Volatility is back. After a multi-month escarpment, the Dow’s quiescent intraday range has surged to more than 1600 points over the last few weeks, as massive selling matched binge buying. The moves suffused fear among investors and whiplash among tape watchers. The S&P 500 plunged 10 percent between January 26 and February 8. What’s keeping investors awake at night? And is it worth tossing and turning about?
The market is expensive relative to economic conditions, such as earnings and dividends. The S&P 500 entered 2018 about 18 percent overvalued when gauged not only against current earnings and dividends, but against anticipated earnings and dividends for the next four quarters. Part of the reason for the equity market premium was artificially low bond yields. Historically, the 10-year Treasury tends to track nominal gross domestic product, which at about four percent, was 1.6 percentage points higher than where the benchmark Treasury started the year. Improving wage growth in the U.S.and stronger-than-expected economic results in Europe pushed global rates higher, prompting investors to reassess the relative attractiveness of equities.
Don’t lose sleep over this. Thanks to the pullback, the market is now trading about 5 percent above fair value. Bond yields are higher, too.
Investor enthusiasm was at an extreme going into 2018, emboldened by sweeping corporate tax cuts and the perpetually rising stock market. As of January 4, the ratio of investors characterizing themselves as “bullish” versus “bearish” was in the 98th percentile of its 10-year historical range, according to a survey by the American Association of Individual Investors. Optimistic investors have high expectations. In a world where short-term market movements reflect the intersection of reality and expectations, widespread optimism made the market vulnerable to disappointment. Historically, the S&P 500 performs twice as well over the subsequent six months after periods when investors characterize themselves as extremely bearish versus periods when they’re extremely bullish.
Don’t lose sleep over this. Thanks to the pullback rain spoiled the bull’s picnic. Bullish sentiment has slipped to a skeptical 34th percentile of its historical range.
The perception is growing that the economy can’t get any better. Washington has pulled out all the stops with monetary and fiscal policy. Rarely in our nation’s history has fiscal stimulus amounted to more than 5 percent of GDP while the unemployment rate was below 5 percent. Economically speaking, investors increasingly believe we’re sitting on the North Pole, where every direction is south. Though President Trump has been flapping his arms for infrastructure spending, it’s not a formal plan. The idea of unlocking $1.5 trillion in investment on $200 billion government spending is far-fetched. Strong growth in Europe is fueling the notion that the world’s central banks are preparing to take their feet off the monetary accelerator.
This is a valid concern. Easy money has been fueling risk taking over the last decade. Central bank reversals have the potential to turn monetary tailwinds into headwinds.
Who is Jerome Powell?
The equity slide earlier this month coincided with Federal Reserve Chair Janet Yellen’s last day on the job. Jerome Powell, the new Fed head, is a policy outsider and an unknown quantity. Over the years, equity investors took comfort with the central bank’s willingness to coddle risk takers and inject liquidity whenever the equity market got dicey. Equity investors aren’t sure whether or not Chairman Powell would come to the equity market’s rescue if stocks suddenly turned south.
This is a valid concern. Central bankers have been helicopter parents since 2009.
Investors should not lose sleep over the equity market near term. Fiscal policies on top of already simulative monetary policies have whipped the 2-percent donkey into a 3-percent racehorse. Running an economy above its potential will eventually result in inflation as production capacity and labor capacity evaporate. Pricing and wage pressure will spur higher interest rates and tighter liquidity. We believe our current business cycle should continue through 2018.