Brian Andrew, CFA

Lessons of a Broken Hand

On a recent ski trip, I admonished my son for taking risks without knowing the terrain. Of course after two days of success, what was there to worry about? Coming out of the woods and off of a jump that looked too high to manage, he took a spill and wound up with a broken hand. Sometimes long periods of success are followed with a new challenge as complacency gives way to concern. After the cast was put on, he said, “I won't be jumping anymore,” to which I replied, “You will in time.”

The stock market volatility we've experienced during the last two weeks is a result of concerns about a new interest rate and inflation environment as well as a substantial increase in volatility that has negatively affected those who for many months benefitted from trades positioned against volatility rising. The combination of the two has led to the first meaningful correction in the global stock market in two years.

Think of the interest rate and inflation environment as new terrain and volatility as what comes after a long period of success and a new challenge.

New Volatility

The Dow Jones Industrial Average has traded over 20,000 points during this bout of volatility and seen many 2% to 4% up and down days. After almost two years experiencing very little volatility, investors are right to wonder what's up, as we've seen the market correct more than 10% from its January highs.

This kind of volatility has been disruptive to those investors who have positioned portfolios or put on trades that benefit from low or declining volatility. Stock market volatility is measured using an index referred to as the VIX, which can be traded in the futures market. When the volatility environment changed on Feb. 2, products that took advantage of low volatility, especially those that were leveraged, either ceased to exist or lost a tremendous amount of value.

Add this to a market that had gone straight up for several weeks and you have the makings of a correction. We haven't seen a meaningful sell‐off in stocks since early 2016, and we know that stock prices don't move straight up.

In addition to the volatility catalyst, renewed concerns about interest rates and inflation have put some pressure on stock prices.

The Fed's Next Move(s)

The Federal Reserve has a new chairman, Jerome Powell. He took over just days after the stock market cracked and now will be tested by this renewed volatility. The Fed began to raise interest rates in December of 2015 as the economy was stabilizing and growth prospects seemed to improve. After many years of keeping interest rates low and using its balance sheet to provide stimulus, the Fed reversed course. This isn't new news to investors, yet there are some who will blame the new stock market volatility on the Fed's actions.

To be clear, we are entering a new environment for the bond market. In addition to the Fed raising the level of short‐term interest rates, it is also beginning to reduce the size of its balance sheet. Central bank counterparts overseas have suggested they'll do the same. Because many believed that the stimulus provided by central banks led to higher stock prices (better returns when compared to ultra‐low interest rates), it isn't surprising that concerns would arise when they reversed course.

It's the Multiple, Not the Earnings

The stock market's price can be thought of as a multiple of earnings. When interest rates are low, a higher multiple may be supported. If investors believe that the interest rate environment may change, higher interest rates can lead to lower multiples. In this chart from Ed Yardeni, you can see the S&P 500 Index value in red and different multiples in blue. We have moved down almost two multiple points with the recent correction.

A graph showing the S&P 500 price indexes, forward earnings & valuation compared from 2007 to today.

At the same time, we've seen corporate earnings expectations for 2018 rise as companies have reported good news for the fourth quarter of 2017 and encouraged this year's estimates higher. Generally, they believe that the positive impact of the tax reform, which reduces their tax bill, and the positive effect of a stronger global economic growth rate could lead to improved earnings in 2018.

Earnings estimates for 2018 have risen since the beginning of the year. S&P 500 companies are now expected to generate $154.39 in earnings, which is up almost 14% from 2017 full year estimates (not all companies have reported for 2017). So while we may see a correction in the stock market due to higher interest rates, that move will compete with the potential for greater earnings.

New Interest Rate Environment

We need to be cautious about using the “runaway” interest rate mentality we see in the headlines. The fundamentals for interest rates have changed. The Federal Reserve is expected to raise the short‐term interest rate this year, and inflation expectations have picked up. This has led to slightly higher interest rates. However, as I wrote about a couple of weeks ago, this does not necessarily lead to a bond market rout. Instead, it means bond portfolios will benefit from higher levels of income.

In addition, higher interest rates have a growth‐dampening effect on the economy. This usually happens with a lag of 12 to 18 months, so the interest rate increase we had after the election, which took the 10‐year Treasury from below 2% to over 2.65%, may just be beginning to be felt. In other words, it is too early to assume that rates will move dramatically higher.

While inflation expectations have picked up, they are expectations. Actual inflation may rise this year, for a time; however, it isn't likely to rise to a level that pushes interest rates dramatically higher. If anything, it's possible that the interest rate increases in 2017, and now early 2018, will slow growth and stabilize inflation later this year. Still, the new terrain for bonds and inflation is something that will take time to get used to, and that means more volatility.

Like 11‐year‐olds who break bones, stock market corrections are inevitable. Evaluating the new terrain and looking for clues as to how to manage this new environment is part of what we will continue to do every day.

*Implied stock price index calculated using actual 52-week consensus expected forward earnings times hypothetical forward P/Es., Source: Standard & Poor’s and Thomson Reuters I/B/E/S.

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Views and comments expressed in this blog are those of the author and do not necessarily represent the positions of Cleary Gull or fellow Cleary Gull associates.