Keeping Your Head in the Storm

By Michal Emory on February 9, 2018

The financial media has been their usual panicked self now that volatility has returned. We have been talking about a market correction since last summer and it is finally here. If you recall in my "10 Surprises for 2018", I talked about the first quarter potentially being a down quarter. We have a long way to go in this quarter, but this correction is not unexpected. I have a few thoughts on it and the economy in general.

First, I think this is your garden-variety correction and not a major change in the market. This does not mean that this correction cannot turn into a secular bear market, but there are no signs that this cyclical bull market is over. The economy is looking very strong and the tax bill should only help. I will dive into this more when we talk about some of the excuses that the media has been talking about. Second, with last year being the least volatile year on record, it is no surprise that volatility has come back with a vengeance. Since it has been since June 2016 since we had even a 5% correction, that only adds to how bad this correction feels. Let’s look at some of the excuses that the media is throwing out there as the cause of this correction.

The Trump tax bill is going to be the undoing of the bull market—This must be the most nonsensical excuse that I have read. First, MILLIONS of families are going to receive HUNDREDS of MILLIONS of dollars in benefits from this bill from bonuses, to higher wages, to lower taxes on their paychecks, and greater 401k benefits. How is any of this a bad thing for families? Second, businesses are going to make more money and much of it will flow out to the economy via the benefits just mentioned, larger dividends, share buybacks (which is another form of returning capital to shareholders), greater capital spending, and healthier balance sheets. How again is any of this bad?

Wage inflation looks to be back after the January job report and that is a bad thing—Once again, how is families making more money a bad thing? Yes, corporations may be spending more money on wages and benefits which could hurt their profits. But, they are receiving a big benefit from the tax bill that will offset the higher wages. Also, with wages increasing, hopefully the labor participation rate will move up and more people will enter the workforce. And if you think about your own job situation, you probably would not mind seeing a bit of wage inflation.

Inflation is back—Inflation may indeed be finally moving up in a sustainable fashion. The long-term average for inflation is around 3% and we have been running below 2% for a significant period of time. If inflation is finally on the move, it has a way to go just to get back to historical averages. Even if, in a worse case scenario, inflation got above 5% or, heaven forbid, we saw a return of the 1980’s inflation, equities are still the place you want to be. In an inflationary environment, equities are one of your best long-term protections against inflation. In addition to equities, that is why we have a Real Assets bucket to help keep your dollar stay worth a dollar. Inflation is not a reason to leave equities but a reason to stay in (or add to) equities.

Interest rates are going higher and that is going to kill the bull market—Out of all the arguments this one makes the most intuitive sense. Higher interest rates do impact whether the market is undervalued, overvalued, or somewhere in between. But if someone has been valuing the stock market based on our extremely low interest rates then they have not been properly watching risk. The 10-year Treasury started the year at 2.4% and has been above 2.8% at points this year. Even if the 10-year was to spike to 4% that is still low historically. Below is a chart of the 10-year Treasury and the S&P 500 from 1/1976-12/1984. In this time, the 10-year spiked to close to 16% and finished at 11.5%.

While there were plenty of market gyrations during this period, the S&P 500 still averaged 11.2% annually including dividends. Higher interest rates can change the equation for the stock market, but it does not mean that it cannot still move significantly higher.

We are closely monitoring the risk/reward with your asset allocation. Despite the current market correction, at this point, we are still very positive on the outlook of the economy and the stock market. We are using this opportunity to find some stocks that now show promise after this pullback. The low volatility environment we enjoyed last year was nice, but it could not last. Volatility may be back but that does not have to be a bad thing. I have no idea if we are at the bottom for this correction or if we have more to go. But I do know that sticking with the long-term asset allocation that is appropriate for your goals will show dividends in the end.

Please do not hesitate to call us if you would like to discuss this further. Have a great weekend!