Volatility is Back!

Stock markets around the globe have sold off over the past few trading days, giving back most of their gains for 2018. Notably, the S&P 500 was down 4.1% yesterday and 6.1% over the past two days, a level of volatility not seen since 2011. This sharp downturn has increased fears of a looming bear market. While we cannot predict where the market goes in the coming days and weeks, today’s market has key fundamental strengths most bear markets lack.

Economic Indicators are positive
The main differentiator between a stock market correction and a prolonged bear market is that bear markets are normally associated with a recession. During a recession, consumption, the main driver of the U.S. economy, falls for an extended period as unemployment rises. Stock markets don’t react well to recessions because earnings across sectors can decrease meaningfully. The fortuitous cycle that helps stocks during periods of earnings increases, improved outlooks and higher valuations reverses as earnings fall, outlooks dim and stock values plunge. Recessions are painful to stock investors.
Unemployment today stands at 4.1%, the lowest level in 17 years! In January, the U.S. economy continued its steady improvements, adding another 200,000 jobs, which marked the 88th consecutive month with U.S. job growth, the longest stretch since 1939. The U.S. economy is unlikely to fall into recession with such strong job growth.

Employment conditions are not the only strong economic indicators. GDP growth has been solid; growing between 2%-3%. Consumers are doing well and worker pay jumped in January by 2.9%. Generally, increased wages are positive for the average consumer and households.

Company revenue and earnings growth are strong
So far about 50% of S&P 500 companies have reported fourth quarter results, representing about 70% of the index market capitalization. About 80% of these companies have beat revenue expectations, which are on pace for a 7.5% revenue increase compared to an expectation of 7%. To this point, all 11 sectors have reported year over year earnings growth.
In the past, it seems recessions are marked by a frothy sector with high investor exuberance that ends poorly. Examples are real estate in the 80’s, dot-com companies in the 90’s and financial services in 2008. During these periods, as the economy slipped into recession, the over investment and hype of these sectors soured into disappointment and large losses. While it is hard to forecast these manias, we don’t see a particularly frothy sector today whose demise will dent economic growth.

What drove the sell off?
While there is no clear catalyst, markets have been concerned about increasing interest rates, rising inflation and high stock valuations. Since 2013, the Federal Reserve has been reducing the amount of monetary stimulus to the U.S. economy. In 2015, the Federal Reserve began to slowly increase short term interest rates. Currently, the Federal Reserve is targeting short term rates at 1.75%. Markets expect that to rise to 2.5% to 3.0% by year end. By historical comparison, these rates are still low, reflecting the relatively slow recovery from the 2008 Great Recession and the measured pace which the Federal Reserve has taken to increase rates. However, given recent U.S. economic strength and job growth, market interest rates, which had stayed flat relative actions taken by the Federal Reserve, have risen. The yield on the 10-year U.S. Treasury bond increased from 2.4% at year-end to over 2.8%. Bond investors have expected wage growth to lead to inflation, which can erode the value of bonds.
While stock valuation are above average, valuations alone are a poor indicator for returns over shorter time periods and are an unlikely catalyst for the recent volatility. A more likely catalyst explaining the sharp decline is program trading. In stock markets, a lot of money is controlled by computer programs based on market trends. When the trend turns negative, they sell. Of course, selling more when the market drops only exacerbates the downturn. Clearly, this market action does not reflect long term investors, because the market fundamentals are still strong.

Crestwood monitors these market dislocations looking for opportunities. Our portfolios are built around diversification with the intent of smoothing out the markets’ ups and downs. Over the past few years we have continuously adjusted allocations as valuations have increased. Importantly, we do not believe the recent market decline reflects a deterioration in economic fundamentals which are strong and improving. Considering the market’s high valuation and recent stock market increases, this decline can be considered a positive to let the market catch its breath.

We recognize that the sharp declines of the past few days are uncomfortable. All of us prefer the relative calm of the generally upward trending stock market in recent years; however, such periods are the exception and the recent spike in volatility has been a less welcome reminder that the greater returns available from investing in stocks has historically come with greater variability.

While some people seek out stomach-turning thrills at amusement parks, most of us don’t care to experience such “excitement” with our hard earned money. At times like this, it’s worth remembering that generally speaking, the only people that get hurt on roller-coasters are those who try to jump off during the ride.

We encourage clients to remain focused on their long-term goals that remain unchanged amidst the current market volatility. We’ve strived to structure your diversified portfolios to meet these goals with consideration to current risks and opportunities as well as the variability of equity market returns that is more the norm.

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