The stock market finally managed to suffer a correction and like people who live in California, investors are wondering if this is the “big one”.  That’s pretty unlikely.

It takes very little or nothing at all to start a short-lived correction of 5% or 10%.  Larger declines require a recession and our economy remains fundamentally very sound, so a recession does not yet appear to loom on the horizon.  There is a risk of rising inflation and higher interest rates.  So the road ahead is likely to revert to more traditional levels of market volatility.

 

The correction in stock prices is clearly due to rising interest rates and the prospect for more increases over the course of the year.  The risk that interest rates might rise has been evident for a few years and it has been widely discussed, although much of the market has been in denial.  That’s why individual investors shifted hundreds of billions out of stocks into bond funds over the past few years and companies have been able to issue new debt at shockingly low yields.

 

Evidence showing faster increases in average hourly wage rates, now 2.9% year-over-year, has dispelled the notion that the tight labor market would not result in an increase in wage inflation.  So it seems the laws of supply and demand have not been repealed after all.  And it takes very little to connect the dots a bit further to anticipate that higher labor costs will be transmitted into higher prices for goods and services.  If inflation does increase, and the handwriting is now on the wall, then interest rates are simply too low.  We have anticipated this development for some time, and have positioned very defensively in the bond market.  In January, the Barclay’s index fell by more than 1.82%, while our fixed income portfolio averaged a modest positive return of 7 basis points, a massive difference for a single month in bond market performance.

 

Higher interest rates do pose a hurdle for the stock market, but it should be manageable at this stage, because corporate profits are also increasing, in fact, quite rapidly.  The consensus estimate for 2018 profits has surged by 4.9% just in the latest 6 weeks to $155.70, bringing the S&P 500 multiple down to a reasonable 17.5 times earnings this morning.  We’re now also trading below 16 times projected 2019 earnings.  And still, analysts remain well behind reality.  The decrease in corporate tax rates, the largest factor behind the upward revisions to earnings estimates, was not much anticipated by the markets.  Many people expected the Trump tax bill effort to be stillborn and few thought he had a real shot at lowering the corporate tax rate so much.  Once it occurred, most analysts decided to await fourth quarter earnings reports to update models, since many companies would also provide earnings guidance for the coming year at the same time and they could incorporate these projections along with recalibrating their estimates based on actual Q4 performance.  However, companies tend to be conservative in providing guidance, since they prefer to beat expectations.  So while earnings projections are likely to rise further in the coming weeks, more upward revisions should trickle out over the coming quarters.  So, corporate earnings will readily justify stock prices, in our view.

 

All of the above pales in comparison to the importance of a growing economy and whether a recession threatens the expansion.  A recession, even a mild one, would serve as a catalyst for a larger decline in stock prices.  But if the expansion is maintained, which is what we expect, then any sizable decline in stock prices would be temporary and actually be an opportunity to buy in more cheaply.  Moreover, the potential for investors to buy into stocks is quite large, since so much cash has moved out of stocks in recent years and into bonds.  The Trump tax package will provide some additional impetus for economic growth in 2018 and into 2019, inappropriately in our judgment, while interest rates are still too low to inhibit economic activity.  The global economy is also performing very well, which is mutually reinforcing.  And there’s little to suggest imbalances or problems of any consequence anywhere in the economy.  So we expect the economy’s expansionary momentum to continue.

 

The notable decline in market volatility over the past several quarters may be at an end, however.  The steady rise in stock prices was nice and soothing to the nerves of investors, especially after the 2008 experience.  We’ve been spoiled with low volatility for a while.  Unfortunately, stocks are inherently volatile and it is quite reasonable to expect more normal volatility to resume.  Even so, a sound basis remains intact for stocks to set new highs, pushing a real bear market somewhere off in the more distant future.

The stock market finally managed to suffer a correction and like people who live in California, investors are wondering if this is the “big one”.  That’s pretty unlikely.

It takes very little or nothing at all to start a short-lived correction of 5% or 10%.  Larger declines require a recession and our economy remains fundamentally very sound, so a recession does not yet appear to loom on the horizon.  There is a risk of rising inflation and higher interest rates.  So the road ahead is likely to revert to more traditional levels of market volatility.

 

The correction in stock prices is clearly due to rising interest rates and the prospect for more increases over the course of the year.  The risk that interest rates might rise has been evident for a few years and it has been widely discussed, although much of the market has been in denial.  That’s why individual investors shifted hundreds of billions out of stocks into bond funds over the past few years and companies have been able to issue new debt at shockingly low yields.

 

Evidence showing faster increases in average hourly wage rates, now 2.9% year-over-year, has dispelled the notion that the tight labor market would not result in an increase in wage inflation.  So it seems the laws of supply and demand have not been repealed after all.  And it takes very little to connect the dots a bit further to anticipate that higher labor costs will be transmitted into higher prices for goods and services.  If inflation does increase, and the handwriting is now on the wall, then interest rates are simply too low.  We have anticipated this development for some time, and have positioned very defensively in the bond market.  In January, the Barclay’s index fell by more than 1.82%, while our fixed income portfolio averaged a modest positive return of 7 basis points, a massive difference for a single month in bond market performance.

 

Higher interest rates do pose a hurdle for the stock market, but it should be manageable at this stage, because corporate profits are also increasing, in fact, quite rapidly.  The consensus estimate for 2018 profits has surged by 4.9% just in the latest 6 weeks to $155.70, bringing the S&P 500 multiple down to a reasonable 17.5 times earnings this morning.  We’re now also trading below 16 times projected 2019 earnings.  And still, analysts remain well behind reality.  The decrease in corporate tax rates, the largest factor behind the upward revisions to earnings estimates, was not much anticipated by the markets.  Many people expected the Trump tax bill effort to be stillborn and few thought he had a real shot at lowering the corporate tax rate so much.  Once it occurred, most analysts decided to await fourth quarter earnings reports to update models, since many companies would also provide earnings guidance for the coming year at the same time and they could incorporate these projections along with recalibrating their estimates based on actual Q4 performance.  However, companies tend to be conservative in providing guidance, since they prefer to beat expectations.  So while earnings projections are likely to rise further in the coming weeks, more upward revisions should trickle out over the coming quarters.  So, corporate earnings will readily justify stock prices, in our view.

 

All of the above pales in comparison to the importance of a growing economy and whether a recession threatens the expansion.  A recession, even a mild one, would serve as a catalyst for a larger decline in stock prices.  But if the expansion is maintained, which is what we expect, then any sizable decline in stock prices would be temporary and actually be an opportunity to buy in more cheaply.  Moreover, the potential for investors to buy into stocks is quite large, since so much cash has moved out of stocks in recent years and into bonds.  The Trump tax package will provide some additional impetus for economic growth in 2018 and into 2019, inappropriately in our judgment, while interest rates are still too low to inhibit economic activity.  The global economy is also performing very well, which is mutually reinforcing.  And there’s little to suggest imbalances or problems of any consequence anywhere in the economy.  So we expect the economy’s expansionary momentum to continue.

 

The notable decline in market volatility over the past several quarters may be at an end, however.  The steady rise in stock prices was nice and soothing to the nerves of investors, especially after the 2008 experience.  We’ve been spoiled with low volatility for a while.  Unfortunately, stocks are inherently volatile and it is quite reasonable to expect more normal volatility to resume.  Even so, a sound basis remains intact for stocks to set new highs, pushing a real bear market somewhere off in the more distant future.

About the Author

Dr. Charles Lieberman

Dr. Charles Lieberman

Dr. Charles Lieberman is the Chief Investment Officer and co-founder of Advisors Capital Management, LLC. Dr. Lieberman began his professional career as an academic at the University of Maryland and Northwestern University. After five years in academia, he joined the...
About the Author

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