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Volatility Update

After the recent increase in volatility and sharp pullback in equity markets (the S&P fell nearly 7% peak-to-trough), investors are understandably concerned about what may have exactly caused the sell-off. However as with similar prior corrections, the answer is not particularly straightforward. We feel there may be a number of factors influencing equity markets, including:

Rising short-term interest rates: Some believe this is reflective of overly-tight monetary policy from the Fed, given the current state of the economy includes solid (but not overheating) growth and subdued inflation.

Tariffs and trade wars: These are further weakening China’s slowing economy (which is weighing on all emerging market economies) and causing disruptions in North American trade.

Domestic Politics: There is a high degree of political uncertainty going into the midterm elections.

Mixed macroeconomic data: Recent durable goods and housing reports have disappointed and inflation may be lighter than previously thought. 

Rising long-term interest rates and equity valuations: With the S&P 500 yielding just 1.9% and a market P/E ratio nearing 21x prior to the pullback, rising Treasury yields looked comparably attractive. However, with rates rising (and bond prices falling), current bondholders could be induced by fear into selling, which puts even more upward pressure on rates, creating a negative feedback loop.

Looking closer at long-term Treasury yields, not only can rising rates draw yield-seeking investors out of equities, they also imply borrowing costs are rising for companies who may have previously enjoyed relatively inexpensive sources of capital and whose profits could be adversely affected by higher rates. When rising rates stymie the ability of companies to efficiently raise capital for investments and expansion, the resulting decline in output and profitability could slow the economy, which is what worries Fed policy critics the most. Should rates rise too quickly in a market that is not necessarily “overheating” by traditional standards, aggressive monetary policy could, in theory, trigger a recession. Still, the Fed has gone to great lengths to be transparent about, and consistent in, its actions, and it would be hard to argue that the market or economy has fundamentally changed since September 20th, when the S&P 500 hit an all-time high despite a rising rate environment. 

Much like its months-long run-up, the market’s recent decline was led by tech stocks, some of whose shares entered “bear” territory (down 20% or more from highs). Some see this as a rotation out of a notoriously cyclical sector, but against fundamental underpinning that still appears solid, this wouldn’t make a lot of sense. Others believe it could be the result of slowing buybacks, which typically decelerate going into earnings season.  A third (and likely) culprit are hedge funds and others who crowded into these “momentum” trades which assume stocks that have gone up in the recent past will continue going up (until they don’t).

It is also possible that growing volatility outside the US may finally be bleeding into domestic markets, led by economic weakness in China that has been exacerbated by trade tensions with the US. While US stocks were falling, Chinese stocks were doing even worse, accruing their biggest loss since early 2016. Mounting pressure on the Chinese yuan has become a growing concern for foreign investors, particularly as the Chinese government attempts to stimulate its economy without devaluing its currency, which could lead to capital outflows and the labeling of the country as a “currency manipulator.” Other emerging market currencies around the world have suffered weaknesses too, most notably the Turkish lira, Argentinian peso, the Indonesian rupiah, the Indian rupee, and the South African rand, which have resulted in investors pulling funds from those markets and largely turning toward the dollar as a safe haven. Meanwhile, a stronger dollar makes conducting business overseas more difficult for US companies and could pressure exports over time.

Whatever the cause of the decline, it is important to remember that, sometimes, these things just happen. The 3% drop on October 10th was the twentieth time since 2009 that the S&P 500 fell by more than 3% in one day. None of those previous drops threw the market or the economy off its long-term trajectory, and there’s no compelling reason to believe that this time will be any different. Corrections can and do happen even absent signs that a recession is in the offing, much like the current situation.  

The chart below shows the both the price (white) and valuation (green) of the S&P 500 for the last 3 years.  Take note of the market correction in early 2018.  Predictably the P/E ratio mirrored this decline.  Yet a few months later notice that these two lines deviate. What would cause the market to increase in price yet make it less expensive at the same time?  Just consider the math and it points to the denominator of the P/E ratio – in other words - Corporate Earnings were increasing faster than the market was rising.   

How should investors digest this?  From a valuation standpoint, this could be viewed as another healthy reset.  With the S&P 500 P/E ratio bouncing along just below 20x trailing earnings for the third time this year, the lowest level since late 2016, and earnings season already off to an impressive start, a strong case can be made here that the market as a whole is not in dangerous territory – and that price gyrations are simply an overdue uptick in volatility.