On Monday (February 5, 2018), the S&P 500 fell 4.1%. This was the steepest decline since August 2011. Should we be worried? Right now, I don't think so. Let's take a rational look at what's going on with this market.
While Monday's decline was steepest since August 2011. The decline back then took place after Standard & Poor's cut the United States' credit rating from AAA to AA+. By the look of it, the current sell-off was fueled by the prospects of economic growth, inflation, and the possibility of continued interest rate hikes. Hmmm. The same reaction to two, very different outlooks. Is that rational?
Throughout much of 2017, investors seemed to be concerned about the flattening of the U.S. Treasury yield curve. A flat yield curve happens when there is very little difference between short-term and long-term rates for U.S. Treasury bonds. Typically, the yield curve curve slopes upward. Meaning that short-term interest are lower than long-term interest rates. In 2017, there was a concern that continued flattening of the yield curve could lead to an inverted yield curve. Historically, inverted yield curves, specifically when the two-year Treasury yield is higher than the ten-year yield, have preceded recessions. Each of the four recessionary periods since 1980 have occurred either while the yield curve was inverted or within one year of when an inversion occurred.
On the other hand, a steep yield curve (ie. short-term interest rates are much lower than long-term interest rates) often indicates a period of inflation. Increased inflation is often associated with strong economic activity. Since the beginning of this year, the yield curve has steepened. This is most likely due to the forecasts of strong economic growth ahead.
According to FactSet Research, earnings reports are indicating that there has been strong economic activity. They recently stated in their Earnings Insight report, "For Q4 2017 (with 50% of the companies in the S&P 500 reporting actual results for the quarter), 75% of S&P 500 companies have reported positive EPS surprises and 80% have reported positive sales surprises. If 80% is the final number for the quarter, it will mark the highest percentage since FactSet began tracking this metric in Q3 2008." Strong economic activity is certainly preferable to a recession.
Rising interest rates, a stronger than expected jobs report, and increased wages have all been given as potential causes for the recent sell off in U.S. Equities. The speculation is that investors fear that a strong employment market will lead to inflation and cause the Federal Reserve to accelerate the pace of interest rate increases. However, these concerns are in many ways the opposite of the concerns of last year when investors feared that a flattening yield curve would lead to inversion and ultimately a recession. Now, because the yield curve has been steepening so far in 2018, this is the cause for the sell-off in U.S. Equities?! This a great example of why I say that the markets can be irrational at times!
For now, the move in the S&P 500 has functioned much like a "reversion to the mean." Since September, the S&P 500 had been in what felt like a perpetual state of being overbought. It just kept going up and up. With Monday's sell-off, that state is now over. The S&P 500 is now in oversold territory.
To wrap things up, we are in the midst of a 5% pullback in the S&P 500. U.S. Equities still are the top ranked asset out of the six major asset classes that I look at every day. International Equities are currently number two. So this is still a positive in favor of U.S. and International Equities exposure right now. Even with the two days of volatility and the market pullback, U.S. and International Equities remain firmly entrenched in the top two spots, so I continue to suggest a tactical overweight to those two areas of the market.
So what's next? We cannot know for certain, but you can rest assured that I am constantly monitoring my indicators and if anything changes, I will react appropriately. As I have said before, it is important to tune out the short-term market noise and listen to what the indicators are saying instead. My indicators have guided me safely in the past; and they will guide me safely in the future. Positioning investments toward current trends, rather than past or future presumptions, serves as the driving force behind my portfolio management methodology. If you would like to discuss anything that you read here in greater detail, please do not hesitate to contact me. Thank you.
Andrew Tapparo is the president and founder of Tapparo Capital Management, a fee-only financial advisory and investment management firm that specializes in working with individuals, families, and their closely held businesses to develop prudent, long-term strategies that protect and increase wealth.
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