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A Painful Return To “Normal”

By Kenneth J. Entenmann, Director of Wealth Management and Chief Investment Officer

NORWICH, NY (February 9, 2018) – This week’s dramatic volatility in the world financial markets has been painful. However, we are not surprised and view this market correction as a healthy return to “normal.” Yes, this week’s market price swings have been record-setting and confidence-shaking. Equity markets are inherently volatile as investors attempt to determine the proper risk and return parameters in an ever changing world. As the risk/return fundamentals change, the markets adjust, sometimes violently, as they have this week.

In fact, since the 2016 presidential election, the equity markets have been behaving in a highly abnormal way. It has been the lack of volatility that is not “normal.” The S&P 500 equity index posted an impressive 21.83% total return in calendar year 2017. More impressively, it posted a positive return in all twelve months. This is not “normal.” In fact, it has never happened! When you add in the robust start to 2018 with the S&P 500 up another 5.73% in January, the S&P 500 posted fifteen consecutive months of positive returns. At the same time, the S&P 500 index failed to experience a 5% correction over the last 80 months. On average, the equity market experiences a 5% correction every 10 weeks. It marks an unprecedented period of market complacency. This week’s market action has washed away that complacency.

This correction was long overdue; it is healthy and marks a return to a more “normal” equity market. Despite the recent volatility, our long-term prognosis for the economy and the markets remain positive for several reasons:

Global Economic Growth

The fundamental economic underpinnings of the global economy remain strong. For the first time since the Great Recession of 2008-2009, the world is experiencing synchronized global growth. At least for the moment, economic growth is strong around the world and is accelerating. And that is before the impact of tax reform and other fiscal stimuli. A recession is highly unlikely. Stronger economic growth typically leads to better corporate earnings. That is a good thing.

Inflation

Inflation remains relatively benign across the globe. One of the purported “causes” of the recent sell-off was the imminent threat of rising inflation and its impact on interest rates. This sentiment was fueled by the Department of Labor’s employment report on Feb. 2. In that report, average wage growth came in at 2.9%, above the recent trend of 2.5%. The equity markets reacted as if this increase in wage growth marked the end of “easy” monetary policy; that would lead to skyrocketing interest rates which in turn would kill the Bull market in equities. We are skeptical of that view for several reasons:

  • The wage report is just one anecdotal statistical data point that is not consistent with recent broader measures of inflation. The Federal Reserve Bank’s favorite measure of inflation, the Personal Consumption Expenditures price index (PCE), posted a 1.7% rate of growth over the last 12 months, below the Fed’s target of 2%.
  • Higher wage growth is a good thing for stocks! Higher wages often lead to greater consumption which leads to better revenue and earnings growth for stocks.
  • Higher interest rates are not necessarily bad for stocks. It is true that interest rates have risen gradually over the last year. The Fed has raised short-term rates 5 times since December 2015 and the 10 year Treasury note yield has increased from 2.43% to a 2.88% high in 2018. However, an analysis of equity returns and interest rates demonstrates that equity prices can in fact rise along with interest rates, particularly when rates are going up from low levels as they are today. Most likely, a modest rise in inflation and interest rates would be the result of better economic growth…a good thing.
  • Interest rates around the world still trade at historically low levels. In many international markets, “real” interest rates (nominal interest rates – inflation) are still negative! This is not “normal.”
  • Surprisingly, the credit markets have remained very calm throughout this equity volatility. Yields in corporate and high yield bonds have barely moved in the last week. This suggests the bond market is not signaling concern about economic growth.

We believe inflation will play an integral role in how the markets act in the near term. We expect inflation to rise gradually as economic growth accelerates. That is normal. We expect interest rates to rise gradually if inflation does indeed pick up. That too is normal and hardly a reason for a Bear market in equities.

Corporate Performance

Based on 4th quarter earnings report, corporate performance has been stellar across the global markets. Importantly, these strong earnings are being driven by strong revenue growth which is up nearly 9% for the S&P 500. For years, critics of the equity markets complained that earnings growth was driven by “financial engineering” (i.e. stock buy backs) and valuation multiple expansion. Today, revenues are growing and the recent correction has clipped the P/E market multiple to below 17 times earnings, near its long-term average of 16x. Strong earnings at average prices are a good thing for long-term investors!

Leverage and Liquidity

Is it a coincidence that this market correction started on Groundhog Day? It seems like Wall Street keeps making the same mistake over and over again. It creates esoteric and exotic products that are based on derivatives of derivatives which tend to lack liquidity and allow for leverage. This drives the supposedly “smart” money to make leverage bets on the markets. Does anyone remember Portfolio Insurance of 1987 or Collateralized Mortgage Obligations (CMOs) of 2008? Once again, Wall Street’s Frankenstein has returned, and the unwinding of these illiquid and leveraged trade vehicles has created a big dislocation. In declining markets, leverage leads to margin calls which leads to indiscriminate selling that has little to do with the sound fundamental foundation of the economy or markets. In times like these, patience is indeed a virtue.

Conclusion

In closing, market corrections are never fun and create all kinds of anxiety and concern! This is normal! However, there is a big difference between being a trader and an investor. At NBT, we always invest for the long-term. Our core investment principal of broad diversification is our first line of defense when markets become volatile. As tough as this correction is, we will not attempt the folly of market timing. While no one can determine when the “bottom” will occur, we remain confident that those who take a long term investment stand will be rewarded for their patience. History tells us that is “normal!”

The views expressed here are those of Ken Entenmann and should not be construed as investment advice. These views are subject to change. All economic and performance information is historical and not indicative of future results.

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