Volatility Returns

Unwelcome, Unpleasant, Inevitable. The recent spike in volatility has certainly caught the attention of investors over the past several days and as corrections go, the market drop has been quick and sharp.

Many market observers have commented that the sell-off has been reasonably orderly but exacerbated by quantitative trading programs and the deleveraging of institutions. As you know, we have been expecting some form of market correction, but one never knows exactly when and how this will occur. What precipitated the beginning of the sell-off?

Friday’s employment report was stronger than expected with a key headline of a 2.9% increase in year-over-year average hourly earnings for workers.

An unemployment rate of 4.1% is viewed as near ‘full employment’ and faster wage growth (consumers account for 70% of GDP) can lead to corporate earnings pressure and higher inflation.

The Atlanta Fed has a GDP forecast measure called GDPNow which has been reasonably accurate historically. GDPNow is predicting Q1 2018 GDP growth at 5.4%. This would represent the fastest rate of U.S. economic growth in many years. Questions have been raised whether the Fed is “behind the curve” on raising short-term interest rates; thus, resulting in a faster pace of growth in inflation. If so, a faster pace of interest rate increases by the Fed could be necessary and this could inhibit economic growth.

Higher interest rates eventually lead to broader competition for stocks. The 10-year U.S. Treasury yield has increased from 2.02% in early September to almost 2.9% last week and 2.76% this morning. Yields have dropped in the last few days as demand grew for safer assets, given the flight from equities.

U.S. stocks were trading at a valuation levels (price to earnings ratio or P/E) around 18.5 times forward earnings prior to the sell-off. This is slightly above the long-term average for P/E levels. Stocks tend to trade at higher P/E multiples when inflation and interest rates are lower. With higher wage growth, faster economic growth and maybe higher inflation, P/E multiples could adjust lower through declining stock prices. In fact, as we write this commentary, P/E multiples have fallen back to near their historical long-term average of 17 times earnings. Importantly, consensus estimates for U.S. forward-looking corporate earnings growth are estimated to advance a robust 15% for 2018 as compared to 2017.