January 2018 Tactical Market Update

February 12, 2018

L&S Risk Pulse™ Score

Medium +

Core economic indicators are healthy, but markets indicate potential near-term volatility and/or mild correction. Valuations are trending high.

L&S Risk Pulse™ Insights – “The Times They Are a-Changing”

General Comments

The market started January as a continuation of last year, with the momentum of the market propelling stocks ever higher.   The market has posted 15 consecutive up months in a row.  No down months, no volatility, and big gains.

We have always thought that when cocktail party chatter revolved around the easy money made in specific stocks, or the market in general, that is a warning signal that risks are building.  Bitcoin anyone?

It really is unclear what changed the psychology as the calendar moved from January to February.  Pundits have articulated many reasons for the dramatic declines witnessed in the first week of February, and there is some truth in all of them, but the reality is that there is probably no one easily ascertainable reason why the character and perception of the market has changed.

Interest rates have moved up dramatically both in January, but also since last fall.  10-year U.S. Treasury rates were 2.04% in early September, and they peaked at 2.84% on February 2nd.  While 2.8% still represents interest rates that are closer to all-time lows than to worrisome levels, it is important to remember that dramatic interest rate hikes are generally disruptive to markets.  On a percentage basis, the 40% market-driven increase in 10-year rates was actually larger than the interest rate percentage hikes that preceded October of 1987.

Early in February, the unemployment report was released for January.  That report showed respectable job growth, but it also showed a pick-up in wage inflation.  Economists would generally expect a strong economy combined with low unemployment to lead to wage inflation, and the data bore that out.  Average hourly earnings rose 2.9%, the highest number since May of 2009.  The perception seemed to support the idea that the Fed would be raising interest rates by at least the three times in 2018, and the odds of a fourth interest rate hike rose dramatically.  Markets appeared to suspect that the Fed was behind the curve in raising interest rates, and a more aggressive Fed would make for a more difficult environment for stocks and bonds.

Perhaps, too, the sugar-high of lower taxes was wearing off.  While companies will report higher earnings, the higher deficits and additional treasury debt financing as a result of a poorly funded corporate tax cut will serve to put additional pressure on interest rates that already seem poised to increase anyway.

Over the past six years, more than half of the stock market’s gains came from expanding valuations, while less than half of the gains came from higher corporate earnings.  At some point, valuations will likely revert toward long-term averages, and higher interest rates put additional pressure on valuation measures.

Certainly, there were other reasons for the markets to correct.  Markets simply do not go straight up without pulling back at some point along the way.  Investor sentiment had grown overly bullish and complacent, and that is often a signal that the market is due for a correction.  Additionally, some high profile companies missed their earnings estimates.  Still, so many companies have exceeded estimates and provided solid guidance for the quarter and year to come that we do not see a few misses as an indicator of continued earnings difficulty ahead.  Whatever the reasons or reasons, the tone of the market changed as the calendar rolled into February.

The market that had been up for 15 months in a row was now correcting and becoming more volatile.  There is an old saying that markets take the stairs up but the elevator down.  Over the past several days of early February, the elevator was an express.

We expect the momentum-driven easy-money market of the past will transition into a market that will be less complacent and more volatile.  Strong economic growth and solid corporate earnings may be offset by contractions in valuations and fears of higher interest rates.  Active managers will have to work for their returns, and we do believe that this is finally a market where active managers will be able to show how they can and do add value.

Data Points and Global Economic Indicators

It is important to remember that there has been no profound change in our data points that might explain the severe correction of the past few days.

There are no signs of credit problems in the economy.  There have been no bank failures, no tighter lending standards, no signs of credit stresses.  Yes, high yield spreads did widen out somewhat, but actual spread levels remain quite low as compared with history.

Economic growth remains quite robust, and we continue to see growth across all 20 of the G-20 nations.  Solid economic growth is not just a U.S. phenomenon but is now a global one. The employment report showed a gain of 200,000 net new jobs, and the unemployment report remained at 4.1%.  The biggest issue with these numbers is the implied support for additional rate hikes by the Fed. Our recession indicators continue to suggest that a recession is unlikely in 2018, and perhaps even into 2019.

Purchasing Managers Indices, Fed reports, and other economic measures all suggest that economic growth is likely to continue for the foreseeable future.

Other than the increase in interest rates, this correction was not data driven.  With that in mind, our Investment Committee decided to leave the Risk Pulse™ unchanged at this time.

Conclusion

Markets go up. Markets go down.  Markets correct.  That is the price of admission.  The biggest declines that typically come with recessions do not seem to be on the horizon.  Still, volatility is likely to be higher than it has been, and news of strong economic growth may be met by concerns over potential Fed policy tightenings.  Strong earnings growth may be offset by valuation metrics that continue to revert toward long-term averages.

This is likely to be a more difficult environment, but one that is not without opportunity.  In fact, this may be an excellent market for active managers to show that we have the ability to add value as compared with a strictly passive approach.  Picking the right stocks and the right sectors will be increasingly important and adjusting the portfolio accordingly will lead to better returns for investors.  In this regard, the times may be changing for the better.