All last year, we were waiting for the 10% correction in the United States equity market that never came. By the fourth quarter, many investors were beginning to think stocks would never go down, especially with real GDP growth picking up to 3% in the U.S. and spreading to other economies globally. All this was reflected in the data for market enthusiasm. The indicator I look at most closely is the Ned Davis Crowd Sentiment, which I like because this tool is based partly on transaction activity. When the reading gets into the 70s, it’s warning that investor optimism is excessive. At the beginning of February, it was close to 80, where I had never seen it before. Investors were euphoric, making stocks vulnerable to a correction should any piece of bad news appear.
The employment report for January proved to be the trigger. The 200,000 jobs created was a sign the economy was still showing strong growth. The problem, however, was with average hourly earnings; they rose from 2.5% during the last year to 2.9%, suggesting that the labor market was tightening. It was becoming hard to hire workers at all skill levels and companies were being forced to pay more to employ the people who would enable them to provide the goods and services demanded in an accelerating world economy. Steve Einhorn of Omega drilled down on the unemployment report and concluded that the aggregate change in labor income was negative year-over-year because the average workweek has shortened and pay increases were concentrated among supervisory workers. As a result, wages may not be as big a problem as the market seems to believe. If wages were rising, however, inflation, which had been basically dormant, might start moving higher. If inflation were starting to pick up, that might be reflected in interest rates. In fact, the 10-year Treasury note has risen to 2.90%, fifty basis points higher than just a few months ago. Stocks compete with bonds as investment alternatives. In several years in the recent past (2013 and 2016-17), the yield on the Standard and Poor’s 500 was higher than the 10-year Treasury, an unusual condition that made equities especially attractive. Now, the yield on government securities is rising and bonds are becoming more competitive with stocks. This condition, coupled with the euphoric sentiment data, precipitated the decline in stock prices and gathered momentum quickly. It took less than two weeks for equities to drop 10%.
Now what happens? Let’s take a look at the fundamentals, and they are in good shape. Profits are still rising. With the tax cut, S&P 500 earnings should be $160 this year and the index is selling at about 16 times earnings. This is not an excessive price by historical standards; they could be $170 in 2019. The leading indicators for the overall economy are still moving higher. They usually begin to roll over a year or two before a recession begins and they are not showing signs of that yet. While average hourly earnings increases have reached 2.9% and may go higher, trouble has not occurred in the past until they had approached 4%.
The market usually begins to buckle when the Federal Reserve is aggressively tightening. We know that the new Fed Chairman Jerome Powell wants to “normalize” interest rates which would mean bringing the Fed funds rate up to 2.75%, about double where we are now. He is likely to do that slowly, beginning in March with a quarter-point hike and he may not do even that if the decline in equities continues. The Fed is unlikely to move rates higher abruptly because there are too many cases in the past where the consequences of sharp increases have created dire circumstances for the economy. Powell was selected by President Donald Trump because he was basically in the dovish Janet Yellen model and not likely to deviate significantly from her policies. Trump wanted to have his own person in the job, but he opted against the extreme alternatives.