Market Update : February 8, 2018
Complacent No More as the Tide Goes Out
Two headline grabbing 1,000 point losses in the same week have shaken the markets out of complacency. With the growing sense the era of cheap money and peak liquidity is coming to a close, a conundrum has developed. The economy is good and earnings are great, but why is the stock market going down? We think there are several key elements to this question, but there are two more important ones to watch:  the rise in inflation expectations and the Fed’s response and  the amount of near term outflows from exchange traded products. The first is a signal for how far the Fed may go in raising rates. The second gives us a clue as to how much selling pressure is on the markets.
The surprise that kicked off this week was strong employment data—better job growth, fewer jobless claims, higher average hourly earnings—which are potential harbingers of inflation. The Fed’s comments (noted in our previous Market Update on February 6) from the January meeting suggested a path of three rate hikes in 2018 and potentially more next year. Historically, the adjustment to higher interest rates is a painful process. When money is cheap, liquidity is abundant and there are few alternatives to stocks. These conditions often lead to expensive valuations and strong stock market performance. We have been in just this period and are now headed toward higher rates as the economy picks up. However, this is not all bad.
The second element to watch—exchange traded product flows—is important because it signals the strength of bullish or bearish sentiment from retail investors and traders. Historically retail investors and traders can be scared in and out of markets easily and this appears to still be the case. According to data from Bloomberg, investors pulled almost $18 billion out of the SPDR ®S&P 500 ETF in the last five days. The lesson: indiscriminate buying on the way up can be mirrored on the way down. Compounding the withdrawals is a number of algorithmic- and volatility- based strategies that have added to the selling pressure. We don’t see this ending just yet, but we are encouraged that market levels today reflect more reasonable valuations. For example, at $154 in earnings per share, the S&P500 is now trading at 16 times trailing earnings, which is well off the earlier peak, and relatively attractive for longer term investors.
All of this leaves us with the view that we are in a correction, but we do not see the beginnings of a prolonged bear market. What would change our view? A few are upside surprises in inflation, much stronger wage growth and more aggressive tightening by the Fed. Yet, with corporate earnings growth still robust at 16.8% for 2018 , we think it is worth putting things in context: after this correction, we are only back to where we were near Thanksgiving. Yes, the liquidity tide is going out and this will reveal a number of things—including where the next bargains lie. For now, we think investors should remain committed to balanced portfolios and be patient in rebalancing portfolios given the volatility we expect as the correction settles out.
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