Let’s first put some of the stock market’s volatility into context.
The February 5th drop was the largest in points, but as a percentage – and that’s what counts – it was relatively tame. The 1,175.21 point drop was the 99th worst in US history; not the 1st, 2nd, 5th, or even 10th; it ranked 99th. It’s even more irrelevant if we consider what has happened since that one-day fall. As of this writing, the Dow is only off 5% from its last high, hardly worth discussing.
But because it received so much hype, and because it is still referenced as some sort of indicator or predictor of the near term, we need to dissect what really happened.
2017 saw significant positive changes in the economic landscape. The economy continued to grow, major public companies reported growing earnings, and consumer confidence improved remarkably. We hit several new “highs” within the year. As the year drew to a close, we enacted a tax reform bill which brings the US back into a strong competitive stance with other developed nations. As a natural result, January 2018 saw the S&P 500 rise 5.6%. All of that was deserved; in fact, it understates the rise we should see shortly (more on that later).
Investors as a whole are wise, but there are many who can be more fickle than wise, and their actions can influence short-term values. We can never know what prompts short-term changes in sentiment. But as we have seen so many times in the past, sentiment (but not fundamentals) changed, and the stock market gave up its 2018 gains. The S&P 500 dropped 10.3% over a number of trading days in February.
But since the fundamentals haven’t changed, these movements really are “white noise”. They don’t matter, yet they occur often. We always forget about them in time, but when they occur everyone wants to find a “reason” to explain what happened, especially when it comes as a surprise.
This time around, the “reason” is impending interest rate hikes. There are other lesser causes floated, but the beneath them all is a still-widely-held belief that stock market gains have been propped up by easy money and low-interest rates. The gains aren’t seen as real; they’re somehow fake, soon to vanish.
We respectfully disagree. We look at fundamentals. Ultimately that is what drives markets. The stock market has been driven higher by earnings growth, not low-interest rates. With more than half of the S&P 500 companies reporting 4th quarter earnings, more than 75% have beaten estimates. Earnings are up more than 15% from a year ago. Furthermore, this double-digit earnings growth is forecast to continue through 2018, even with higher interest rates. Corporate balance sheets remain stronger than they have been in decades, spending is accelerating, and the tax cut will spur growth further.
We do expect interest rates to go higher. They need to for the health of the economy and the markets. We trust the Fed knows this, too, and will make 3 to 4 interest rate moves this year. This will benefit – not harm – the stock market. Such increases will confirm that the economy is growing and that the Fed is taking steps to prevent run-away inflation.
We know corrections scare people. Rarely does anyone see a correction coming, and it is the surprise factor which amplifies small downturns into corrections. In our opinion, we are witnessing an emotional correction, not a fundamental correction. The US is not entering a recession. In fact, economic growth should actually accelerate to 3% or more.
In our view, there are five key ingredients of economic growth:
1. Taxation – Tax policy needs to reward growth, not punish it. The new tax law dramatically helps growth.
2. Spending – Excess government spending hurts the economy. The recent budget deal increases spending at least as fast as GDP growth over the next couple of years. That won’t help long-term economic growth, but it is also not an immediate threat to economic growth.
3. Regulation – The regulatory burden must be appropriate and predictable. Too many regulations stifle growth, as does inconsistent, subjective implementation of regulations. Currently, the trends are in the right direction.
4. Trade Policy – Free trade ultimately benefits both the exporting nation and the importing nation. The protectionist talk coming out of Washington is problematic, but it currently appears to be more bluster and posturing than real substance.
5. Monetary Policy – A relatively consistent value of any country’s currency is a foundational requirement for economic growth.
Nobody would argue that the Fed has been too tight, but there are dangers the Fed could become too easy if it doesn’t increase interest rates appropriately in the near term. We believe they will, and that is why we see interest rate increases as good for the economy right now.
The bottom line shows that the fundamentals of the economy are strong and even improving in some key areas. It is rare for markets to contract when earnings and economic growth are strengthening. What we have just witnessed is the momentary triumph of emotion over reason.
In light of all that, we retain our confidence that equities are still undervalued. They were before the correction, they remain so today, and will likely be undervalued until we see 10-year Treasury interest rates in the 4% range. So, a long way to go before there is any irrational exuberance or recession threats on the horizon.