Days like today, and last week, are not fun for stock investors. The S&P 500 was down 4% today and has lost around 7% over the last five days. After a freakishly calm 2017, our old friend, Volatility, is back. So, what’s going on?
First, this downward move is not about deteriorating economic fundamentals. Quite the contrary – it comes on the heels of overwhelmingly positive economic news. The latest jobs report showed more jobs AND more pay for Americans. And corporate earnings have continued to show tremendous strength.
This pullback is driven by fears of rising interest rates and inflation. And for some, it’s just an excuse to take some money off the table, which often leads to panic selling.
Interest rates have risen and will probably continue to rise to a more “normal” level. Inflation has been almost non-existent during this recovery, so any indication of life there would be a good thing. These are signs of a healthy economic expansion. Obviously, we don’t want rates to rise too fast or inflation to heat up quickly – but we’re nowhere near that yet.
When it comes down to it, there are two main factors that drive the stock market over the long run: earnings (i.e. “cash flows”) and risk (i.e. a “discount factor”). Why did tax reform boost the stock market? Because it’s a boon to corporate earnings. Why does North Korea make investors nervous? Because it makes the world a riskier place. Why have low interest rates boosted stocks? Because they boost corporate earnings and lower the discount rate. Until recently, both factors were pushing stocks to new highs.
This Recent Upward Cycle Has Accelerated Quickly.
The U.S. market has led the global recovery since 2009, returning over 300%. The market accelerated as we entered 2018 for two simple reasons: global growth boosted corporate earnings while perceptions of risk fell. Together, these factors pushed markets to new heights. We always expect the long-term trend for stocks to be upward, but this latest “straight-up” trajectory was unsustainable. We needed a breather.
Volatility has begun to pick up, and this is normal.
The market was extremely calm throughout 2017. In fact, the worst pullback was less than 3%, the lowest since 1995. However, unlike the long run trend in earnings, such a low level of volatility is highly unusual.
As shown in the chart above, almost every year experiences a market pullback of at least 5%, and the average intra-year pullback has been 14%. Yet, overwhelmingly the market ends up in positive territory in most years.
Earnings are still growing rapidly due to healthy global growth.
Even if stocks move randomly in the short run, they tend to follow earnings in the long run. Corporate earnings grew by over 11% last year and are expected to grow by 15% in 2018. While future expectations may be optimistic, the fact of the matter is that earnings have provided a foundation for the market rally.
Can this continue? The short answer is yes. The U.S. economy is in the later stages of the cycle but is still healthy. Meanwhile, the biggest positive surprise over the past 18 months has been international growth, in both developed and emerging economies. If this continues, earnings could continue to support the market.
What does this all mean? Over the long run, it’s fair to expect healthy growth in earnings but a return to more “normal” levels of volatility. We could be in for more days like this, but keeping a long-term perspective and maintaining a diversified portfolio is more important than ever. Tune out the financial media for a while – at least until they’re not running around with their hair on fire.