A Time to Reflect, Not a Time to Run

If you own stocks, we will venture out on a limb and say Wednesday was not fun. The S&P 500 fell -3.3%, its fifth straight decline.^[i] Most European gauges fell, too. The S&P 500 is now down -4.9% in price terms since September 20, its most recent high, nearly halfway to correction territory.^[ii] Whenever stocks fall fast, the urge to flee can be strong, but we think it is wrong—even dangerous—for those needing long-term growth to reach their financial goals. If you sell after a drop, and stocks bounce before you reinvest, you have locked in losses and missed a chance to recover quickly. That can be an unnecessary setback. So in our view, at times like this, the best thing investors can do is take a breather and think critically about whether anything has fundamentally changed for the worse since stocks’ decline began.

Media broadly seem to be pinning Wednesday’s drop on Fed rate hikes, rising bond yields, US-China trade tensions and some iffy economic data (namely auto sales, down -4.4% q/q in Q3, and housing).^[iii] We struggle to see how anything has radically changed on either front in the past 15 trading days. Yes, long rates have risen since then, and the Fed has jawboned about more rate hikes. But long rates were also rising a bit before then, and the Fed was similarly jawboning. Overall, we think sentiment has this backward. Fed hikes are generally negative only if they risk inverting the yield curve. If you expect short and long rates to rise together, overall and on average, that is more consistent with a stable or even steeper yield curve. Thanks to 10-year Treasury yields’ recent rise, the US yield curve spread is about where it was before the Fed last raised rates on September 26.

Mind you, our forecast isn’t for long-term interest rates to rise. Bond markets are volatile, and yields’ spike seems sentiment-driven. It is also global, as rate movements typically are. While sentiment can make bonds swing in the short term, in the long run, bond prices are a function of supply and demand, with inflation expectations a primary influence. In general, long rates typically won’t rise a lot and stay there without a material increase in global inflation. Today, prices are benign. While headline inflation metrics are up lately, this stems largely from higher oil and gas prices—usually a fleeting factor for CPI. Stripping out volatile energy and food prices, “core” inflation readings are low and stable globally. Many in Europe are around 1% y/y or even lower, barely budging over the past year. UK and US readings are a little higher, in the neighborhood of 2%, but this isn’t astronomical by any stretch of the imagination. Nor is inflation likely to soar, given most broad money supply growth metrics have slowed lately. As sentiment stabilizes, markets should better see this.

Trade relations haven’t significantly darkened since late September either. The US and China were squabbling before then. They threatened to tax all of each other’s imports months before that. China threatened non-tariff retaliation months ago. Hence, investors have speculated for months that China might fire back by blocking mergers involving US companies, selling its holdings of US Treasury bonds and wielding its regulatory might—all of this week’s big fears. As best we can tell, there is nothing new here. We say that with full knowledge of Vice President Mike Pence’s recent speech on Chinese relations, notable for its tough rhetoric. It merely encapsulated 21 months’ worth of the administration’s China chatter in one handy package.

As for economic data, our firm’s founder and Chairman, Ken Fisher, likes to quip that no US recession ever began because auto sales fell. Cars might seem like a timely economic indicator, as they represent consumers’ willingness to splurge on big-ticket items as well as their ability to secure financing. But if that is the case, then why have monthly auto sales mostly fallen since peaking at an 8.2 million seasonally adjusted annual rate in June 2014? In September, that number was down to 5.2 million. Yet the economy has grown quite nicely in the last four-plus years, which have also been quite good for stocks. Autos’ steepening slide in 2018 has coincided with faster GDP growth. At some point, falling auto sales will probably coincide with a weakening US economy, but there is no way to know in advance when that will be. However, we can look to indicators like The Conference Board’s Leading Economic Index (LEI) for hints. Presently, that index is high and rising, most recently up 0.4% m/m in August.^[iv] Numerous other indicators, from purchasing managers’ indexes to loan growth, are also expansionary—not just in the US, but globally.

Housing isn’t any better of an indicator. People think it is, because the housing bubble’s aftermath was part of the financial crisis’s backstory. But that was an aberration, tied to an esoteric accounting rule forcing banks to take massive paper losses when hedge funds fire-sold exotic securities tied to temporarily troubled mortgages at pennies on the dollar. (See this and this for more.) Nothing resembling that exists now. Residential real estate is just 3.9% of GDP.^[v] That segment, we would note, is rising, as new home sales continue growing. The nexus of alleged weakness is existing home sales, which aren’t part of GDP. Plus, one of the primary headwinds against sales is a supply shortage, which the sector has been battling since the recession ended—particularly in high-demand coastal metropolises. So here, too, it seems too much of a leap to go from one weaker real estate metric to big, broad economic problems.

Global factors haven’t much changed lately, either. Most economic indicators showed growth before the S&P 500 peaked and still show growth now. The IMF downgraded its global growth forecast, but it has done that many times throughout this global expansion. Besides, they now forecast 3.7% global growth this year, which is a fine rate and only 0.2 percentage point lower than the prior. The global yield curve has actually steepened a wee bit—good, not bad. Brexit negotiations are a mess, but that isn’t new. China is slowing, but it has been for years. It has also been trying to cushion that slowdown with targeted stimulus for years, so Monday’s monetary policy easing isn’t new.

Bull markets generally don’t end when economic data are strong and the headlines are full of long-running fears. Usually, they end when headlines are broadly cheerful and investors overlook weakening leading indicators. That was the case in March 2000, when the inverted yield curve and slipping LEI gained little notice.

So, we urge investors to stay patient. Remember stocks are volatile and can swing hard for any or no reason in the short term. Sentiment is a fickle beast. But over time, stocks weigh fundamentals, and it seems to us fundamentals broadly remain as positive today as they did when stocks were notching all-time highs just 15 sessions ago.