“The monetary climate - primarily the trend in interest rates and Federal Reserve policy - is the dominant factor in determining the stock market’s major direction.”
- Marty Zweig
Heading into the final stretch of 2018, it has been a year most investors would like to forget. The fourth quarter has seen volatility rise across the stock market and it has been the worst start to December since the 1930s. Much of the recent volatility has been pinned on fears of a recession, of which investors will put the blame on trade wars, rising interest rates, or even just the simple fact that it has been 10 years since the last major slowdown in the U.S. Given the extreme nature of recent market volatility, we think it is a good exercise to take stock of where we are fundamentally and offer some perspective on where things could go from here.
At WhartonHill, we closely track many barometers of economic and market health and follow their trend to determine where we see the tides moving. From our perspective, we think recent volatility is overdone and the market is due for a more positive turn heading into 2019 for a few reasons. The first reason relates to the job market. Prior to the start of the last 10 recessions in the U.S., the unemployment rate has started to trend higher. Currently, the unemployment rate in the U.S. is at 3.7% and is at its lowest level since the 1960s. More importantly, it is trending lower, not higher.
In addition to employment, we also look closely at gauges of economic health. The Leading Economic Index, a composite of multiple data points that coincide with growth accelerating or slowing, is continuing to show signs of growth and has not turned lower. Rail traffic, a good gauge of industrial production, is also up 3.4% this year, one of its fastest growth rates of the last 5 years.
What about corporate profits? The reaction to Q3 earnings in the market has been disappointing, but that is mostly a result of companies not meeting lofty estimates rather than an indication of stress across corporate America. Darden Restaurants, owner of the Olive Garden and other casual dining restaurants reported revenue grew at a 4.9% rate in the most recent quarter. Consumers are still eating out, which is usually the first expenditure to go when people feel the pinch of tighter finances. Costco reported that sales rose 10% in their most recent quarter, another healthy sign for consumer spending.
If profits and revenue are showing solid growth, then perhaps valuations are too high? With the recent sell-off in stocks, the S&P 500 is trading at forward earnings multiple of 14.8x, its lowest level in three years and 7% cheaper than its 20-year average. Mid and small cap stocks are trading at their lowest valuations in 5 years.
Perhaps the most pressing concern to the market is that of the Federal Reserve policy. “Don’t fight the Fed” is a famous axiom on Wall Street that cuts to the chase of what moves the economic and investment machine in the U.S. The thought that the Fed is on a mission to push rates higher despite a potential economic slowdown is what has brought market volatility to the forefront. The following chart shows how many interest rate hikes the market was expecting in 2019. As the economy strengthened, Fed chairman Jay Powell signaled a greater willingness to raise rates. His comments on October 3rd, not coincidentally the high point for the stock market this year, noted that we were a “long way from neutral interest rates.” This signaled to the market that he was going to keep hiking rates faster than many expected.
Since that point in time, volatility has reigned, and the U.S. Treasury market has come close to “inverting”, where longer maturity yields are lower than shorter maturity yields (2-year bonds and 10-year bonds). In addition to the aforementioned economic gauges we monitor, the yield curve is another signal that deserves to be watched closely. This bond market event typically occurs when forward estimates for economic growth decrease and the signal often precedes a recession. Where the uncertainty with such a signal lies is in the timing – a recession could occur in a year, two years, or further out. This signal has not occurred yet, but we are closely watching fixed income markets, along with many other signals, to gauge what lies ahead for the economy.
The market sold off after the December Fed meeting as a result of another 0.25% rate hike despite little pressure from inflation. The Chairman noted recent market volatility but was intent on pushing rates higher one last time this year. Where there may be some positivity for the market resides in how the Fed manages policy going forward. Language surrounding potential future rate hikes softened in the event that economic data continues to cool from recent levels.
Does this mean the markets will go straight up from here? That is unlikely, but it does mean the Federal Reserve is acknowledging recent volatility and is taking a step back from aggressively tightening policy. To be sure, there is more incentive to own bonds with yields higher than where they were a year ago; however, a recent shift to slow the path of rate hikes is positive for liquidity and the market. While U.S. stocks looked a little frothy earlier in the year, they are much cheaper now and are discounting an overly pessimistic scenario in our mind. We are cognizant of the possibility that the economy could enter a period of slower growth, are always wary of the risk of recession and understand that it may be difficult for investors to maintain discipline during turbulent markets. Yet based on our view of the facts on the ground, we believe recent volatility has gone too far to the downside and the market could be due for a bounce in the near-term.
Investment advisory services offered through Independent Financial Partners, a Registered Investment Adviser
WhartonHill Investment Advisory is not owned or controlled by Independent Financial Partners
The opinions voiced in this material are for general information only and are not intended to provide specific investment advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.
All data via Wall Street Journal, St Louis Federal Reserve, Morningstar, and Natixis