Newsletter – Quarter 1, 2018

It looks like Isaac Newton’s observation under the apple tree can be applied to the stock market as well as to fruit: What goes up must come down (at least a little bit). After a strong January concluded an unusually steady two-year rise, the S&P 500 whipsawed to its first 10% correction since early 2016. The heightened market volatility ended a historically long stretch of market calm. In fact, the S&P 500’s longest streak of monthly gains since 1959 ended at 10 in February. The index also incurred its first pullback of at least 5% in 404 trading days, the longest stretch in nearly 90 years.

There are several reasons for the recent return of volatility. Chief among them is the fear of rising interest rates. Early signs that inflation has started to pick up surfaced in February, prompting fears that the Federal Reserve will need to raise rates more aggressively than anticipated. This resulted in Treasury bond yields rising to four-year highs. Historically low interest rates, induced largely by the ultraloose monetary policies put in place by the Fed and other central banks during the Great Recession, have served to boost stock valuations and suppress volatility by making equities more attractive than low-yielding fixed-income alternatives. With the economy now on more stable footing, the Fed and other central banks are starting to scale back their crisis-era stimulus programs through rate hikes and balance sheet reduction. It is ultimately a healthy sign that the economy finally now appears to be on stable enough footing to begin the process of normalizing rates, and we expect this normalization to take place very gradually. Still, a major underpinning of the bull market is starting to be removed, and the market is likely to be more turbulent as a result.

Anxiety over trade friction has also added to market volatility. As part of its effort to reduce the U.S. trade deficit, the Trump administration recently launched tariffs on the imports of steel and aluminum from some of the country’s trading partners and announced additional tariffs on a broader array of imports from China. The measures announced so far are small in the context of global trade and would likely have a very minimal impact on the U.S. and global economies. However, there is concern that the tariffs might signal the start of a broader protectionist trade policy that could result in a global trade war. Such a turn of events would have the potential to disrupt the global economic expansion that has been a key driver of the market rally over the past year. While the administration’s trade policy has yet to fully take shape and we are still a long way from the development of an all-out global trade war, it is an additional risk that has disrupted the market in recent weeks and is likely to linger for a while as it all plays out.

The market’s lofty valuation has been another contributing factor to the recent turbulence. Following its run-up in January, the S&P 500 traded at nearly 19 times forward earnings, well above its historical average of 15. There were some solid fundamental reasons for this as the global economy has strengthened, corporate earnings growth has improved, and interest rates remain low by historical standards. However, a high market valuation lowers the bar for even the sign of unwelcome developments to trigger a market reaction. As a result, when interest rates climbed a little faster than expected in February and tariff concerns arose in March, the market was ripe for a correction. The silver lining to the recent pullback is that the market now trades at a more reasonable 17 times forward earnings. Though the market as a whole is still not cheap, the decline has created opportunities to purchase a few more individual stocks at attractive valuations.

While volatility has spiked and the recent market pullback has been sharp, it is important to note that such turbulence is not unusual. Far more atypical was the market’s continuous climb higher for most of the past two years. Though some cracks have started to appear in the bull case for stocks, the overall fundamentals remain pretty positive. Corporate earnings are expected to grow at a very strong 19% clip this year (boosted in part by tax cuts) and by a still solid 10% next year. And many companies are sharing this good fortune with shareholders through healthy dividend increases and stock buybacks. We expect this to keep the bull market on track for a while longer, though we anticipate a bumpier ride along the way. While volatility can certainly be unnerving for investors, it often presents chances to buy quality individual stocks that have fallen for non-fundamental reasons. We expect to take advantage of such long-term investment opportunities created by the short-term effects of market volatility.


Gamble Jones Investment Counsel