By Scott Rives, CRPS®
If you’re like most investors, your neck might be a little sore after the whiplash your head took from watching equity volatility over the past two quarters. The market was cruising down the road at a steady pace leading into the fourth quarter of 2018. Then, in October, the S&P 500 suddenly started to pump it’s brakes due to uncertainty, before slamming on the brakes in December. As soon as the market had time to pause and take a breather from this scare, we saw equity prices begin to climb again, stomping back down on the gas pedal in January, again increasing acceleration.
So, what caused the market to pull back last year? Was it rising interest rates? Uncertainty of tariffs? Slowing global growth? The million-dollar question for investors right now is this: Was this a short-term correction or a precursor for more volatility to come?
One way to gauge the pulse of the stock market is to evaluate the health of the economy. Real GDP increased 2.9% in 2018, compared with an increase of 2.2% in 2017. GDP has increased every year over the last three years. You pessimists say, “But Scott, GDP growth has been declining since the second quarter of 2018. My answer is this: “so, what?” Quarterly GDP growth has declined in the back half of every year since 2016, but if you measure annual growth year after year since 2016, it has steadily increased. The benefits of reduced regulation and corporate tax cuts should only help propel future growth. Many analysts are forecasting another year of 3% annual growth. As for corporate earnings, the operating earnings for the S&P 500 have been steadily rising since the beginning of 2016. The same is true for profit margins.
Another important thing to watch when reviewing the health of the economy is the Leading Economic Index (LEI). An increasing LEI number means the economy is strong, and a decreasing number shows a weakening economy. The LEI is composed of 10 indicators, including the Institute for Supply Management’s (ISM) manufacturing report, unemployment claims, average hours worked in manufacturing, interest rate spreads, and building permits. Let’s talk about some of these indicators for a second. Unemployment is as low as it has been in years, and as of last week, unemployment claims dropped to 202,000 for the first time since the 1960’s. The ISM brought in solid news with the overall index rising to 55.3 for March. Because an ISM number above 50 signifies typically signifies an expanding economy, this figure suggests that we will continue to see growth at least for the time-being. The average weekly hours worked is still holding strong above 40 hours for manufacturing. Housing starts have slowed some but are still sitting at as solid a position as they did in 2016. Take a look at a full LEI graph below:
So, why is the LEI so important to the stock market? The LEI has been a helpful indicator of whether the economy is heading into a recession. The LEI’s momentum has turned negative several months prior to the last 7 recessions since 1970. As of March, the LEI is currently sitting at 111.9 and is a strong economic outlook for the near future.
Conversely, I’m not telling you everything is great. There is a large amount of debt globally, especially in the public sector. Governments across the globe, including the U.S. and other developed countries, have continued to increase budget deficits, adding to their already substantial debt. These debt levels will need to be reduced or future spending will need to be capped so that economic growth will not be diminished. Odds are, these government spending deficits will not be addressed any time soon and could continue for years and years, but the mounting debt will have to be addressed at some point whether we like it or not.
Interest Rates: the two words that everyone seems to hang on to lately. Since 2008, the Federal Reserve Bank, in an effort to stimulate the economy, has continued to reduce rates while increasing its balance sheet through Quantitative Easing and the Troubled Asset Relief Program (TARP). These decisions reduced the Fed Funds rate to virtually zero. Since the economy has recovered, the Fed decided in December 2015 to implement interest rate hikes and has recently been reducing its balance sheet. In my opinion, both are good things to allow the Fed to get back in a position of strength and put more bullets back into their gun to help shoot at any future recession to stimulate the economy.
One thing that is slightly concerning is that the yield curve has tightened its spread between short-term and long-term rates. We do not want the yield curve to invert (meaning short–term rates are higher than longer–term rates) because that has historically been a precursor of past recessions. As we stand today, there is a slight gap between the 2–year and the 10–year Treasury notes. I feel the Fed will try its best to keep the yield curve from inverting and will slow down on its monetary tightening. This change in position has also given a slight boost to the markets in 2019.
If you became fearful and sold out at the end of last year, you captured some significant losses and missed a strong rally in the start of 2019. Investors who did this made a short-sighted decision to sell when the economic data did not fully support such an event. I feel that the incoming economic data will continue to support favorable results for this year. So, yes, market volatility has been increasing, but the best treatment for that case of investor’s whiplash you have experienced is a properly diversified portfolio that will better protect your account against wild swings in certain sectors of the market. That said, make sure you discuss your investment strategy and portfolio positions with your financial advisor before making any decisions about your accounts. Your advisor knows your investment strategy regarding your personal situation and is best equipped to make the proper recommendations.
Thank you for your attention and trust,