Back to the Future

A market commentary in response to market volatility

Dennis Johnson
If I told you the U.S. stock market would be down approximately 1% year-to-date on February 5, 2018, your response would more than likely be minimal. Well, we’re down about 1% year-to-date, but this outcome was derived by the U.S. stock market increasing approximately 5% during the month of January and declining 6% over the last week. Such a quick 6% decline certainly gets the attention of the media and some investors.
  1. This is not a “pullback” in the market. We are almost exactly where we were five weeks ago. In addition to normal market volatility, the recent decline in the market has been driven by the exit from the stock market by trend-following investment strategies. These strategies followed the upward trend in the equity market for a very long time and are now “jumping off the train.” Selling pressure from these strategies will abate.
  2. Also contributing to recent market weakness was the increase in interest rates. However, the yield on the 10-year Treasury closed Monday at 2.71%, after peaking last week at 2.88%. The short-term distortion in the equity market is highlighted by the fact that interest rates declined and bond prices increased materially Monday, but the stock market declined by 4%. The near-term trend to lower rates should stabilize the equity market.
  3. The stock price for very large companies like Exxon, Chevron and Apple declined materially in response to their less-than-stellar earnings reports. These companies have a significant impact on the stock market because of their size. However, overall fourth-quarter earnings are coming in much better than expected, and expectations for earnings growth in 2018 are rising. These factors should support a resumption of a rising stock market.
  4. Last Friday, the Federal Reserve implemented regulations on Wells Fargo that will restrict the company’s ability to grow this year and potentially beyond. This decision by the Fed is 180 degrees away from the administration’s policy to reduce regulations and the cost of doing business for companies, particularly for banks. This action by the Fed has caused investors to question if the administration will continue with its policy of reducing the financial impact of regulations on companies. We think the Wells Fargo decision is a company-specific event and the administration’s business- friendly policy remains intact. The continuation of these policies should be supportive of a rising stock market.
  5. The labor report last Friday indicated a significant increase in U.S. wages. This indicator is indicative of an economy that continues to improve, which is good for stocks. However, given our expectation for 2% inflation this year, we will closely monitor data for additional signs of greater-than-expected increases in inflation.
  6. Finally, the strong economic data and last week’s wage inflation report has caused some investors to think the Fed will be more aggressive with raising interest rates this year. We currently expect the Fed to raise rates three times this year, in-line with their current forecast. More importantly, if the financial markets were to remain volatile, we think the Fed would be inclined to temper the number of times it increases interest rates this year, which would be good for the financial markets, specifically stocks and bonds.
In closing, a quick decline in the stock market and spike in volatility can cause investors to make emotional decisions. Do not panic. We believe the factors contributing to recent stock market volatility are short-lived. The economy remains on solid footing, and corporations are expected to continue to experience growth in profits.

In the event the financial markets remain volatile for a period longer than we expect, consumer confidence could begin to slip, which could cause the Federal Reserve to be more cautious about the number of times they increase short-term interest rates this year. Such caution will cause interest rates to go lower and stock prices higher. Either way, we are back to the beginning of 2018. We maintain the same outlook we had at that time; good economic growth and rising financial markets, particularly the stock market.
The Investment Management Group (IMG) consistently identifies, assesses and monitors both the source of any risk potentially impacting an investment, as well as the potential returns associated with that risk. Doing so is a part of IMG’s ongoing investment management process.
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