US Stocks Have Led Global Equities Lower
- Behind the recent market pullback were 2 imbalances: investors’ seeming disregard for rising bond yields, and stock valuations that were high by historical standards.
- It could be argued the stock market is now being in much better balance, with strong earnings growth pushing the market higher, but rising rates acting as a valuation headwind.
- It is possible we are still in a bull market scenario, albeit a more late cycle one than before.
After a record run of very strong gains and very low volatility, the stock market correction of late January /early February was swift and violent, with stocks getting hit by various liquidity air pockets as levered positions in various corners of the market were liquidated.
At its worst point last Friday, the S&P 500 index had fallen 11.8% from its intraday high of 2873 on January 26.The market has since recovered half of these falls.
How did we get here?
The stock market decline was the inevitable correction of 2 imbalances that have accumulated since last August. One imbalance resulted from the stock market’s apparent lack of attention to the sharp rise in bond yields (even bringing with it memories of 1987 when the market plummeted in the face of rising rates).
The other imbalance was the product of the US stock market gaining twice as much as can be justified by recent tax cut and its resulting sharp rise in earnings estimates.
The yield on the 10-year Treasury has now more than doubled off its historic low of 1.32% in July 2016. As of last week, the 10-year has now climbed to 2.88%, which is up 87 basis points since last August’s 2.01% low.
Amid the euphoria of the explosive re-rating in corporate earnings it has been clear that the markets were too complacent about the other side of that trade, which is that adding fiscal stimulus to an economy that is operating at full capacity 9 years into an expansion might just create a classic late cycle overheating phase, with all the implications therein for the Fed, interest rates, the yield curve, and risk premium. In retrospect, a yield of 2.0% last August didn’t make much sense.
So where does this leave us now? The good news from my perspective is that these 2 imbalances—rising rates being ignored by the stock market and valuation multiples rising beyond what I think can be justified—have now mostly corrected.
Predicting interest rates is a notoriously difficult exercise, but my guess is that at a yield of near 3% the 10-year is a lot closer to some sort of equilibrium than it has been in several years. At 3% or so, bond yields are consistent with another 4 or 5 Fed hikes and that seems to me like a reasonable bet for this Fed cycle.
So, between these 2 adjustments, I see the stock market as now being in much better balance, with strong earnings growth pushing the market higher but rising rates acting as a valuation headwind. This is a market regime wherein stock prices should rise less than earnings growth, not more than earnings, as has been the case for several years. With earnings up strongly, this is still a bull market scenario, albeit a more late cycle one than before.
Whether last week’s correction ended on Friday or continues for several more weeks or months to come is of course unknowable. But the good news is that (a) bond yields are now in much better synch with the Fed, (b) the stock market has given back its (in my opinion unjustified) valuation bump from last August, and (c) it is paying attention to the bond market again (as well it should). And of course we have (d) double digit earnings growth.
All in all, that makes me feel a lot more comfortable about where the market is at and where it is likely to go.
S&P 500: 2736
FTSE 100: 7250
Bonds – 10 Year Government Yields
EUR/USD 1.2400 (1 euro buys 1.2400 dollars)
GBP/USD 1.4100 (1 pound buys 1.4100 dollars)
OIL: Brent: 68.50 (dollars per barrel)
GOLD: 1345 (dollars per ounce)
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