After posting sharp gains in January, the stock market encountered a wave of selling in February, resulting in the first 10% correction since Brexit in 2016. While the stock market attempted to rally several times in March, it was not enough, with all of the major indices posting losses in the first quarter of 2018. And, unlike recent years, bonds were not a beneficiary of stock market weakness, as the Barclays Aggregate Bond Index lost more than 1% in the first quarter. To state the obvious, it was not an easy environment for a diversified portfolio to make money in.
What are some of the potential factors contributing to the market’s recent struggles? And are these factors merely transitory, leading to a pause that refreshes before the market resumes its ascent, or is it a sign of something ominous, like the start of a bear market?
One factor that is potentially weighing on the market is the Federal Reserve’s (the Fed) recent rate hikes, and more importantly, their current plan to increase short-term interest rates by possibly 3 more times this year. Historically, the Fed has killed more than one bull market by increasing interest rates one time too many, which then begins a negative feedback loop in the real economy. While the U.S. economy is still clearly in expansion mode, the rate of growth appears to be slowing on the margin. The Federal Reserve Bank of Atlanta’s GDPNow tracker had an earlier estimate for Q1 growth as high as 5.5%. It is now down to 2.8%. In addition, recent retail sales numbers have been weaker than expected. This may be nothing more than short-term noise, but it doesn’t point to an overheating economy requiring an overly aggressive Fed.
Another sign to pay attention to is the relentless rise in the London Interbank Offering Rate (or LIBOR for short). This rate is important as hundreds of billions of dollars of consumer debt, such as adjustable rate mortgages, and business debt are based upon this rate. At the end of the first quarter of 2018, three-month U.S. dollar LIBOR had risen for 37 straight days, the longest consecutive streak of rises since 2005. The rise in LIBOR, will on the margin, cost businesses and consumers more in interest, acting as de-facto tightening in credit conditions.
Another potential headwind is the fear of a global trade war. President Trump recently announced tariffs on various Chinese imports. China in turn retaliated by slapping a 25% tariff on various U.S. imports such as soybeans and aircraft. While the absolute economic impact of these tariffs is quite small in relation to total global economy, it is the fear of an ever-increasing trade war that is rattling the markets. U.S. Commerce Secretary Wilbur Ross has openly stated that the U.S. has no desire for a trade war but rather is attempting to re-negotiate trade deals that in the opinion of the administration are inherently unfair to the U.S.
The factors cited above would not be as concerning if the U.S. stock market was already priced for potential difficulties, or, said another way, was cheap from a valuation perspective. Unfortunately, that is not the case. In a recent missive put out by economist David Rosenberg at Gluskin Sheff, David examined the S&P 500 from four different valuation metrics:
- Forward Price-to-Earnings Ratio
- Price-to-Sales Ratio
- Price-to-Book Value Ratio
- Enterprise Value-to-EBITDA Ratio
Rosenberg then calculated the percentage of time that each of these had been at its present level or below. The following is an excerpt from his comments on his findings:
“In other words, only 8% of the time in the past has the stock market in the United States been as richly priced as it is today. And if you want to come up with reasons why that’s the case, that’s fine. But just understand that we are extremely pricey. We’re more than just one standard deviation event versus historical average.”
While this is not a shocking discovery to regular readers of our commentaries, it is yet another reminder that stocks aren’t cheap nor priced for negative surprises.
When we survey the financial markets and economy to assess the probabilities of whether the recent stalling action is nothing more than a pause versus the start of a bear market, we observe conflicting signals. The economy is still growing and the recent tax cuts will increase corporate profitability and provide more spendable income for many Americans. Unemployment, although a lagging indicator, remains very low by historical standards. There are no signs of a recession in the immediate future. While some are concerned about the gradual rise in longer-term interest rates, we believe these fears are overblown for now. While the interest rate on the 10-year treasury note has risen to within a few basis points of 3% in 2018, it is unlikely to spike significantly higher and stay there for any length of time. The level of indebtedness in the U.S. economy cannot withstand significantly higher rates for any sustained length of time without tipping the U.S. economy into a recession, thereby leading to a fall in interest rates. Our basis case is that rates remain range-bound for the next 12 to 18 months.
Turning to the potential headwinds in the market, the Fed does seem to be on a path to increasing short-term interest rates at least a few more times this year, in spite of core inflation remaining well contained. There is always the risk the Fed makes one move too many and creates a negative feedback loop in the financial markets. We are also observing a breakdown in the leadership in some of the technology names that have led the market the past few years. In addition, we are seeing a narrowing of the advance in the number of stocks participating, with many stocks now trading below their 200 day-moving-average. Finally, the most important factor in our way of thinking is how expensive the overall market is at the moment. Risk comes from paying too high a price for an asset. Many assets today are priced for perpetual growth and “goldilocks” conditions. It is certainly possible those conditions may continue for a few more years, but as time goes on, the risk increases that a negative shock will occur.
Given this environment, we are currently positioned on the lower band of our risk exposure in our model portfolios. This is not a timing mechanism but rather a natural outcome of our investment discipline and the paucity of compelling risk/reward opportunities we currently observe in the markets. As those opportunities increase, so will our risk exposure. For now, we will remain patient and focused on executing our investment discipline. Despite the struggles experienced by diversified portfolios in the first quarter, we remained convinced it is the most successful path for long-term investors.
As always, we remain committed to helping you achieve your financial goals.