Follow Up to Recalibrating to Higher Interest Rates

We suggested on Monday that it takes very little for a 10% correction to hit the stock market, but the decline was unlikely to be long lasting as long as the economy continued to grow, which is what we expect.  So, any decline might prove to be just an opportunity to buy at lower prices.  It’s only been a few days, and stock prices may be rebounding already off a sharp decline that came remarkably close to 10%, but let’s review anyway.

What caused the decline?

It seems very clear that the decline was triggered by the sizable rise in Treasury bond yields, which was in direct response to a rise in wage inflation to 2.9%.  Since September, 10-year Treasuries have risen from around 2.00% to 2.80%, with half that rise occurring within the past few weeks.  This was the trigger, but other factors were contributing influences.

1.   Investors have been worried about a “correction” for a long time because the market’s rise was so unrelenting. (This concern reflected the rise in prices without full regard to the rise in profits that actually justified higher stock prices.)  The media fed this narrative by repeatedly suggesting stocks were overvalued and vulnerable to a decline.  (Some have been saying this for years, so they will now claim they anticipated the correction, while ignoring all the years they were wrong.)  But when the market started to decline, fearful investors fled.

2.  Investors have been fed a stream of ideas that inflation would remain low and interest rates could only rise slowly for a variety of reasons. The prospect of higher wage inflation undermined that narrative.

3.  Considerable sums were invested in structured products that benefited from declining volatility, specifically in products tied to the VIX index. When the correction started, that money had to get out and this exacerbated the decline.  Those products in which they invested totally blew up and many became worthless or nearly so and were liquidated on Tuesday.  So, that game and its influence on the market are over.  We would not be surprised if such products are banned after regulators review what happened.

4.  Some strategies are designed to sell when the market goes down by some predetermined amount, which reinforces a sizable decline. The market’s rebound on Tuesday would commonly reverse some of that selling.

5.  Domestic politics has been extremely partisan and contentious, while hot spots around the world, like North Korea and the Middle East are also nerve wracking. These developments made many investors nervous.

It remains our judgment that the economy is very likely to continue its growth trajectory.  As we’ve written many times, we expect corporate profits to rise rapidly in 2018, aided by the new tax structure that isn’t even entirely built into profit forecasts, as yet.  Our longer term concern is precisely the one the market just woke up to.  We do expect inflation pressures to rise and to take interest rates along for the ride, which is precisely why we’ve been positioned so defensively in bonds for quite some time.  But while rising interest rates are a problem for stock market valuations, rising corporate profits are extremely positive and offsetting.  The stock market decline was, in part, due to the sudden realization by investors that inflation is a real concern.  And then all those other factors entered into the equation, which caused the excessive, sharp, and seemingly short lived decline.  We still expect a respectable gain in stock prices in 2018.

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