Commentators often call a decline in stock prices after a sustained rise a “correction,” as if the previous rise was somehow in error. Normally, we refrain from such nomenclature, because no one knows what drives share prices in the short run. But in the case of recent declines in U.S. stock prices, we think it applies. First, the numbers:
The S&P 500 has dropped 10.2 percent from its high of 2,874 on January 26. It is now down 3.5 percent for the year, and back to where it was on November 21 of last year. The last time the S&P was in correction territory was February 7, 2016, over two years ago. At that time, it was down 19 percent. As shown below, the selloff is starting to show up on long-term charts. This chart shows both how steep the rise in prices has been since year end, and how steep the current selloff has been (187 points in five trading days) compared to the selloffs since 2009. In percentage terms, however, it is quite comparable to previous declines.
We’ve been stating for months that markets don’t move in a straight line, particularly if economic fundamentals indicate neither extreme under- or overvaluation for stocks, as is the case today. As mentioned above, this is the first decline for U.S. shares of this magnitude in over two years. Normally, declines of 10 percent or more happen just over once per trading year. So we were overdue.
What caused it? We said at both of our recent client gatherings that the chief risk to markets in 2018 was higher long-term interest rates. Higher rates drive Price/Earnings (P/E) ratios lower. Apparently (no one really knows) recent stock price declines were triggered by a spike in interest rates since December 15th, in which time the yield on the 30-year U.S. Treasury bond increased by 17 percent. All else equal, this translates into a decline in P/E ratios of about 15 percent. Given the 10.2 percent decline in the S&P 500 in the past week, we’re about two-thirds of the way there. We’re obviously watching long term interest rates very closely. If they stabilize in the current range, we would expect stock prices to do the same.
Importantly, we have not changed our estimate for S&P 500 earnings for calendar 2018. It remains at $151, the fastest growth since 2011. Part of the reason interest rates are up is because profits are growing, corporate capital spending is rising and the economy is strengthening. This is a good thing! Particularly given the tepid economic growth the U.S. experienced over the past decade. Accelerating growth means middle America can begin to share in the benefits of economic expansion, including rising wages. Some investors believe this strength will be inflationary, however, and have been selling bonds (pushing up interest rates) on that expectation. We think inflationary pressures are a late 2019 to 2020 story, at the earliest.
To sum up, recent declines are more a return to normalcy than anything else. Volatile price swings are part of the bargain in public stock markets. As we’ve preached for years, the returns from owning a business (or a portfolio of businesses) don’t happen in a nice, neat straight line, even though this has been the case for the past two years. This return to normalcy doesn’t mean you need to change your investment behavior one iota. Also, remember that every investment we make on your behalf is part of a well thought out plan, designed and built to get you through the periods when markets are doing what markets do, which is fluctuate, sometimes violently. As advisors, we earn our keep by helping you stick to your plan when the world appears to be afraid of its own shadow. That time is now.