Volatility strikes back. Is this the start of a bear market?

After an exceptionally strong year in markets, volatility has struck back in recent days. At the time of this writing, the S&P 500^® Index has fallen roughly 10% from its record close on Jan 26.¹ The Australian equity market has seen falls of smaller magnitude, given it did not participate to the upside through most of 2017 and January of this year. Nevertheless, the age-old adage of the US sneezing remains, and sustained volatility in the US is likely to weigh on our domestic market. Many of our clients are asking us if this is the start of a bear market. Our answer—probably not. Bear markets are almost always caused by a decline in the real economy. That’s because it takes a recession to simultaneously damage both the valuations multiples AND earnings growth of businesses. And right now, this does NOT look like a recession scare to us. Instead, two distinct forces are conspiring against global equities.

• First, the high frequency U.S. data suggests inflation is starting to re-accelerate—wage inflation in the January employment report surprised to the upside and touched its highest level since 2009.²This pushed the 10-year U.S. Treasury yield up to its highest level in four years.³ Higher discount rates are proving to be a challenge to the elevated valuation levels of U.S. stocks. In comparison, the Australian 10 year has pushed up to 2.9%, similar to the start of 2017. Australian equity valuations are not as stretched as that in the US, so any re-rating of valuations will not be as severe.

• Second, investor sentiment has taken a hit—market psychology was bordering on euphoria in late Januaryand is coming back down to earth now. For example, the share of respondents expecting stock prices to increase in the Conference Board’s Consumer Confidence Survey⁴ hit an all-time high in January. Our research teams have also pointed to evidence that a lot of the selling activity has been driven by technical reversals in trend-following strategies. A step back toward rationality should be a healthy development for the market outlook. The Australian market has been a bit of an anomaly through this period, missing out on the ride to euphoria in January. To put it in context, the S&P/ASX 200 actually fell by 0.5% in January, while the S&P 500 climbed 5.6%.

Economic and earnings fundamentals, by contrast, are actually quite robust at the moment. The J.P.Morgan Global Manufacturing PMI^™ hovered close to an 82-month high in January.⁵ And the fourth quarter corporate earnings season in the U.S. is tracking ahead of schedule—over 80% of S&P 500^® Index companies are beating consensus revenue estimates (i.e., one of the highest beat rates in many years), and earnings growth is tracking north of 13%.⁶ Earning season for Australia kicks off in the next fortnight, and we note that expectations for Q4 earnings growth are much more muted than they are in other regions.

Bottom line: We will continue to monitor economic and market conditions carefully in the coming days. But for the time being, this looks like a healthy correction in markets, rather than the onset of a bear market. Depending on the depth of the dip that we see in asset prices, this selloff could create an attractive entry point for investors to take more risk.

Recent events highlight the importance of a diversified, multi-asset investment strategy. Even with the latest selloff, valuations on U.S. equities are still expensive. And elevated valuations create a negative asymmetry to the market outlook—the upside potential is limited, but the drawdown potential can be significant.

It can be difficult to stay invested during periods of market stress. Buying low and selling high is hard. But it is precisely this emotional aspect to markets that creates opportunity for a disciplined investment process to add value in the long-run.

¹ Source: https://www.cmegroup.com/trading/equity-index/us-index/e-mini-sandp500.html
² Source: Bureau of Labor Statistics
³ Source: Thomson Reuters Datastream
⁴ Source: Conference Board
⁵ Source: J.P.Morgan and IHS Markit
⁶ Source: FactSet

February 2018 By Paul Eitelman