Is the Party Over for the Markets?

Well, this long-felt sense of unease people have had about things being “too good” showed up quickly last week and Monday as the stock markets had a sell-off (with a pretty solid comeback today).  After the unprecedented run-up we have had to new highs seemingly every week with historically low volatility in 2017 there has been a feeling among many I've talked to of “not if, but when” there would be a pullback.  Market pullbacks are historically a normal part of a healthy functioning market, but everything has pretty much lined up this past year to give us positive months in the S&P 500 ever since the election (and 22 of the last 23 months - Ycharts). 

Corporate tax reform combined with strong earnings outlooks carried 2017 into January of this year with a 5.73% return to start the year for the S&P 500.  The market action from the last few days (as of this writing) erased the 2018 gains and brought us back early January levels (still way up over this past year).  It is important when you hear the scary-sounding headlines that we keep things in context.  The drop on Monday, while the largest point drop in history, was only the 100th largest from a % standpoint in the history of the Dow and the 127th largest in the history of the S&P due to the massive increases in value the markets have experienced in the last 9 years.  Where things go from here is the obvious question.

A few of the triggers for the drop:

1)      Too much of a good thing? – as mentioned, the corporate tax rate cuts have significantly impacted outlooks on corporate earnings and repatriation of money previously held overseas, not to mention massive government spending and coordinated growth globally.  These are favorable for expectations of future reinvestments by companies into technology and infrastructure for more growth, which includes the need for more workers to support that growth.  With unemployment at record lows, and companies adding 200,000 jobs in the most recent jobs report there just are not many skilled workers sitting on the sidelines.  Therefore, in order for companies to compete for the workers, they need to increase wages, which we also saw last week with a 2.9% yearly wage growth (most since the summer of 2009).  Inflation concerns lead to a focus on increasing interest rates, which occurs in a normally functioning market to keep things from overheating.  We saw that with pretty significant increases in bond market rates this past week (and now pushing over into mortgages).  Increased borrowing costs going forward make people question the impact on growth rates for companies (and the consumers who support our economy).  The bigger picture is the longer term impact sustained increasing interest rates would have on consumers who have pushed credit card and other debt to an all time high and our government, set to borrow nearly $1 Trillion this year, an 84% increase from last year.

2)      Forced selling on Monday – while the factors above seemed to be the force of last week’s decline, Monday had a bit of forced selling due to risk management models and a return of volatility as measured by the VIX (up 115% on Monday) that may have long-term impacts on certain incredibly risky funds created to magnify moves in the volatility index (the inverse XIV Exchange Traded Note was down 80% on the day and will liquidate on February 21).  Unfortunately, when greed and short-term focus (and margin debt) mix you can see situations like this.  It is quite different from the longer-term focus that we use to build portfolios for our clients that match up to their situation and needs.

3)      Political issues – this seems less like a cause, although there has been continued debate about the ongoing budget agreement and potential looming government shutdown again, although it sounds like progress is being made.  Either way, it seems the White House may focus a bit less on taking credit for the markets as they realize stocks don’t only go up.

It was nice to see things settle down and recover some losses today, but we don't have a crystal ball for the rest of the week.  Here’s a reason to be positive on stocks: Corporate America is reporting strong earnings.  These numbers sure give reason to believe we could see renewed positive stock market energy (although the issues above are still in play). 

With 50 percent of the companies in the S.&P. 500 having reported results, profits are on pace to grow 13.4 percent, according to FactSet. If that growth rate holds through the end of earnings, it would mark the third quarter in the past four that S.&P. 500 companies have reported a double-digit profits increase.

•75 percent of companies are reporting earnings above estimates, above the five-year average.

• Companies that are beating estimates are doing so by a 4 percent margin, below the five year average.

•80 percent of companies have reported revenue above estimates, a record high.

• All 11 sectors are reporting earnings growth. (From NY Times)

To summarize, although the declines happened fast (and therefore seem more intense), nothing about the declines is surprising, and although things seemed to recover today we could certainly continue to see volatility going forward (as we didn’t even hit 10% correction territory).  I have talked with each of you (to whatever level you are invested in stocks) about the expectation of a market pullback at some point, because it is just a natural part of investing that we haven’t experienced much of in the last couple of years (and really nothing sustained in the last 9 years).  I’ve also said that the stock market still appears to have the characteristics of the best opportunity to grow your accounts over a sufficient time frame, even if maybe at a lower projected rate going forward than what we have seen these last 9 years.  Cash and bonds, while important for reducing risk in more conservative accounts don’t appear to have the same opportunities.

Those of you with shorter time-horizons and/or lower risk tolerance have already been positioned in your accounts to lessen the impacts of this past week’s events.  Those with longer time horizons and/or a higher risk tolerance have been positioned to have benefitted well from the great increases we have had recently and to benefit from future growth of the market while navigating short term ups and downs.

If your situation has changed to where you feel a portfolio review is important, please let me know and we can have a discussion.