At market highs and deep into multi-year economic recoveries, a wrestling match often ensues as the market begins to contemplate its next chapter. Add rising tariff rhetoric and a fairly new Federal Reserve Chairman, and you have the recipe for increased market volatility. As these words will find their way to you a few weeks after they are written, we will outline the forces at work and try to keep a longer-term focus, versus attempting to suggest the market’s shorter-term path.
“Growing corporate profits and reduced corporate tax rates mean corporate cash positions are healthy and companies feel more confident to invest.”
The important news is that the U.S. economy is strong, corporate profits are booming, and consumer confidence as well as small business confidence are high. Growing corporate profits and reduced corporate tax rates mean corporate cash positions are healthy and companies feel more confident to invest. The unemployment rate continues to grind lower. We do not see the risk of a recession in the near future, as the economy is likely to continue to grow, albeit probably at a slower pace. All of this is very good support for the stock market.
“There are budding inflationary pressures from higher wages and increases in the costs of doing business (parts shortages/supply chain issues).”
However, late in this recovery and for the first time since the late 1990’s, the economy is starting to exhibit growing pains. There are budding inflationary pressures from higher wages and increases in the costs of doing business (parts shortages/supply chain issues). These are signs of economic health. Still, the risk of inflation brings with it a Federal Reserve response: higher interest rates to prevent the economy from overheating. While still quite low by historic standards, interest rates have recently moved to the highest levels seen in the past few years. This is also a sign of a healthy economy, but can cause the financial markets to experience more volatility. We expect interest rates to continue their ascent, so volatility could remain with us for a while.
“...the risk of inflation brings with it a Federal Reserve response: higher interest rates to prevent the economy from overheating.”
The other near-daily news story is threats of tariff escalations, mainly between the U.S. and China, but to a lesser extent with our other trading partners as well. It is the current U.S. administration’s belief that our trading partners are using their own tariffs to protect their domestic industries. In particular focus is China, who the U.S. asserts is providing financial support to its domestic industries, giving them an unfair advantage in international markets. Additionally, China is being pressured to stop stealing intellectual property and to recognize international property laws.
“Used as a trade negotiation stick, tariffs act to raise the price of select goods imported into the country."
Used as a trade negotiation stick, tariffs act to raise the price of select goods imported into the country. The intended consequence is to inflict pain on the foreign economy, as higher prices shift demand away from imports and toward domestic producers, leading to lower import volumes. There are, however, a couple of secondary impacts. Tariffs increase input costs for domestic manufacturers, making their final products more expensive to produce. Depending on the demand dynamics of these products, this additional cost can either be passed through to the consumer or result in lower profits to the selling company. Additionally, there is the risk of retaliatory tariffs on U.S. exports resulting in our products becoming more expensive overseas. Neither is good, as prices go up (inflation) or company margins go down (reduced company value). A relevant data point—as of the end of October, according to CNBC, more than one-third of the S&P 500 Index companies who have reported third-quarter figures addressed tariff concerns in their earnings announcements.1
“These kinds of periodic corrections are healthy, as they temporarily chasten speculators and offer opportunities for investors."
Against this economic and political backdrop, we entered October with valuations on stocks high relative to history, and the technology sector, in particular, over-extended. We quickly found ourselves in yet another October correction. These kinds of periodic corrections are healthy, as they temporarily chasten speculators and offer opportunities for investors. Carter Worth, a CNBC commentator, recently put this current correction into perspective. He noted that since 1927 there have been 218 corrections of five percent or greater. The average of these corrections resulted in a decline of 12% and lasted for an average of 40 trading sessions.2 As of this writing, the S&P 500 Index is down 11% and has thus far lasted 25 sessions. Importantly, he points out, we remain in an upward trending trading channel (a range of security price levels) that began with the market bottom in 2008—a calming sign for those who chart market movements.
“Has the correction completely played out? It is hard to know, since the math above implies that, thus far, this is only an average correction.”
Has the correction completely played out? It is hard to know, since the math above implies that, thus far, this is only an average correction. However, keep in mind that the “market” is a collection of stocks, so some (down 30% from recent highs) may have bottomed, while others have farther to fall. The tea leaves do not portend a major bear market, such as the one experienced in 2008-2009. Bear markets almost always coincide with a recession, and we do not forecast a recession. In fact, with the recent pullback and continued earnings growth amongst our companies, we are finding good value in certain sectors of the market.
“...with the recent pullback and continued earnings growth amongst our companies, we are finding good value in certain sectors of the market."
As market returns have been above average with below average volatility for the past several years, it is easy to forget that, as long-term investors, we need to be prepared for market pullbacks, corrections, and even bear markets in order to achieve attractive returns over time. Being prepared means maintaining an appropriate asset allocation and reserves such that we can afford to ride out volatility for longer-term gain. We don’t time the market as studies continue to show that is a loser’s game. Looking ahead, the economy continues to look good, the Federal Reserve is moving deliberatively, and the market appears to be discounting the possibility of any positive outcome in the tariff dispute. As a result, we recommend striving to focus on the longer-term horizon and using this volatility to establish positions in high-quality companies that temporarily find their share prices a bargain relative their company’s value.
1. Franck, Thomas. “Tariffs are dominating earnings calls with more than a third of companies discussing the fallout.” https://www.cnbc.com, 24 October 2018.
2. Worth, Carter. “Chart master says it’s about to get worse before it gets better.” [Video file] https://www. cnbc.com/video, 29 October 2018.
The above information is for educational purposes and should not be considered a recommendation or investment advice. Investing in securities can result in loss of capital. Past performance is no guarantee of future performance.