February Stock Market Volatility Comment
Stock markets are seeing their first sustained weakness in several months. The loss from its high on January 26 is nearing correction territory (defined as a decline of 10% or more) and has wiped out all the January gains. While the loss has been swift and unsettling, when put into the context of significant big gains since the 2016 election, this pullback could be seen as nothing more than a normal part of a bull market. The problem is, since there hasn’t been even a 5% correction in stocks in over two years, it potentially makes this correction feel worse.
Market watchers are kicking around a lot of reasons for the decline. The fundamental reason that seems most compelling to us is the rise in bond rates. The swiftness of Monday’s decline has probably more to do with technical factors, like computer trading and the market breaking through some long term support levels. The flattening of the yield curve in 2017, caused by the Federal Reserve raising its short term interest rate and the refusal of long rates to go up, has been much discussed. Well, that has changed in 2018, and the 10-year Treasury has increased from 2.41% at the beginning of the year to 2.84% at the close of trading on Friday; the highest rate on this bond since January 2014. One of the main reasons for the increasing rates was reflected in Friday’s jobs report -wage gains, the biggest increase since 2009. Increasing wages often leads to higher inflation,which could mean more rate hikes from the Fed this year than the anticipated three; which may lead to still higher bond rates. At some point, higher bond rates could potentially create problems for stocks, as the higher rates make bonds a more attractive investment, and stocks potentially less attractive. The result is investors may direct less money to stocks. We don’t think a yield of 2.8% represents the inflection point for this swap, but we are keeping a close eye on this development.
Another contributing reason for the sell off is that bullish optimism has risen significantly. High levels of bullishness and consumer sentiment are good contrary indicators that often point to a short term pull back. Both these indicators have hovered close to extreme levels for a couple weeks.
The good news is that corporate earnings are continuing to grow and many companies have raised earnings forecasts for the year. In addition, economic indicators in the U.S. and abroad continue to point towards growth. This means one of the most common causes of a bear market, an economic recession, does not look likely in 2018. This was as true Monday evening after the steep decline as it was before the market opened on Monday morning.
Once the high optimism gets corrected, which a sharp decline like the one seen the last two days can do pretty quickly, and interest rates stabilize, we think it’s likely that stocks will stabilize as well.This doesn’t mean that stocks will lurch higher immediately, but in the absence of some “black swan” event, and with robust economic growth continuing, the stock market should follow suit.
Some information provided above may be obtained from outside sources believed to be reliable, but no representation is made as to its accuracy orcompleteness. This document is intended for discussion purposes only and should not be considered a recommendation. Please note that investments involve risk, and that past performance does not guarantee future results.