Correction Underway
Feb. 6, 2018 Commentary

Volatility Has Returned

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Over the last week we finally saw the long-awaited correction in stock prices appear. From the highs in late January 2018, the Dow Jones Industrial Average (DJIA) declined by 8.9 percent on a peak to trough basis, although we have since seen a recovery of 2.5 percent. This downward move is the most meaningful downward shift in stock prices we have seen in about two years. More importantly we have finally seen that volatility is back.  

It is important to place this move in proper perspective. The U.S. stock market is now selling at the same level we saw at the end of last November 2017…barely two months ago. So, to say this is a real technical, or fundamental problem is, in my opinion, misplaced worry. The “froth” is being knocked off the top of stock prices. For the betterment of the longer-term health of the market, these types of declines tend to be healthy.

The downward move in stock prices has been driven primarily by one of the oldest, most pervasive reasons stock prices face short-term pressure – interest rates have been rising. At the time, I wrote my annual outlook piece, I knew interest rates were going to rise in 2018, but just not when or how. Now we know.

So, the drawdown is being driven by shorter-term, new-found fears. These fears are:

Fear of inflation: Is inflation rising? We believe it is, but not at an alarming rate. A number of the core fundamentals (the jobs market, Producer Price Index data, delivery delays) suggest structural inflation has probably bottomed. Additionally, the output gap globally has closed to 0 percent, according to the World Bank.  All of this leads to….

Fears of higher interest rates: The benchmark 10-year Treasury note is selling at 2.86 percent, up from 2.44 percent as of the first of the year. While this roughly 42 basis point move isn’t earth-shattering, the problem of higher rates is exacerbated by the speed of the upward move. As of Jan. 16, 2018, the 10-year was selling at 2.54 percent. So, the actual upward move in rates has taken place in approximately three weeks. Secondly, the upward move is occurring in the face of….

Fear that the Fed may make mistake: Today was the first working day for the new Federal Reserve Chair, Jerome Powell. Welcome to the correction, Mr. Chairman. Chairman Powell is yet to be tested. This raises the level of uncertainty and market anxiety. We need to remember that while the Fed has been raising interest rates, they haven’t inverted the yield curve.

With an 8 percent move to the downside, are stocks cheap? Not by historical standards. A week ago, the market was selling at 18.5x earnings. Now, the ratio stands around 17.3x. The “Rule of 20” (P/E + Inflation) stands at 19.5, so while stocks are not yet cheap, they are not expensive either (if inflation stays below 2.5 percent). If inflation rises beyond 2.5 percent and inflation expectations also rise beyond 2.5 percent, then it is hard to say stocks are a great buy at current levels. But we are not there, yet. 

Important Things To Remember During Declines

It is important to remember a number of factors during market declines:

  • Declines occur. According to the folks at JP Morgan, the average intra-year decline in stocks, over the long term, has been around 13.8 percent per year. Investors should have an expectation each year that stock prices are going to swoon sometime that year. It has been a couple of years since we have seen any kind of swoon, but here it is.
  • 20 percent, meaningful bear markets normally occur as the economy is moving into a recession.  That doesn’t appear to be occurring. 
  • Downward moves in markets normally occur when capital isn’t available to consumers and companies. If a reasonably sound borrower wants money, they can still easily get it. Money supply and lending standards are not yet tight. 

We Have Been Anticipating a Market Correction and Increased Volatility

Now it’s here. If you have been waiting to place capital within the risk-based markets, now is a reasonably good time to do so. Does this mean we have seen the bottom in stock prices? I don’t know, but I do know that stocks are on sale at a 9 percent discount from a couple of weeks ago. 

This all should be viewed in the context of the overall plan you and your advisor have put together. Are you still on track to meet your financial goals after this correction (that came on the hills of a 20+ percent increase in equity prices)? The answer is almost certainly yes. Adding more equity exposure to your portfolio may make sense if your overall portfolio asset allocation has drifted from your targeted exposure. Harry Markowitz, one of the fathers of modern finance, said that diversification is the only free lunch in finance. Part of that free lunch comes when you have the opportunity and ability to rebalance.

The views expressed in this article are for commentary purposes only and do not take into account any individual personal, financial, or tax considerations. It is not intended to be personal legal or investment advice or as a solicitation to buy or sell any security or engage in a particular investment strategy. Please consult a financial services professional.

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