For the last two to three months, volatility has returned to the markets, something we haven’t experienced in a while. Here is some context and some thoughts on the reasons for the volatility.
Volatility in context
In 2017, stocks steadily rose with only small pullbacks. When the year ended, the largest peak to trough decline for the S&P 500 Index was just under 3%.
Since the beginning of February, volatility has returned. It is our opinion that long-term investors should look past it even though it can create some anxiety. Volatility would be cause for concern if there were something going on signaling a recession, but right now, we don’t believe that is the case.
Consider:
Thanks in part to the tax cut, corporate profits are forecast to rise nearly 20% this year. (Thomson Reuters)
Weekly first-time claims for unemployment insurance recently hit a level not seen since the late 1960s (St. Louis Federal Reserve). It’s a concrete sign that companies don’t want to lose employees. If business conditions were deteriorating, the opposite would be true.
The Conference Board’s Leading Economic Index (designed to detect emerging trends in the economy), just hit a new high. We are facing some challenges (we always will), but the economic fundamentals are solid right now.
Coupled with rates that still remain at historically low levels, the fundamentals have cushioned the downside and remain supportive of good share performance.
Causes of volatility
Two issues have surfaced that have stirred up volatility.
In March, the president announced that he wants to impose steep tariffs on steel and aluminum imports. His apparent goal in doing this is to open foreign markets to U.S. exports, but the announcement has also led to concerns over protectionism and the potential impact on the economy. Trade tensions, and potential tensions, create uncertainty.
Most economists support free trade. It’s a net benefit to the U.S. and global economies. But “net benefit” means there are both winners and losers. Losers – those whose jobs disappear amid a flood of cheaper imports. Winners – consumers who pay less for various goods and those who work in export-oriented industries. In 2017, U.S. exports totaled $2.3 trillion (U.S. Bureau of Economic Analysis).
U.S. manufacturers are consumers of steel and aluminum. This includes everything from farm equipment to construction supplies and equipment, to aerospace, pipelines, drilling equipment, and cans for soft drinks.
At the margin, tariffs may modestly boost inflation and could force some U.S. manufacturers to delay projects or move production elsewhere.
Additionally, U.S. tariffs may invite retaliation, pressuring exporters, jobs, and profits in globally competitive sectors.
While the odds of a major trade war remain low, all this has injected uncertainty into market sentiment.
Meanwhile, trouble in the tech sector have added to volatility. Facebook is embroiled in a controversy over privacy and data sharing, and Amazon has also come under increased scrutiny. They are only two stocks, but both have been keys to leading the tech sector higher and have a combined market capitalization of $1.1 trillion (WSJ).
A few final thoughts on volatility
This is only a brief explanation for the recent volatility that summarizes the conditions around it. Some more perspective by reviewing the data:
- The average intra-year pullback (peak to trough) for the S&P 500 Index since 1980 has been 13.7%.
- Half of all years had a correction of at least 10%.
- Thirteen of the 19 years that experienced an official correction (10% or more) finished higher on the year.
- The average total return for the S&P 500 during a year with a correction was 7.2%.
This is an evidenced-based way of saying turbulence surfaces from time to time, but patient investors who don’t react emotionally have historically been rewarded.
Some degree of risk is inevitable. Our recommendations are designed to minimize risk, and they are designed with your long-term goals in mind.
First quarter big-picture review
Over half of all companies that make up the broad-based S&P 500 Index have reported through the end of April. So far, profits are expected to rise an astounding 25% versus a year ago, according to Thomson Reuters I/B/E/S.
For perspective, anything above 10%, a double-digit increase, is viewed as solid.
Also, nearly 80% of companies that have reported earnings are beating analyst estimates and by a wider-than-normal margin (Thomson Reuters).
Analysts had already been raising forecasts in response to the just-passed cut in the corporate tax rate (from 35%-21%). So expectations were high.
Companies are performing extremely well, and strong growth is expected throughout 2018. The cut in corporate taxes is adding to profits, but so are the fundamentals–economic growth at home and abroad.
So why aren’t shares soaring to new highs? Great question.
First, the forecasts that were issued for Q1, as mentioned above, were already quite strong. It’s a sign of confidence, but it also raises the bar.
A second factor is the impressive surge in profits. That sounds counterintuitive, but investors are not only interested in current numbers, they are also interested in the future. It is too soon to say profit growth peaked in Q1, but it’s likely we’ll see a slowdown to a more sustainable level.
Rising interest rates have also dulled interest in stocks. The Federal Reserve is expected to raise interest rates at least three times this year, and the yield on the 10-year Treasury bond has been ticking higher.
Strong profit growth is not fueling new highs but, coupled with a growing economy, has provided underlying support for the broader stock market. While stocks may not be cheap, the odds of a bear-market-inducing recession this year remain low.
Last year, we were treated to an outsized gain, which may have left some with a false sense of security. Throw in very low volatility, and it’s easy to forget that pullbacks are the norm.
Shares are now in a consolidation period. Since peaking in late January, the S&P 500 Index is down a modest 7.8% (MarketWatch data), well within normal gyrations we’d expect in a year.
In the context of a growing economy, the current pause skims away the excess euphoria and can reestablish a foundation for shares.
