The new year began much like the last one ended, with markets closing at record highs seemingly every day. Then, without warning, volatility came roaring back. On Friday February 2, the Department of Labor issued its monthly report, which merely hinted that wage growth might finally be picking up. The Dow plunged an ominous 666 points. After taking the weekend to stew over what was actually a fairly pedestrian report, markets opened Monday in near panic, plunging 1600 points (6%) before recovering slightly to end down 1175, the largest ever one-day point drop. By the end of the week, the market was in an “official” correction, down more than 10% from the January 26 peak. That week began a period in which the market traded up or down at least 1% in 14 out of 19 trading days. For some context, the market made a 1% move only 10 times in all of 2017. Last quarter’s column discussed the extraordinary nature of markets in 2017 and how unlikely we are to see a repeat. We don’t make a lot of predictions, but so far this one’s looking good.
No single explanation for the sudden return of volatility really satisfies. It is true that political risks have shifted. Last year the months-long prospect of tax cuts created a tailwind that made for smooth sailing. With those cuts realized and fully priced into the market, other issues have come to the forefront. The President’s tariffs (and threats of far more) have us closer than ever to a trade war with China, not to mention Mexico and Canada and virtually all of our traditional allies. We also have the possibility of a new anti-trust regulatory regime against the power of tech behemoths like Facebook and Amazon. And we have mid-term elections that could deal a significant blow to the business-friendly Republican agenda. This all adds up to quite a bit of uncertainty. But uncertainty is ever-present, and cannot alone explain the abrupt return of volatility. What made 2017 unique was not the absence of uncertainty, but rather the stock market’s lack of reaction to it. What we are most likely seeing now is a return to normal market behavior, with perhaps an extra touch of vulnerability because of how far and fast the market has come, and, perhaps, how unpredictable the President has become.
The adjacent chart is one we’ve shown before. It describes how expensive the market is in terms of company stock prices relative to their earnings (the P/E ratio). Three years ago, the P/E ratio for stocks in the S&P 500 was 19.5, which we pointed out was below the level of the last four market peaks that preceded a bear market, defined as a price drop of more than 20%. Presently, that ratio is 21.5, which is more expensive than stocks have been preceding all recent bear markets save the dotcom bust in 2000. What those markets didn’t have going for them – that this one does – is strong earnings growth. In 2017, profits for S&P 500 companies grew 15%, boosted by synchronized global expansion and a weaker dollar (which means foreign earnings get translated into more dollars). While those effects will moderate in 2018, last year’s tax cuts are forecast to add another double-digit bump to earnings this year. This suggests that a truer measure of P/E would be under 20, near the average of the past 30 years. That doesn’t make stocks cheap, but neither does it suggest another correction is imminent.
The macroeconomic environment remains supportive. Over the past two quarters the economy has expanded at a rate of 3%, with the acceleration spurred by business investment, which is growing twice as fast as during the Obama presidency. Last year’s tax cuts and this year’s increase in Federal spending will almost certainly keep the economy growing in coming quarters. But such massive stimulus this late in the business cycle, with the economy at close to full capacity, is unprecedented in American history. Investors worry that inflation will accelerate and force the Federal Reserve to aggressively raise interest rates to keep the economy from overheating. In fact, that’s how the last four bull markets ended. Increasingly, it looks like this one is headed for a similar fate.