December 26, 2018

In terms of stock market returns, it appears this year may come to be known as the year that the Grinch stole Christmas. After a bruising selloff that hit especially hard on Christmas Eve,  the major U.S. stock indexes are near bear market territory. Bear markets can be defined as declines of 20-25% from the most recent high levels. In this note, we will consider some of the possible reasons for the seemingly abrupt change in direction in the U.S. stock markets.

To begin with, at the end of September interest rates, which had been moving higher, hit a high point of about 3.20% on the 10 year U.S. Treasury Note. Citing evidence of a strong domestic economy, our Federal Reserve Chairman, Jay Powell, declared that the central bankers in the U.S. were planning on normalizing interest rates over the coming months. In Fed-speak, this meant that interest rates were headed higher. We believe this may have been the initial trigger to the decline in stock prices. Why? Since the Financial Crisis, central banks around the world have been highly accommodative, implementing experimental policies to revive the larger global economies, including Europe, Japan and China. These accommodative policies have worked in the U.S., and our banking system and overall economy are now healthy enough to “normalize.” This is an important shift in terms of the underlying liquidity for the stock, bond and other asset markets. As you know already, we have been looking for higher domestic interest rates and we expected a reaction from other markets. The negative reaction in the U.S. stock markets has, frankly, been more than anticipated.

Since September, the narrative seems to have changed somewhat. Investors have been  bombarded with a daily news flow (recently, continuing trade tensions and the government shutdown) that makes long-term thinking and action (which is necessary for successful investment) more difficult. In a sense, it appears there has been a buyers’ strike in the stock market, with short-term traders dominating activity and reacting to every bit of news. Chaotically, one day the market is down due to a strong economy causing higher wage inflation and interest rates, while the next day the market is down due to the perceived risk of recession around the corner. Experienced investors have seen periods like this before, and successful investors try to remain dispassionate as chaos seemingly reigns.

The news flow is not going to stop. Most importantly, the underlying framework for the financial markets is sound. The U.S. economy is growing at a healthy pace, inflation is still under control, and interest rates have been increasing, and are expected to go higher yet. All these conditions are conducive to the stock market moving higher. Valuations on stocks have come down significantly with lower stock prices and much higher corporate earnings. In fact, for the first time in a few years, we are finding companies that are trading at very inexpensive valuations. This is a significant positive condition for future investment returns.  

Higher interest rates do not necessarily lead to poor stock market returns. As economic cycles mature, interest rates increase along with corporate earnings. In fact, during the late 1990’s (1996-1998) we experienced a very similar period of volatility (and chaos), wherein corporate earnings in the U.S. were strong, interest rates were increasing, the U.S. dollar was ascendant, and the then-reigning President of the U.S. was under threat (Clinton impeachment process). The ensuing three years provided the best stock market returns in recent history (the tech bubble).

We believe the stock market correction has run most of its course. We do not see the risk of recession as a high probability. Much of the speculation and consequent high valuations in the technology sector of the market has been reduced. Unlike 2007, we do not see any apparent excesses in the markets or the economy. Corrections like the one we are experiencing are never pleasant. They are necessary, however. In 2017, investors experienced the least volatile stock market in U.S. history. Conversely, 2018 has turned out to be a more normal experience in terms of price volatility, and the market has taken back some of the above average gains of 2017.

We wish you a happy holiday season and will provide additional commentary in our regular quarterly insights in January.

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.

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