What happened? Could it be…the first days on the job for a new and untested Fed chairman? High valuations? Higher interest rates? The XIV—an exchange traded note—that is blowing up? Margin calls that are coming in?
We want to know. We feel we need to know. Markets correct 5% or more, on average, at least 3 times per year. But rarely do we witness a 1650-point one day drop. In fact, it’s so rare that it actually has never happened. The drop yesterday was especially painful because it came one day after Friday’s 700-point decline (by the way, we have seen much bigger one day percentage declines, but at this level on the Dow, we’ve never seen this type of point decline).
Don’t get me wrong. Attempting to ascertain the cause of market moves is an essential practice for every investor and money manager. A thesis is important because it should help guide our future investment decisions (hopefully within a disciplined framework so that we’re not trying to aggressively time the market).
To that end, I think it’s important to express my current thesis on the market, along with some context:
First, equity markets have run-up…and run-up hard. You’ve heard this from me before. Here is Shiller’s price-to-earnings (P/E) chart as of the end of the year (2017):
All else being equal, you’d rather have a market with a lower P/E ratio than a higher ratio. As the higher ratio indicates an expensive market. The chart above shows a market that has rarely been this expensive (and yes for those in the know, Shiller’s P/E ratio does show valuations at an extreme, however, just about any valuation metric will show a market at high levels).
Second, the domestic economy is doing quite well. And even of greater importance, the global economy is doing well, too.
In the above chart, green equates to positive quarter over quarter growth. For the first time in many years, the world is growing in sync.
Third, as we have discussed repeatedly in the past, lower interest rates act as a boost on the economy. They make it easier for us to afford a house, car and to pay our credit card bill. They make it cheaper for corporations to borrow and easier for banks to earn profits on their loans. Lower interest rates also provide an impetus for investment, as the yield earned on savings accounts is so low. It’s for these reasons that the Fed helped to keep interest rates low. Most importantly, there should be no debate that low interest rates have unquestionably pushed up asset prices—most notably, stocks.
But now, with a slew of strong economic reports culminating with Friday’s unemployment report, there is real risk that the economy is heating up too quickly. If it does, the result will be higher interest rates and an end to the tailwind that helped fuel the stock market growth since the Great Recession. Below, you can see the trend in wage growth from 2014. Friday’s print of a 2.9% increase in wages was the largest gain in years.
After the print on Friday, interest rates went aggressively higher. We saw a spike in the 10-year yield as it almost hit 2.9%. The fact that rates have spiked in the face of a market with high valuations and abnormally low volatility over the past 24 months is as good an explanation as any for the harsh selloff. One reason that I’m not panicking is that we saw the 10-year yield stabilize, and even decrease, yesterday through the market sell off.
At this point in time, interest rates will be the single most important metric that I will be evaluating. If we see rates move to the upside, then this will necessitate taking some risk off individual accounts (remember, I do not attempt to aggressively time the market, but do move money— on the margin—to safer areas when necessary).
We also must acknowledge that the market is a complicated beast. Sometimes it doesn’t fit into easily related narratives. Knowing this is a crucial element to managing money. As Josh Brown wrote, “There’s no reason to believe that things will get better or worse in the near term because the emotions of millions of people cannot be predicted in real-time – and emotions are what dictate short-term prices, regardless of economics or underlying fundamentals. Traders will place their bets, some will win and some will lose.”
After a prolonged almost 2-year absence, we now know that ‘uncertainty’ is back. Uncertainty brings volatility. Stock markets are traditionally volatile. But, over the long term, stock market uncertainty also brings a higher return stream than can be gained with any other investment class. Yes, I believe we need to adjust strategy on the margin when the data dictates, but we must also be mindful that we are investors, not traders.
As always, call or write at any time with any questions or concerns.