No matter what transpired the last few trading days, economic fundamentals are still improving. The sharp decline in the market is a buying opportunity for long-term investors.
The market decrease of more than 600 points or over 2 percent on the Dow on Friday last week, followed by the more than 4 percent or 1,100 points decrease during Monday’s trade erased the year to date gains that the month of January produced.
What caused the severe and sudden drop in the markets?
The upward momentum of the market in January reached overbought levels. Economic fundamentals are currently solid, corporate profits are increasing and investor sentiment increased to its highest levels in years. Investment flows began to sharply increase in equities in the last couple of weeks as enthusiasm over corporate tax reform drove demand.
Then the market began to have concerns over inflation, rising yields, accelerating wage inflation and the possibility that central bankers may have to increase the pace of rate hikes. In addition, the transition to a new Fed Chairman, Jerome Powell, and comments regarding over valuation in equities and real estate by policy makers added to investors concerns. Within a span of a few trading days the entire gain of January, approximately 7.5 percent, in the S&P 500 Index evaporated and now in the red year-to-date. It took eight trading days to rise from 25,000 on the Dow to 26,000 and only two to remove it.
As yields increased, volatility in equity markets also increased. Since many investors worldwide have been accustomed to low volatility (the market had not experienced 2 percent moves either way in the S&P 500 in 2017 and the US 10-year Treasury yield started the year around 2.4 percent and ended the year close to 2.4 percent) there was a false feeling that markets were going to keep on grinding higher as long as inflation remained low and earnings outperformed, therefore complacency grew to excessive levels and the market has no adjusted for a new reality.
Once volatility began to increase, many investment funds started to re-calibrate and reposition. They began to rebalance for late cycle positioning in which inflation begins to increase, more cyclical investments outperform and central banks tighten policy more. We have not been in this type of investment environment since before the credit crisis more than 10 years ago. This began the unwind of low volatility, lower yield and higher beta trades. Then the domino effect can take over in which institutional investors such as trend followers or momentum investors (the S&P 500 index is considered a momentum trade) could begin to accelerate the market drop by selling their market exposure.
Today’s market is more connected via quantitative investment computer driven algorithms than ever before and this can cause trends to become over extended. We saw this on the positive side in January when is was traded up by more than 7 percent to begin the year and just experienced its reversal. Some may call it a flash crash and draw some similarities to 1987. I believe this is more akin to a market “taking a break” when new information (rising yields and inflation expectations) is absorbed.
This revaluation based on new expectations can take time, but soon quantitative based trading will resume, people will pour back into equity index funds and the rising need to hedge future risks will increase. High volume trading and excessive negative volatility when fundamentals have not changed for the worse indicate short term reversals are not a new trend, especially when technical factors are a large reason for the drop. I don’t think it’s any different this time.
What has changed fundamentally?
Nothing has materially or significantly changed in the last week that would merit the decrease in the market. Economic growth is still the story in the US and overseas, what people are calling the global growth synchronization. Corporate profits are healthy and it is expected that the U.S. will experience a 16 percent gain in 2018. I believe financial conditions are still attractive despite the expectation for a normalization of short-term rates.
Emerging market consumer spending and capital equipment investment growth are still driving improvement in the world economy. The only real change is that equity valuations are now fairly valued. The S&P 500’s price-to-earnings multiple now stands at about 17 versus 19 times in 2017.
Again, the recent equity market correction indicates that the expectation of tighter policy is starting to ripple through the real economy. The recent rapid increase in global bond yields complicates matters for equity markets and valuations of proposed future capital investments by corporations. Much of the increase in yields have been driven by higher inflation expectations. This has actually kept real yields down, the real 2-year yields have actually declined in the Europe and Japan over the last several months. This is generally seen as growth-enhancing and not as a warning sign of a recession. Recently, the yield curve is stepping and not getting more flat. In my view, a small rise in yields, driven by rising inflation expectations due to higher growth, should be viewed as a good reason to stay in equities. With fundamentals healthy and the 10-year Treasury bond yields only about 26 basis points higher at 2.7 percent versus the close in 2017, I view this latest volatility and market drop as a buying opportunity for longer-term investors.
I do expect more short-term volatility in both directions as portfolios are further repositioned and quantitative trading algorithms are re-set, but I believe investors should take advantage of this weakness in the equity market by buying.
