26 Nov Sudden Paradigm Shift and the Q4 Stock Market Correction
The fourth quarter is off to a rough start, as volatility has come storming back. October saw the S&P 500 Index drop by 6.8%, its biggest monthly decline in five years, and November is experiencing additional carnage as recapped here.
How can this be when Q3 corporate results were excellent overall, as seen in S&P 500 companies growing sales by 11%, and earnings by nearly 30% on profit margin expansion to all-time highs (12.2% of sales)?
Wasn’t the market appreciation fundamentally driven as earnings growth over the past 1 – 2 years exceeded the S&P Index advance?
Aren’t interest rates still at favorable levels, and isn’t inflation largely under control even as we’ve experienced nine consecutive quarters of accelerating economic growth?
Isn’t President Trump justified in his more aggressive trade policies to ‘level the playing field’ and force the Chinese to show even a modicum of respect for our intellectual property laws?
An Abrupt Inflection Point
While these questions can all be answered in the affirmative, let’s remember financial markets are forward-looking, generally discounting events 6 – 9 months in advance. So, despite indications of an expanding economy and a robust consumer – courtesy of full employment, rising wages, and lower oil prices – the markets appear to have abruptly arrived at an inflection point. Increasingly jaundiced investors perceive ‘peak earnings’ amid slowing global growth, as interest rates rise and corporations begin deleveraging. Fixation on a persistent ‘Trade Wars’ threat to the two largest global economies (US and China) also contributes to an environment which renders good news irrelevant and bad news more impactful.
Consider the on-going tidal wave of corporate share repurchases, which support stock prices by boosting per share earnings as share counts shrink. This had long been viewed positively since companies buying back their own stock reflects executive confidence, and companies with large buybacks have historically outperformed the market. With Goldman Sachs estimating S&P 500 companies will have record buybacks in 2018 skepticism is now growing that this important support to stock prices (supply reduction) is peaking / destined to diminish (while debt incurred to finance it remains).
Stimulative measures drive growth, and the U.S. economy and stock market have benefited from quantitative easing, lower rates, less regulation, and now tax cuts. The first two of these props (artificial liquidity) are waning, as the US and other central banks reverse monetary stimulus (sell Treasury securities and other assets) and hike interest rates, while corporate tax relief looks more transitory and even a detriment to earnings comparisons.
Deceleration in growth momentum is becoming more evident as trade tensions persist, and record corporate profitability is increasingly seen as not sustainable this late in the business cycle. Earnings can be volatile, and sharp increases tend to be reversed fairly quickly as pre-tax profit margins are among the most mean-reverting series in finance. Ostensibly, profitability has nowhere to go but down. Beyond slowing revenue growth, increasing labor costs and interest expense perceptively threaten the strong corporate earnings narrative. Given the extended bull market run among atypically benign volatility, the reaction to a change in sentiment has been swift.
“You never know what the American public is going to do,
but you do know they will do it all at once.”
The Fed and Interest Rates
Higher interest rates, of course, weigh on stock prices beyond simply additional interest expense and bonds’ enhanced appeal. Stock prices reflect future cash earnings being discounted to the present, and interest rates figure prominently in that calculus. Higher rates result in lower stock values as future earnings are discounted more harshly. Higher rates also comprise headwinds by hampering consumers’ ability to borrow and spend. Rising interest rates aren’t always a disturbing portent for stocks, however; the real threat is rapidly increasing rates. As with other important data points the rate of change, rather than absolute levels, drives the always-forward looking markets.
Interest rates are greatly influenced by the actions of our Federal Reserve (“Fed”). Among other objectives, our central bank has a dual mandate to maximize employment and stabilize prices, which it does via moderating interest rates (monetary policy). Presently, the Fed is attempting to normalize interest rates which remain subdued in the extended aftermath of the global financial crisis of 2008-2009. Having won the employment battle, the Fed has been elevating interest rates to avoid the inflation which would accompany an overheated economy. The current tightening cycle has thus far featured seven consecutive rate hikes with an eighth on deck for December, as our central bank reasserts policy order in an economy enjoying its lowest unemployment rate since 1969. Easy-money programs are no longer needed.
In addition to discount rate hikes, the Fed is reversing the quantitative easing (decreasing banking system liquidity) undertaken in response to the financial crisis. As investors balk at the unabated pace of interest rate hikes, the media features a stream of commentators pleading the case to Fed Chairman Jerome Powell, via anecdotal data points, of a rapidly slowing economy. They want the Fed to adopt a more moderate and data dependent approach to the multiple .25% rate hikes indicated as forthcoming in 2019 (i.e. be less hawkish and more accommodative). Investors hope these and other sluggish current indicators are enough to pause the scheduled rate hikes, and still preserve the Fed’s independence:
- the deflationary ‘wealth effect’ associated with this Q4 stock market decline; when asset values collapse people spend less.
- the rapid descent in oil prices (-25.4% in eight weeks) is also deflationary,
- the housing sector remains depressed,
- auto demand is slowing,
- hotel revenue are softening
- tariffs figure to continue slowing the economy, with many of the biggest jolts yet to come.
The Fed’s dual mandate includes stabilizing asset prices, and their recent actions and rhetoric have rapidly reduced prices. The argument for a more measured, wait-and-see approach to rate hikes is echoing loudly, with President Trump leading the chorus.
Inflation is important, not only because it influences the Fed’s actions on interest rates, but because investors watch it as well. Future earnings are worth less if realized in cheaper dollars. For the past 35 years, the core annual inflation rate has generally been below 5%. It’s been below 3% for most of the time since the mid-1990s. Since inflation has been low for so long, an entire generation of investors often consider it a nonevent. Yet, during the last 35 years, even very modest accelerations from very low inflation rates have been challenging for the stock market.
Positive Backdrop and Reasons for Hope
At reduced valuations and still-decent fundamentals, interest rates, and inflation, sentiment could quickly improve with positive developments in the Fed’s stated outlook or in the economic cold war with China.
Both the US and China want to avoid tariff escalation. Each also has ample incentive to reach a short-term deal, even if trade tension relief is only a brief respite in a new normal of a more contentious relationship between the two superpowers. China has already been hurt more than the US by the tensions, and likely has more to lose with any escalation. President Trump also has powerful incentive to de-escalate tensions and seek a short-term deal which he could spin as a victory. Neither is it a secret that he, rightly or wrongly, envisions a healthy US stock market as essential to his MAGA mandate and a proxy for his overall job performance.
Investors hold some hope for this, and realize the President’s modus operandi has been to dramatically escalate U.S. rhetoric just before negotiating a tactical retreat. While any comprehensive agreement will require more time as part of a longer-term process, positive near-term momentum on trade negotiations with China could go a long way toward averting a global economic slump and help both countries. Recalibrated investor assumptions – on this or the interest rate front – could catalyze a sudden market rally, just as absence of progress may reaffirm the current risk-off bias and continue pressuring valuations.
Next week could shed light – one way or the other. Fed Chairman Powell may provide monetary policy hints at his speech in New York on Wednesday, and President Trump and his Chinese counterpart, Xi Jinping, are slated to meet at the Group of 20 summit in Buenos Aires on Saturday.
Other reasons for optimism also exist. For starters, the S&P 500 now trades at 15.4 times the per share earnings its constituents expect for the four quarters ending 9-30-19. That’s 17.6% cheaper than the 18.7 multiple at the start of the year. While that may suggest earnings estimates in need of reduction, significant drops in valuations like this tend to be short-lived. Strong consumer sentiment suggests the economic expansion can continue, and the election cycle portends a positive backdrop. Since 1946, in years with midterm elections, the S&P 500-stock index has gained a median of 18.4% in the nine-month period from September 30 (just ahead of voting) through June 30 of the following year, according to data compiled by Ned Davis Research. For that same period in nonvoting years, the index gained 4.9%.
Whether or not the recent change in sentiment proves to be warranted, markets will always find a wall of worry. Uncertainty and tumultuous periods come with the territory. We’ve had growth scares before, and we’ll have them again. Pessimists will continue to extrapolate present trends without accounting for how reliably markets react.
The recent volatility is consistent with long-term market behavior. Since 1980, the average intra-year peak-to-trough dip has been 14% (LPL Research). Yet stocks have a clear long-term upward bias. Based on history – admittedly, an imperfect guide – the market is likely to rise over extended periods. Anticipating volatility, our client portfolios are constructed with an emphasis on asset allocation and diversification, two effective portfolio management tools.
“During the last 100 years, there have been more 10% market pullbacks than Christmases. Everyone knows Christmas will come; think of volatility the same way.”
To weather inevitable market volatility, your investment plan should reflect a clear objective, risk tolerance and capacity, time horizon, and need for liquidity. Constrained investors in or approaching retirement should consider structuring a lifetime income with a portion of their assets. Such a constructively conservative approach has minimal opportunity costs given the abysmal outlook for bonds (as the rate hike cycle progresses) and it can help mitigate unique retirement risks, including longevity risk and the impact poor timing can have on sustainable withdrawal rates.
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