Gauging Market Volatility
2018 reminded investors how volatile markets can be with 64 of the 252 trading days resulting in a market movement (measured by the S&P 500) of greater than 1%. By contrast 2017 had only 8 days with over 1% movements. The S&P 500 finished the year -4.38% after being up 10.56% at the end of the third quarter. The speed of the selloff in the 4th quarter left most investors wondering what happened.
There was certainly a change in sentiment as the equity markets flipped from being overly positive to completely negative. Markets shifted from ignoring some potential problems to obsessing over them. This is a marked contrast to the end of the third quarter when the S&P 500 closed near record highs.
One potential problem is slower growth due to higher interest rates. For the fourth time during the year the Federal Reserve raised the benchmark rate which now stands in the range of 2.25%-2.50%. The rise was accompanied by hawkish statements from Fed Chair Jay Powell. However, the statements and interest rate hike were preceded by a dovish Fed report lowering forecasts of GDP growth and inflation, fueling concern the Fed would envenom an already slowing economy. It has often been said bull markets don’t die of old age, but rather they’re killed by the Federal Reserve.
The president was quick to publicly admonish the Fed both prior to and after the interest rate hike for their decision. Some questioned whether Mr. Powell raised rates due to a strong economy or was forced to act to demonstrate the Fed’s independence. Either way, we believe the Fed will likely take a more cautious approach to raising rates in 2019.
Trade disputes with China remained a focus for investors. The market has ongoing concerns that increased costs as a result of tariffs could pressure corporate profits. Currently, the US and China agreed to a 90 day cease-fire to allow negotiations to take place. As of close of the year these appeared to be progressing well. However, the ambiguity of the trade negotiations allow for several interpretations.
Also adding to the negative sentiment was the U.S. government shutdown. A bipartisan spending deal was stopped by President Trump over lack of funding for a US-Mexico border wall. Congressional Democrats, who have the votes to do so, have vowed to deny any funding for a wall. It is unclear how long the shutdown will last and what the resolution will be. The situation is likely a window into the divided government that awaits us in 2019.
If correct in that assumption, we would anticipate volatility in marketplaces to continue. Large swings in the market by themselves are unsettling. Nonetheless, if they aren’t validated by deterioration in fundamentals they will likely be temporary. Over time the stock market reflects the health and growth of the real economy.
Economic data at year-end was still largely positive. Unemployment remains very low, auto sales have been strong, and durable goods orders showed a rebound in December. MasterCard’s SpendingPulse, which provides insights into overall retail spending trends, pointed to the best holiday season in six years.
Of course there is always a concern that markets themselves can change fundamentals. Negative markets can impact household wealth and undermine consumer confidence. Consumers who feel less wealthy due to a stock market drop are likely to curtail spending which is known as the “Wealth Effect.”
In this regard we have witnessed a concurrent decline in consumer confidence as the stock market has fallen. The Conference Board Consumer Confidence Index fell in December. Nevertheless, the cyclical areas of the economy that are most vulnerable to consumer spending such as housing, autos, and investment spending haven’t shown material weakness.
As an offset, oil prices collapsing from their high of $76.40/bbl in early October to approximately $45/bbl at year-end may provide support to consumer spending. Lower oil prices and by extension lower gas prices can act as a de-facto tax cut for consumers increasing their income.
At the end of December almost two thirds of the stocks in the S&P 500 were down 20% from their peak. A shift in investor sentiment saw the markets begin to price in pessimism instead of optimism for the first time in several years. One area that was particularly prone to this change were stocks with high starting valuations. By example, FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google) were down an average of -23.45%.
Yet there remains reasons for optimism. Although a moving target, Price/Earnings ratios are now trading at below historical averages. Since 1920 there have been twenty instances where the P/E ratio of the S&P has fallen by 20% or more. In the year following those instances the market recorded a positive return three-quarters of the time.
Market psychology is difficult to predict. Provided the economy remains healthy we believe with time equities will reflect the underlying fundamentals of the economy. As the Ben Graham, the father of value investing, stated “In the short run, the market is a voting machine, in the long run it is a weighing machine.”