By Camp R. Wynn, CFA, principal and trust officer, Colonial Trust
The S&P 500 hit an all-time high Jan. 26. By midday Feb. 9, it was trading 11.5 percent below its high. Corrections of 10 percent are a typical market occurrence. The S&P 500 has had 36 corrections of 10 percent since 1950.
This correction feels different in two ways. First, we have not seen a correction in some time. Prior to last week, the market had not seen a 3 percent correction since the presidential election or a 5 percent correction in more than 400 trading days. The market averages a 5 percent correction about every four months. Second, the speed of this correction has been jarring. The market moved from all-time highs to a 10 percent correction in fewer than 10 days. A long period of no downside volatility, followed by extreme downside volatility, makes this feel different.
It is logical to ask, “Is this different?” To answer this question, we first need to understand what caused this correction. The lack of a correction and strong market results meant the market was ripe for a pullback and only needed a catalyst. The catalyst came Feb. 2, with an increase in average hourly earnings of 2.9 percent, which was above expectations. This strong number caused markets to consider the possibility of higher inflation, which leads to higher interest rates and tighter monetary policy from the Federal Reserve. Low interest rates are good for stocks and all risk assets, and high rates are not. This signal of inflationary pressures caught the market off guard, and anticipation of higher interest rates served as the catalyst for the correction.
Every correction has its own aspect that makes it different. In this correction, the distinction was investors betting the days of steady and predictable market increases with no volatility would always continue. There were securities created to allow investors to profit from this lack of volatility. It created a self-reinforcing cycle in the derivatives market where investors sold volatility, thereby driving down the price of volatility, allowing them to profit from the falling volatility — rinse and repeat. Like all financial innovations, this strategy worked until it died of its own weight.
The most publicized example of this was an investment that profited from a decrease in the index that measures volatility (the VIX). The ticker of this security was XIV. This security began 2016 at $50.29 and reached an all-time high of $145 on Jan. 11 before falling to $5.37. This short volatility trade has worsened this correction because the players in this trade must unwind their positions, creating wild swings in the market. For example, on Feb. 6, the Dow moved between positive and negative 27 times in a day. Corrections are always frightening, and when coupled with the unknowns of this volatility trade and the wild swings it’s creating, this correction is especially jarring. This has prevented long-term investors from coming back into the markets at cheaper prices. There is a collective sentiment of waiting until things settle out before getting back into the market.
During a correction, it is helpful to take a step back and see if economic fundamentals have changed. The fundamentals are strong and improving. Real GDP growth in 2017 was 2.3 percent, and the second half was stronger than the first. Unemployment is 4.1 percent, and the U.S. economy created 2.17 million jobs last year. Business and consumer sentiment remains high. Companies in the S&P 500 reported record earnings in 2017. The strong economy and tax cuts have analysts forecasting more than 25 percent growth in corporate earnings in 2018. Expectations for economic fundamentals have improved over the past few months.
A byproduct of improving expectations is higher interest rates. The economy and the market have become accustomed to the support offered by low interest rates since 2009. The justification for low rates has been tepid growth, making it reasonable to expect higher rates to accompany stronger growth. The market will digest higher rates and higher inflationary pressures, and the Fed will manage monetary policy to prevent excessive inflation. As I examine the fundamentals, the only change over the past month is quicker growth and slightly higher interest rates, which I don’t believe will increase to a level that will end this expansion in the near term.
I think it wise to take a long view of markets and economic fundamentals. Portfolios should be managed when your view of the economy-at-large changes, not by short-term changes in the market. While we have not seen a correction in some time, they are a part of the market and should be periodically expected. I believe that in time, economic growth and earnings, not short-term investor sentiment and volatility, will determine the course of stock prices.
