10-15 Associates

A New Era

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For the fans who wanted to see volatility return to the market, they got what they wanted and more this past month. February was easily one of Wall Street’s wildest months since 2008. Sparked by what would finally be good news for Main Street, the January unemployment report revealed that hourly wages are finally rising in the United States. This news was followed by the Dow Jones Industrial Average shedding more than 3,200 points, or 12% of its value, in just two weeks. Just as quickly as the market declined, investors raced back into markets and erased approximately 2/3 of those losses, only to sell off once again. Despite great earnings and strong overall economic data, investors focused on fears of inflation and rising interest rates. When all was said and done, the Dow lost 4.29%, the S&P declined by 3.89%, the NASDAQ shed 1.87%, and interest rates climbed by 5.75% during the month.

On Monday, February 5th, the new Federal Reserve Chairman, Jerome Powell, was welcomed to his new post with a loss of 1,175 points on the Dow, the worst one-day point decline in history. Although it was double the points lost on Black Monday, October 19th 1987, it represented just a 4.6% decline as compared to the 23% decline of Black Monday. The volatility index, or the VIX, doubled that afternoon marking its largest one-day percentage gain of the index in its history. The VIX made the intraday selling pressures take on a whole new dimension. With computerized trading and investors having the capability to move large “baskets” of stocks in one key stroke, the speed of the move felt more like a flash crash than a normal market move. Joe Saluzzi, head of Themis Trading, said, “The action is probably just a preview of what investors can expect as trading gets more and more driven by algorithms and programmed trades. Selling has always begat selling, but in the current environment things can get out of hand in seconds.”

volatilityThe market continued to demonstrate a concern with our new Fed chairman on his first day of Congressional testimony. His upbeat outlook of the economy sent interest rates higher and led markets lower. The Dow slid 299 points, or 1.2%, and the S&P gave back 1.3%. All 11 sectors of the S&P 500 finished in the red, with consumer discretionary and real estate leading the losses down more than 2%. Investors are worried that we are potentially entering a period of time where bad news is bad for the markets and good news is bad for the markets. An economy that shows signs of heating up will push the Federal Reserve to raise rates more aggressively. Powell’s comment, “We’ve seen continuing strength in the labor market. We’ve seen some data that will, in my case, add some confidence to my view that inflation is moving to target. We’ve also seen continued strength around the globe and we’ve seen fiscal policy become more simulative;” reinforced the market’s concern that we could see rates move higher than anticipated. Given that we don’t yet really know Mr. Powell, it too has added to the uncertainty. Rich Guerrini, Chief Executive of PNC Investments, recently commented, “I don’t know if the markets can really anticipate or figure out where he wants to go as it would relate to the economy.”

The prospect of rising wages is welcome news for workers across the country. With an unemployment rate at 4.1%, the labor market continues to tighten and put upward pressure on wages. This can be problematic for employers as they are forced to compete for talent, which, increases the cost of doing business. The additional cost will eventually get passed on to consumers in the form of higher prices on goods and services. So far, tightening labor markets in the United States, Japan, and Europe have failed to result in higher wages. The average unemployment rate among 36 major countries tracked by the Organization for Economic Cooperation and Development, has recently fallen below its 30-year average. This is of significance due to the fact that as a global economy, wages are increasingly being influenced by the global labor supply. Worldwide tightening of the labor markets, especially in areas like Europe, could cause a global shift in monetary policy. U.S. interest rates have been “anchored” in part due to the lower structure of rates around the world. A pickup in inflation could become a global signal for swift and unanticipated action by central bankers around the world. There is a strong probability that interest rates and inflation will be a major driving force for the direction of the markets. This means the return of volatility this month is likely to persist for the year.

Volatility does not mean that markets have to fall. Markets can live with some inflation and as long as the economic fundamentals remain intact, stocks can trade higher. Fourth quarter earnings as one metric of economic health, confirmed the optimism of what we saw in early January. According to FactSet, with 90% of the companies in the S&P 500 reporting earnings so far, 74% beat on earning and 78% beat on sales. If 78% remains the final number after all companies have reported, it will be the highest percentage since FactSet began tracking in 2008. Earnings growth came in at 14.8% and if it stands, it will be the best level of growth since the third quarter of 2011. Thanks to an improving economy, along with the corporate tax cut, 2018 profits are expected to surge by 18%. Although 4th quarter GDP came in lighter than expected at 2.6%, optimism remains high on seeing a positive 3% GDP growth in 2018, fueled by strong consumer and business spending. According to CNBC & Survey Monkey, the Small Business Confidence Index saw an increase of 5 points to a record high and the largest quarter-to-quarter move since the survey began. Most telling is comments from the Vice President of Public Affairs for the National Small Business Association, stating, “I think the jump in optimism isn’t just due to tax reform, but largely due to the economy doing better.”

Consumer confidence also rose again last month from an already elevated level. Strong labor markets, rising wages, and the strength in confidence, appears to be filtering through to the housing market as the homeownership rate is finally moving higher. The housing market’s contribution to the economy is significant. For many households, the home represents their largest asset and greatest source of savings. Housing constructions represent approximately 6% of GDP and services related to housing represent another 12-13%. Like the economy, the housing market has been experiencing a Goldilocks-like recovery, not-too-hot and not-too-cold, at least in most regions of the country. Its continued health could play a large role in the overall economy throughout the next several years. Lead Portfolio Manager of the Smead Value Fund, Bill Smead, commented that, “Housing is in the third or fourth inning of a nine-inning game.” One contributing factor is the new millennial buyer, creating a huge opportunity as millions of millennials will be purchasing their first home. With banks finally providing access to credit and rates remaining below historic levels, buyers armed with more discretionary income are motivated to take advantage of lower rates while they last.

Although the era of low-inflation and low-volatility are likely in the rear view mirror, the economic backdrop can still support higher prices. Volatility can provide an excuse for panic or it can create an environment for opportunity. Current conditions warrant treating this past month as a normal correction within a longer term bull market. 2018 is only two months old and has already reminded us that markets are a forward pricing mechanism that are likely to overreact to the upside and the downside during any short period of time.


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