Stocks staged a sharp rally yesterday cutting losses to date in October to less than 4%.
One needs to understand that computer generated trading accelerates as volatility increases. One measure of volatility embraced by Wall Street is the VIX which keys off of the size of put and call premiums. It is associated with risk in that premiums rose as volatility increases. They are highly correlated. Thus, while the VIX doesn’t measure volatility directly, it is deemed to be as true an indicator of volatility as exists, at least in simple form. While logic might suggest the VIX can spike in both up and down markets, it only seems to do so during market corrections or the steepest part of bear markets. The broad buy and sell programs generated by computerized traders accelerate as volatility increases. When multiple programs hit the market at the same time, you see the spikes we saw last week on the downside and yesterday on the upside. While market pundits might be able to attach a fundamental reason for these spikes, computers are not basing buy or sell programs on Fed policy or geopolitics; they simply kick in based on technical factors that algorithms say have a high probability of generating a short term trading profit. Of course, there might well be a connection between Fed policy and the fundamental deterioration that led to the spike in volatility and the sharp selloff last week. But the actual reaction was all technical.
When these downward spikes occur, trading and price movements often accelerate into the close of trading, especially in the last half hour. Thus, what we have is a rather slow steady move up mixed in with sharp corrections keyed off of volatility. For all of 2018, that has come to net an overall market increase of 0-5% with the lower end of the range relevant for value-oriented portfolios and the top end for growth oriented accounts. That coincides with a year where earnings are up close to 25% offset by the impact of an approximate 75-100 basis point increase in interest rates. At this juncture next year promises much smaller increases in earnings. The key, therefore, will be what happens to interest rates.
That leads me to Fed policy. Jerome Powell has laid current strategy out rather explicitly. There are likely to be approximately 3-4 more rate increases between now and mid-2019 to return short term rates to what the Fed deems to be normal. Normal is the rate that allows the economy to continue to grow along side an inflation rate that is at or a bit over 2%. Given there is a lag between the time rates are increased and their impact on the economy, the Fed has to rely on any forward looking data it can find to estimate the future impact of current rate increases.
The Fed, therefore, can lead us down one of three paths. Behind window number one (as in Let’s Make a Deal), short rates get to 3% but the economy slows more than anticipated, due to some combination of tariffs, weak housing, slower growth overseas, etc. Under this scenario, they yield curve might even invert. Inflation almost certainly be less than expected. In hindsight, the Fed would have done too much, too fast and could even sow the seeds for recession. This is the fear that Donald Trump shows every day he chastises the Fed’s actions.
Behind window number two, the Fed gets to the same 3% but it can’t move fast enough to stop the accelerating freight train we all call inflation. With wages rising, higher oil prices, etc. inflation starts to push toward 3% amid stronger than expected growth. Central banks worldwide slow or ease QE programs. The 10-year Treasury yield moves over 4%, maybe well over 4%. The Fed would have to keep raising rates well beyond 3% to try to limit the impact of inflation.
Then there is window number 3. That’s going to be the one with that holds the fancy car or the vacation package. It is the one where the Fed gets it right. 3% turns out to be just about the perfect guess for normal inflation combined with steady sustainable growth. Under this scenario, the Fed can stop raising short term rates at 3% and the 10-year only rises a bit more, perhaps into the 3.5-4.0% range. Growth goes on for many more years and everyone smiles.
Obviously, we all want the last outcome. I can’t put odds on which will be right. Given the size of quantitative easy programs promulgated by central banks worldwide, the unwinding process this time around will be very tricky. Stopping a car going 5 mph is much easier than stopping a car going 105 mph. So, far there are no signs of going way off course. Yes, housing is slowing in response t higher rates but it isn’t a disaster like in 2008. Debt outstanding is high and there are some signs that credit quality is deteriorating a bit, especially in the shadow banking areas. Sovereign deficits are rising and debt service is becoming a noticeable issue. Thus, there are some clouds aloft but no obvious rainmaker yet.
As I say to everyone, tell me S&P earnings for 2019 and the year end 10-year Treasury rate and I will tell you where the stock market will be a year from now. I suspect it will be easier to be close to forecast on the earnings front than on the interest rate front. Up to the start of 2017, the Fed only instituted two rate increase in 10 years. Since then there have been six and we know, barring sudden changes in the economy, 3-4 more are on their way. Simply said, the hard part of QE unwinding is right in front of us. Therefore, forget the tariffs, the mid-term elections and geopolitics. For the next 12 months or so, it’s all about how well the Fed does its job. So far, it is on course. That offers some comfort. The tricky part lies just ahead.
With that said, there are no obvious disasters behind any of the three windows. The worst outcome is a modest mid-course correction, maybe even a short mild recession. At the same time, none of the world’s leads to an investor’s version of Shangri-La. The bull market is simply too far along for that to happen soon. Forward looking returns are going to be more moderate than they have for the past decade. That’s an outlook we all can live with.
Today, Eminem is 46. Ziggy Marley is 50. Today is also the 100th anniversary of the birth of Rita Hayworth.
James M. Meyer, CFA 610-260-2220
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