Notes on the Week AheadContributor Dr. David Kelly
A Tumble without a Theme
It’s early Monday morning and I have writer’s block. This is a little frustrating because I should have lots to write about. Last week saw a surge in volatility with the S&P500 falling by 5% on Wednesday and Thursday combined. Even with a rally on Friday, large cap U.S. stocks have now fallen in seven of the last eight sessions.
The problem is that it is pretty hard to latch on to a theme behind the tumble.
Some have said that it is overheating pressures. However, CPI data last week were pretty reassuring on this score with headline prices up just 2.3% year-over-year and core CPI up just 2.2%. These CPI numbers should translate to increases of 2.2% and 1.9% year-over-year for the September headline and core consumption deflators respectively. While there could yet be some impact from rising wages, productivity growth appears to have picked up somewhat in recent quarters, limiting any gain in unit labor costs. And although recently high oil prices and tariffs could feed through to somewhat higher inflation in the months ahead, there is little sign of a broad increase in inflationary pressures.
Real economic growth also shows few worrying signs of overheating. Data due out this week should be mixed with strong Retail Sales and inventory data being offset by continued weakness in Housing Starts and Existing Home Sales. Economic growth in the third quarter appears to have been solid, with our models suggesting an annualized growth rate of between 2.5% and 3.0%. However, much of this growth has come from inventory stockpiling, suggesting less momentum in the fourth quarter and into next year.
Another possible theme could have been worries about earnings. However, through last Thursday, of the 22 S&P500 companies that had reported third-quarter results, 19 had beaten expectations. In addition, the ratio of negative preannouncements to positive preannouncements has only risen to normal levels following two very optimistic preannouncement seasons before the first and second quarters. So far, despite grumbling about tariffs, U.S. companies appear to be continuing to churn out profits with S&P500 operating earnings per share growth likely topping 25% year-over-year last quarter for the third quarter in a row. With the selloff last week, U.S. large cap stocks ended at very close to their 16.1 average forward P/E ratio of the last 25 years, suggesting no overarching valuation issue.
Concerns about the rest of the world in general and China in particular have also been suggested as a theme for the tumble. However, PMI data from Europe and Japan remained solid in September and both appear to have good momentum entering the fourth quarter. Meanwhile, although this week’s Chinese GDP report will likely show continued slowing, Chinese authorities are clearly taking steps to improve lending and have shown themselves to be adept at macro management for many years.
Finally, there is the notion that the Federal Reserve is too aggressive with some suggesting their actions are “crazy” or “loco”. I don’t know what the Fed governors and presidents will be dressing up as this Halloween. However, no amount of costuming or face paint could transform them into “wild and crazy guys”.
The Fed has been raising rates at a pace of 0.25% per quarter over the past year, far below the average 2.5% annual pace of tightening they implemented in the last 5 tightening cycles. Even with the moves they have taken so far, the federal funds rate, now in a range of 2.00% to 2.25%, barely matched core CPI inflation, essentially implying a real short-term interest rate of close to zero. To put this in context, this represents easier monetary policy than was in place for 80% of the time in the 50 years before the financial crisis.
The Fed will likely continue to raise rates in a gradual way, boosting the federal funds rate in December and at their meetings in March and June of next year. However, this should be well understood by financial markets and shouldn’t, in itself, lead to a sharp fall in stock prices.
And so, I am left without a theme for the tumble. However, this is perhaps significant in itself. For the most part, a big correction needs a theme. In the 2007-2009 market the theme was the collapse of a housing bubble and the extraordinary edifice of leverage and derivative bets that was built upon it. In the 2000-2002 bear market, the theme was the extreme overvaluation of many tech and internet companies.
As of today, we don’t have such a theme and that should limit the depth of any immediate market decline. However, that doesn’t mean that such a theme couldn’t develop in the months ahead. Because of this, investors would be well-advised to consider whether market movements have added unintended risk to their portfolios in the last few years. In other words, a tumble without a theme is not so much a signal to sell but a reminder to rebalance.