To say that the stock market rout of the past few days has been unnerving is at best an understatement. In this short memo, we will try to put all of this in perspective. Starting with our bottom line: This sell-off does not represent the beginning of a protracted bear market in equities.
The US economy is quite strong, and indeed the global economy is still accelerating. Our technological prowess and a weak Dollar act as strong support for our export position to countries throughout the globe. The translation of foreign source profits is enhanced by the relatively soft Dollar. At this writing, the Standard & Poors 500 Stock Index, at 2637, is selling at 17 times projected 2018 earnings of $155, which produces a 5.9% earnings yield, well above the 4.25% yield on BBB corporates. And if anything, there is an upside risk to this earnings forecast.
On the other hand, the strength in the economy has pushed up the yield on the 10-year US Treasury Note to 2.75% currently, from around 2.3% not long ago. The tipping point may have been reached on Friday, February 2nd, when the January Payroll Employment Report came in stronger than expected and noted that Average Hourly Earnings were now up 2.9% year on year. The fallacy here is that rising wages are never the cause of higher inflation, which remains quite subdued and well below the Fed's 2% target goal. That said, however, the Fed is no longer buying securities, but is letting its balance sheet contract, albeit slowly. Furthermore, thanks to the ill-advised and ill-timed tax cuts, the Federal Government will have a substantially larger fiscal deficit to finance this year. This occurs at a time when corporate borrowing and household borrowing are likely also to be strong. The result is a gradual tightening of the US financial system, which is in sharp contrast to nearly a decade of Fed easing and lackluster economic growth, which enabled surplus liquidity, not needed by the economy, to drive financial asset prices higher. In short, when the money supply expands at a more rapid rate than nominal GDP, it benefits financial asset prices. The reverse is now the reality. However, the 10/2 spread is still solidly positive at 70 basis points, which indicates the total absence of a liquidity squeeze. Nevertheless, surplus liquidity is now contracting. As a result, we expect some gradual compression of P/E multiples over the balance of this bull market. We anticipate that going forward, gains in equity prices will merely track the growth of corporate earnings.
The current market decline is being accelerated in speed, and most probably depth, by the contraction of ETFs, as well as the computer driven algorithms, both of which account for the overwhelming proportion of trading volume. Our best guestimate at this point is that a "Benchmark Low" in the popular market averages will be reached within a few days. However, history tells us that even if a bounce off the bottom and a sideways move in stock prices ensues, it will require a retest of the original low, a so-called "Confirmation Low" in order for the secular bull market to resume. The emergence of this "Confirmation Low" can take anywhere from a few weeks to a few months. For perspective, we note that in 1987, the "Benchmark Low" in the averages was reached on October 20th, but the "Confirmation Low" did not occur until the first week in December.
During this turbulent period our strategy is to sit tight and be sure that the corporate fundamentals of each of our equity holdings remain strong. We thank you for your confidence and trust during the weeks ahead.
