Good Morning,
Oh how fast things can change. After a big January, U.S. equities ended their worst week in two years as rate-hike fears pushed markets into a correction.
The recent turmoil in equities began last Friday, when the Dow fell 666 points after a better-than-expected jobs report ignited inflation fears. That fall was exacerbated Monday after the yield on the benchmark 10-year Treasury note hit a 4-year high, sending the Dow tumbling another 1,175 points as investors grew more nervous about an overheating economy.
Trouble with securities called exchange-traded notes that decline in value when volatility increases likely helped create more turmoil in the markets this week. The Cboe Volatility index (VIX) — the market's best fear gauge — shot above 40 again Friday after jumping as high as 50 earlier in the week. At the end of January, the VIX was below 14.
Traders are now focusing on next week’s U.S. consumer-price data after a week in which the 10-year yield pushed as high as 2.88 percent. Equity investors took the signal to mean interest rates will rise as inflation gathers pace, denting earnings and consumers’ spending power.
In only a week the S&P 500 has tumbled 5.2 percent, its steepest slide since January 2016. At one point yesterday before a furious rally, stocks had fallen as low as 12 percent from their latest highs. The volatility Friday was impressive: the Dow jumped 349 points in morning trading, fell 500 points later in the session, before closing 330 points higher.
Still, the selloff has wiped out gains for the year and signs have mounted which suggest that jitters have spread to other assets, with measures of market unrest pushing higher in junk bonds, emerging-market equities and Treasuries.
Our Take
Hindsight being 20/20 it was easy to see this coming: record high valuations, record high returns (the S&P’s risk adjusted return was close to the world’s best in 2017), a strengthening economy, synchronized global growth, signs that inflation is picking up, risk-on behaviour gaining ground, massive equity inflows, monetary policy normalization, the shift from a monetary driven economy to a fiscal driven economy...the list goes on.
U.S. stocks have enjoyed a nearly uninterrupted bull market since late 2009. Two factors have helped create a Goldilocks scenario driving this surge. First, the shock administered by the 2008-2009 financial crisis left stocks significantly undervalued, creating plenty of room for equity prices to recover. Second, U.S. inflation has consistently held below the Federal Reserve’s 2 percent target, leaving the central bank with little reason to tighten monetary policy.
Finally conditions are now changing.
Stocks are richly valued and at the same time, inflation looks set to overshoot the Fed's target in the medium term. The overshoot won't be large, but it could ultimately trigger faster rate hikes than presently are being priced by the market. That could cause the bond market's yield curve to invert, as short-term rates rise above those for longer-term maturities. Fiscal stimulation is hitting the gas, which is driving the economy forward into the capacity constraints, which is triggering interest rate increases that are hitting the brakes, first in the markets and later in the economy.
This confluence of circumstances will make it difficult for the Fed to get monetary policy exactly right. As Ray Dalio has pointed out, this is classic late-cycle behavior (when it’s difficult to get monetary policy exactly right, which leads to recessions), though it is more exaggerated because the durations of assets are uniquely long, which means that when interest rates are low, prices of assets are more sensitive to changes in interest rates than when interest rates are high.
A yield curve inversion is normally a clear signal the economy is heading for a recession. We're not there yet, but the risks are rising.
Caution is warranted and longer term return expectations should be lower. Nevertheless, what so far looks like a purge of sorts, will likely be long-term positive; flushing out the excess and re-calibrating investor psychology. For now we see this pullback a potential opportunity to dollar cost down in existing positions as well as to initiate new positions at more attractive multiples. Nevertheless, a watchful eye should be set on volatility as measured by the VIX. For if the VIX continues to rise sustainably as the stock market rallies and retests its lows, more meaningful trouble may lie ahead.
Some things to consider:
The S&P 500 would have to fall an additional 52 percent to reach its long-term average valuation. Bulls have nothing to panic about yet, and bears have not been vindicated.
The return of major volatility is unpleasant for many, but does give some much-needed negotiating power to investors in IPOs and stock sales. As stock volatility jumps -- as in recent days -- so the risk of loss rises and discounts should widen. The problem is that US startups don’t want to go public anymore and that's bad news for investors.
The current market rout -- which is occurring smack dab in the middle of a nice earnings season -- may put a damper on the recent trend towards record-high takeover valuation.
Musings
After a year of abnormally low volatility, this past week has been particularly gut wrenching. But these types of selloffs should be expected in the stock market from time to time. Let's remember that although the raging bull of the 1980s and 1990s which is likely the greatest of all time in U.S. stocks, investors were forced to deal with the 1987 crash, when stocks fell more than 33 percent in the span of a week. In addition, most investors forget there was an emerging-markets crisis in 1997 and 1998 that caused the S&P 500 to fall just shy of 20 percent. Stocks still charged afterward, reaching highs in 1999 and early 2000 before crashing after the tech bubble popped.
The stock market should not be mistaken for the economy. Fundamentals are still solid and while double-digit losses should be expected when investing in equities, investors must also realize that human beings tend to panic more often when money evaporates before their eyes. In the short-term, emotion rules. In the long-term, fundamentals prevail.
Bull markets end when economies go into recession, not because of high valuations or old-age. At present, there appears to be little on the horizon to suggest the economy is on anything but stable ground as the best-known recession triggers -- asset bubbles, oil-price spikes and interest-rate hikes -- all look reasonably unlikely.
Continue to buy and hold quality at a discount, shut off the screens, get some air and be grateful.
Logos LP January 2018 Performance
January 2018 Return: 1.57%
2018 YTD (January) Return: +1.57%
Trailing Twelve Month Return: +39.19%
CAGR since inception March 26, 2014: +21.33%
Thought of the Month
"Then the flood came upon the earth for forty days, and the water increased and lifted up the ark, so that it rose above the earth.” -Genesis 7:17-20
Articles and Ideas of Interest
- Investors may want to calm down since history shows rising rates have been good for stocks. Using Kensho, a hedge fund analytics tool, CNBC looked at what happens during major periods of rising interest rates. The findings show there were six periods with major rises in interest rates in the last three decades. The market rose big during five of those instances and only fell slightly during the one lagging period.
35 steps to a market bottom by Michael Batnick. Where are we and where are you?
-1% Mock the permabears
-2% Meh
-3% Yawn
-4% Off the highs
-5% Pullback
-6% Healthy correction
-7% Buying opportunity
-8% Stay the course
-9% This too shall pass
-10% Correction territory
-11% I’m a long-term investor
-12% Stocks always come back
-13% Don’t panic
-14% Draw lines on a chart
-15% Look for attractive valuations
-16% I knew this was coming
-17% Blame Cramer
-18% This sucks
-19% I should buy some downside protection
-20% Bear market
-21% I should have listened to my gut
-22% Buy when there’s blood in the streets
-23% I was early
-24% Is this the bottom?
-25% This sucks
-26% Uggggh
-27% I can’t take this much longer
-28% I sold my stocks
-29% I’m never buying stocks again
-30% Good thing I sold
-31% I should buy gold
-32% And silver
-33% I don’t even care anymore
-34% Glad I stopped looking
-35% Bottom
- President Trump’s first year in 14 metrics. A year ago, we chose benchmarks for his administration's progress. The results are in.
- Gene editing - and what it really means to rewrite the code of life. We now have a precise way to correct, replace or even delete faulty DNA. Ian Sample explains the science, the risks and what the future may hold.
- Post-work: the radical idea of a world without jobs. Work has ruled our lives for centuries, and it does so today more than ever. But a new generation of thinkers insists there is an alternative.
- It’s the (democracy-poisoning) golden age of free speech. Here’s how this golden age of speech actually works: In the 21st century, the capacity to spread ideas and reach an audience is no longer limited by access to expensive, centralized broadcasting infrastructure. It’s limited instead by one’s ability to garner and distribute attention. And right now, the flow of the world’s attention is structured, to a vast and overwhelming degree, by just a few digital platforms: Facebook, Google (which owns YouTube), and, to a lesser extent, Twitter. Yes, mass discourse has become far easier for everyone to participate in—but it has simultaneously become a set of private conversations happening behind your back. Behind everyone’s backs. Not to put too fine a point on it, but all of this invalidates much of what we think about free speech—conceptually, legally, and ethically. The most effective forms of censorship today involve meddling with trust and attention, not muzzling speech itself. As a result, they don’t look much like the old forms of censorship at all. No wonder our political future is hackable.
- Most unhappy people are unhappy for the exact same reason. In other words, every activity that didn’t involve a screen was linked to more happiness, and every activity that involved a screen was linked to less happiness. Perhaps the formula for phone addiction might double as a cure. Happiness is a skill you can build with consistent practice.
- The driverless revolution isn’t coming anytime soon. Self-driving cars have come a long way, but still have a long way to go. We’ve all heard the story at some point in the past few years. The tech and auto industries are on the cusp of rolling out vehicles that can drive themselves and will forever transform the way we move. We’ll be able to summon driverless pods that will whisk us to our destinations, making personal vehicles unnecessary and freeing up all the space wasted on parking to be used for parks and public gathering spaces — or so they tell us.
Our best wishes for a fulfilling month,
Logos LP