March Investment Comments

After two years of a steadily rising stock market it finally happened: the dreaded correction.  Corrections are defined as at least a 10% drop in market value after achieving a peak.  On Thursday, February 8th the Dow Jones Industrial Average finished the day at 23,860.46, down 10.4% from its peak on Friday, January 26th of 26,616.71.

The media had a field day reporting all the red ink.  On two separate days, February 5th and 8th, the Dow fell more than 1,000 points, the largest point drops in history.  What wasn’t emphasized as much was the percentage drops, 4.6% and 4.1%, respectively, which pale in comparison to the 22.6% drop on October 19th, 1987 (Black Monday) and the 12.8% decline on October 28th, 1929 (Wall Street Crash).

This correction unnerved investors due to its swiftness as it was accomplished over just nine trading days.  But corrections aren’t unusual and aren’t always a sign of anything wrong with the economy.  According to Deutsche Bank, the stock market on average has a correction every 357 days, or about once a year.  Since the bull market began in March 2009, corrections have occurred even less frequently.  Over this last 9-year span we have had only five, with the prior one occurring in February 2016.

The good news is that stock market corrections rarely last long.  Based on research conducted on the Dow between 1945 and 2013, MarketWatch determined that the average correction cost stocks 13.3% and lasted 72 trading days, or about 14 calendar weeks.  Corrections are far more damaging to short-term market traders than to buy-and-hold investors.

Did something in the economy bring on this latest correction?  The data doesn’t point in that direction.  Fourth quarter GDP did slow, growing 2.6%, a bit less than the 3%+ readings of the prior two quarters.  However, growth looks better than the headline number as consumer spending rose 3.8%, the fastest pace in three years, and capital spending was up 6.8%.  A decline in inventories and a surge in net imports subtracted 0.7% and 1.1%, respectively, from GDP.  We would expect production to replenish inventories and the weaker dollar to reverse these declines.  As of February 9th, the Federal Reserve of Atlanta projects 4.0% GDP growth for the first quarter.

Other economic readings look solid.  The U.S. economy added 200,000 jobs in January and the unemployment rate was unchanged at 4.1%.  Average hourly earnings grew 2.9%, the fastest growth since June 2009.  Car sales recorded an annual selling pace of 17.1 million units, down slightly from the 17.4 million pace of a year earlier.  The housing market turned in its best performance since 2009 as overall home ownership hit 64.2% in 2017, up from the recent low of 62.9% in 2016.  These indicators point to steady and possibly even accelerating growth.

The global economy is also performing well. The October 2017 forecast from the International Monetary Fund projects 2017 global GDP grew at a 3.6% pace and is set to accelerate to 3.7% in 2018.  According to the same forecast, Asia’s projected GDP growth is 5.6%.  In late January, the 19-country EuroZone reported GDP growth of 2.5%, the fastest pace since 2007, with France accelerating to growth of 1.9%, its strongest pace since 2011.

While the economy doesn’t look like the cause of the correction, we can speculate on other reasons.  According to Lipper U.S. Fund Flows data, after pulling money out of the stock market in both 2016 and 2017, investors deposited $60.7 billion in January.  This fresh money likely was put to work, helping drive the Dow to its peak on January 26th, up 7.7% for the year.  This short-term demand has reversed as investors pulled out $23.9 billion in the first week of February.

The wage gain of 2.9% reported on February 2nd was a point of focus.  Investors fear that a pickup in wage growth will be inflationary, leading the Federal Reserve to raise interest rates more rapidly than expected.  This concern was magnified by a Labor Department report on the previous day that productivity of workers decreased 0.1% in the fourth quarter and grew only 1.2% for all of 2017, far below the average annual pace of 2.1% observed since 1947.  Without productivity gains companies can’t offset wage gains to maintain their profit margins and are more likely to raise prices, which is inflationary.  Both outcomes are bad for stock prices.

Fiscal stimulus could also stoke inflation.  Tax Reform is projected to add $1.5 trillion over the next 10 years into the pockets of businesses and consumers.  A further increase of $300 billion of spending on defense and domestic programs over the next two fiscal years comes from the recently negotiated federal budget deal.  This stimulus could be inflationary as companies compete for workers and raise prices in the face of stronger demand.

The market will be watching new Fed Chairman Jerome Powell very carefully to discern clues on the future direction of interest rates.  The Fed has said it expects to raise interest rates three times over the course of 2018.  If this occurs the Fed Fund rate would be 2.0%-2.25%, still somewhat short of the roughly 3.0% rate we feel is neither stimulative or contractionary for a normally functioning economy.  The bond market seems to have taken notice as the 10-year Treasury rate has increased to roughly 2.8%.

For buy-and-hold investors, the correction coupled with very strong earnings growth has eased market valuation concerns.  With 68% of the companies in the S&P 500 reporting through February 9th, FactSet Research projects fourth quarter S&P 500 company composite sales and EPS growth of 8% and 14%, respectively.  Importantly, sales growth is accelerating, with the fourth quarter recording the fastest pace in six years.  For all of 2018, analysts expect sales growth of 6.5% and EPS growth of 18.5%, aided by corporate tax reform.  This has reduced the 12-month forward P/E ratio of 16.3, 2% above the 5-year average of 16.0 and 14% above the 10-year average of 14.3.

Daniel J. Boyle, CFA