The WMA Weekly Market Wrap v. 180213

February 13, 2018

Correction Territory

Last week’s stock market price action has taken the S&P 500 into correction territory (down 10 percent from the highs) for the first time in two years. Whether we get to “bear territory” is another matter. Of the fifteen true corrections from record highs since 1928 (prior to this one), ten turned into full-blown bear markets while five did not. The average bull market correction is 13 percent and takes just four months to recover, according to Goldman Sachs research. But the pain lasts for 22 months on average if the S&P falls into bear territory. The average decline is 30 percent for bear markets. Perhaps most importantly, stocks have spent 55 percent of the time since 1928 at least 10 percent off the highs, so whether we get to bear territory or not, we’re in completely normal territory.

For the 54 million Americans who are actively contributing to 401(k)s, in 550,000 plus corporate retirement plans across the country, should current levels stand, when they get their next paychecks they will be buy 10 percent more of the stock mutual funds to which they allocate without doing anything. Even though the stock market is the only place I know of where people don’t want to buy on sale, this is fantastic news for anyone who is funding a goal years out into the future.

But that doesn’t mean it’s easy.

There have been a wide variety of proffered explanations for the sudden downturn. As usual, there are some great stories being told now, all with crystal-clear hindsight.

Here are six, although some of them are less explanations and more cries of anguish. None is altogether convincing, which shouldn’t be surprising in that the markets do not need a reason — a trigger — to drop. The explanation I think the most plausible follows. But your mileage may vary.

As reported in this space last week (see here and here), two Fridays ago the U.S. Department of Labor released a strong jobs report showing wages rising at their fastest rate since the global financial crisis nearly ten years ago. The stock market promptly proceeded to plummet, a beating that continued on Monday and Thursday and which has led to much volatility all week. Although I addressed this point last week, it is helpful to reiterate why good news for workers and the economy is bad news for the stock market. The short answer is that the stock market and the economy are quite different things.

Right now, traders seem to be worried that if wages rise too fast, the Federal Reserve will hike interest rates in order to head off inflation down the road. When, earlier this year, the central bank suggested that it would raise rates, much of the market was skeptical, in part because inflation has been so subdued for so long and because the Fed has been reticent to raise rates too fast. However, faster pay gains for workers make it more likely the Fed will follow through, both because rising wages are a sign that the whole economy is heating up and because employers will eventually have to raise prices to keep up with the cost of labor.

Matters were made worse this past Friday in the wee hours of the morning. Republicans have generally been seen as opposed to federal debt and budget deficits. However, Friday’s government funding deal, on the heels of the recent tax cut package, will likely cause the 2019 deficit to balloon to $1.2 trillion, with trillion-dollar deficits to continue indefinitely. Putting aside the policy implications, that’s highly inflationary. Not surprisingly, stocks suffered a rapid sell-off on Wednesday following word that Senate leaders had reached the spending deal that came to fruition early Friday.

If the Fed does hike rates quickly, the pace of growth should slow a bit and could put a damper on corporate profits. But that’s probably not the main reason the market is all worked up. Stock prices have been supported for almost a decade by low interest rates around the world. Investors (especially retirees) haven’t been able to make much money on safer assets like American and European government bonds. Instead, they’ve piled money into riskier bets like sovereign debt from developing nations and stocks. As interest rates go up, and money managers (retirees too) can make a better return on vanilla investments like U.S. Treasuries and other bonds, we should expect stocks to deflate a bit.

The current volatility is a good reminder that the Dow and the S&P are not barometers for the well-being of the whole economy. Indeed, the Dow isn’t even a good barometer of the stock market. Sometimes prices go up because the economy is doing well. Sometimes they go down because of it. And as of this month, the economy seems just a bit too strong for the market’s taste.

So let’s get down to particulars. Last week, domestic stocks suffered their worst weekly decline in two years. The major benchmarks fell largely in tandem, and all entered correction territory. Friday was especially volatile, although stocks ended the day up a bit after a late rally. Things could have been much worse! Despite the downturn, the S&P 500 is still up over 13 percent from a year ago.

Much attention was focused on the narrow Dow Jones Industrial Average last week, which suffered declines on both Monday and Thursday exceeding 1,000 points, the largest (by points) in history, if not close to a record in terms of percentages. On a percentage basis, the Dow’s 4.6 percent drop on Monday ranked only 25th among declines since 1960 and 108th overall. Having reached all-time lows in 2017, the CBOE Volatility Index (VIX), spiked to its highest level in several years. No sector escaped the downdraft, and correlations — the tendency of stocks to move in sync with each other — increased as selling pressure intensified late in the week.

Thursday brought further evidence of a tightening labor market, with weekly jobless claims falling to their lowest level since January 1973, when the U.S. labor market was a little over half its current size. Much of the week’s other economic data also surprised on the upside, increasing the prospects for higher inflation and interest rates. The Institute for Supply Management’s gauge of service sector activity rose more than expected, as did wholesale inventories in December. New job openings declined a bit, however. Despite inflation and deficit fears, longer-term U.S. Treasury yields dropped slightly as investors sought government bonds and other perceived “safe havens.”

The market’s sharp decline stood in contrast to continued favorable news about corporate earnings. As the fourth-quarter earnings reporting season began to wind down, data and analytics firm FactSet raised its estimate of overall earnings growth (on a year-over-year basis) for the S&P 500 to 14.0 percent, which would mark the third quarter in the past four of double-digit gains. Accordingly, economic and earnings fundamentals continue to be constructive for stocks, despite the price action.

European stocks were down overall during a week of volatility and fears about the global ramifications of a broad stock sell-off in the U.S. Early last week, the pan-European benchmark Stoxx 600 posted its biggest one-day percentage drop since June 2016. Despite a brief respite midweek, European stocks continued to slide as the week came to a close. The UK blue chip FTSE 100 Index, whose companies earn much of their revenue from outside the UK, dropped to a one-year low, hobbled both by the global rout in equities and a weakened pound. Germany’s DAX 30 and France’s CAC 40 were also weak. Banks, utilities, and energy stocks were notable laggards.

The week was not devoid of good economic news in Europe, however. Quarterly corporate earnings reported during the week were largely positive there too. China’s demand for European imports remained strong, and French industrial production rose more than expected in its latest reading. In Germany, Chancellor Angela Merkel finally hammered out a new government coalition between her conservative alliance and the left-leaning Social Democrats. Alas, investors shrugged at the news, as the German DAX and the euro barely moved following the announcement.

Asian stocks followed suit. The Nikkei was off more than 8 percent for the week and the dollar weakened further. Chinese stocks ranked among the biggest losers last week as domestic benchmarks in China slid more than 10 percent from their most recent peaks. In previous sell-offs, Chinese state-backed funds have stepped in and bought shares to stem market declines, but there was little evidence of state-led buying this time.

While last week’s pain is still fresh, there are some good lessons to be learned.

1.    Trying to time the market is dangerous business indeed. Although many (most?) analysts recognized the the market was pricy, nobody called this correction specifically. Moreover, the U.S. and virtually all global economies remain strong and are generally improving. Perhaps most tellingly, those who may have escaped some or all of the current drawdown have no good idea when or how to get back in.

2.    Hedges need to be diversified. Between late 2007 and early 2009, from the stock market’s peak to trough, the average managed-futures hedge fund gained 12 percent while stocks dropped 41 percent. On Monday, when the S&P lost 4 percent, managed futures funds lost 3 percent. They were trend-following, as advertised, but the trend turned on a dime. They turned out to be long and wrong, like the market generally. If that was your only hedge, you weren’t really hedged at all.

3.    Picking up nickels is dangerous. Those who sell (write) options are said to be “picking up nickels in front of a steamroller.” The fast turn in market fortunes hurt those nickel-picker-uppers a lot last week. For example, those whose option-writing effectively shorted volatility, got crushed (e.g., LJMIX lost more than 80 percent). Writing options can seem like easy money. It isn’t.

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