, on the upper edges of historic valuation ranges, that central banks were ending the easing phase of monetary policy, the notion that the recent tax cuts could stoke greater than expected inflation, and even the collapse in price of cryptocurrencies ignited a spark that started a correction.

While volatility has been muted for the past 21 months except for the Brexit moment, it is important to understand the role volatility plays in corrections like the one we are undergoing. Without going into technical details, when volatility is low, algorithmic trading continues at a slow pace that doesn’t disturb overall markets. But volatility is the catalyst for computer trading to rev up into overdrive. These forms of trading thrive on elevated volatility, although they sometimes behave chaotically when volatility becomes too extreme. We saw that in the flash crash of May 2010, and we saw it briefly again on Monday around 3:00 PM when stocks fell by 800 Dow points in just a few minutes, only to recover just as quickly. In times like these, computer-generated trading becomes an ever increasing part of overall market volume. While it seems that all it does is drive prices down, as we saw yesterday, stocks can move rapidly and seemingly spasm-like in either direction. When large traders are heavily one sided, and there is no reason to believe that one trader’s technical algorithms are not much different than the next one, there is no one left to buy when they are all selling, and there is no seller when they are all buying.

History shows that these spasms of volatility, while violent, are brief. But even as markets settle down, we should expect future behavior to be different than what we experienced in the 21 months leading up to February. First, while the extremes we are witnessing this week will fade before too long, the likelihood that we are heading back to a world without significant volatility isn’t very high. Volatility is normal and back to stay for a while. Second, while economic recoveries never die of old age, we are at a significant juncture where central banks are rotating from stimulating markets to one where they apply various levels of restraint in order to keep price changes orderly. Another way to look at the same point, is that we are leaving a world of deflationary fears and entering a world where the need to control inflationary pressures will be the dominant concern of central banks.

Over the past month, the yields on 10-year sovereign debt around the world rose by about 30 basis points. That was, in part, recognition that central bank policy was changing. It was, in part, due to some early signs of rising inflation. And it was, in part, due to the threat of rising deficits, which mean more government debt issuance in the future. More supply normally means lower debt prices, and therefore, higher rates.

Now we need to put all this into context. For the past eight years, central banks have been struggling trying to increase inflation to a 2% target. We are just getting to that target. Deflationary pressures still exist as well. There are absolutely no signs that inflation is about to accelerate to worrisome levels, and while central banks have few tools to fight deflation, other than flooding the market with money, they have many tools at their disposal to fight inflation. But once again, the pace at which inflation is returning is so modest that very few steps, at least at the moment, appear necessary.

Note that during a week of stock market chaos, both the bond and currency markets have traded in very narrow ranges. The 10-year Treasury, for instance, hasn’t moved as much as 10 basis points all week and is below last week’s peak. This market correction is much more emotional than factual. The emotion is accented by computer trading. As the emotion and panic fade, markets will calm down.

Let’s now look at the markets themselves. At the peak, stocks were getting close to 18 times 2018 estimated earnings. History will say that is high, although not extraordinary. After this week’s decline to date, that has come down into a range of 16-17, still above average by about 10% but not out of line with what continues to be historically low inflation and interest rates. Certainly, we can argue that January’s rise was a bit too much too fast. Now prices are closer to normal. However, that doesn’t mean the correction is over. I am not sure that we are going to see another 1000-point drop or the volatility of yesterday’s session, but a reoccurrence of either can’t be ruled out. In an emotional market, nothing can be ruled out. But while emotions rule in the short run, facts win in the long run. At the moment, the economic news is all good, interest rates are low and contained, inflationary pressures are modest at best and all leading indicators remain strong. If there is one thing to fester upon over the next several months, it could be the impact of the expected increase in government borrowing necessitated by exploding deficits expected to reach more than $1 trillion both this year and next. That is the dark side of unpaid-for tax cuts.

The reality may be that rising deficits will trigger higher interest rates out on the curve beyond the reach of Federal Reserve policy. While that could work to slow economic growth down the road, over the near term, the stimulus of bonuses, lower tax payments and higher wages should make the middle class a happier lot. For years, the investor class has been the winner as Fed policy penalized savers in order to try and stimulate economic growth in the absence of fiscal policy moves. Now fiscal policy is stimulative, and the Fed may have to take steps that will reward savers. That combination may be less beneficial to the investor class. I doubt Washington thought along those lines when it cut taxes, but that is the net result.

For equity investors, it is important to look beyond the emotions of this week and possibly for a few weeks to come and remain focused on the economic facts. Earnings are going to continue to rise at a very healthy clip. Interest rates will reflect both inflation expectations and the enlarged borrowing needs of the Federal government. The trend in earnings and interest rates will fight each other and lead to increased volatility. Unless rates rise sharply, earnings should win in 2018 and stocks should end higher. But that isn’t a sure thing. In 1994, interest rates rose sharply in an expanding economy sending bonds sharply lower. But stocks ended the year flat. One should remember that stocks rose the following four years before the 2000 selloff.

Market corrections are a normal part of market behavior. They tend to become more frequent and get larger in the later stages of a bull market. With that said, if earnings continue to grow and inflation remains contained, there is no reason that the current strong economic cycle has to end anytime soon.

One shouldn’t overread this correction. There is no change in the economic backdrop except for modest increases in interest rates and inflation expectations that represent nothing more than a mid-course correction. Certainly, market technicals and investors’ emotions are stimulating a response outside our comfort zone, but it will pass. Corrections rarely last more than 4-6 weeks and the volatility extremes we are witnessing this week rarely last for more than a half-dozen sessions. My two-day rule, which suggested becoming defensive by the middle of last week, says to stay defensive until you get two strong up days in a row. Yesterday’s closing rally was measured in minutes, not days. It will take a while for the emotion to clear. I wouldn’t be surprised to see at least another test of yesterday’s early morning lows before the correction ends. If you have investable cash, make a shopping list of stocks you really want to own and pick your bargain price. If the stock falls to that level, buy a little. If it dips further, add a little more. These corrections can present very juicy buying opportunities.

Today, Ashton Kutcher is 40. Chris Rock is 53. Garth Brooks turns 56.

James M. Meyer, CFA 610-260-2220

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