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Correction: Volatility has returned

Money Tree blowing leaves

By Kyle Tetting

This year is off to a strong start. Continued global growth and prospects from tax reform have raised expectations for corporate earnings. At the same time, each new release of economic data suggests more of the Goldilocks growth story (not too hot, not too cold) that has underlined the past few years. However, just as we began to tie a bow on January’s strong returns, a single dark cloud emerged.

Friday Jan. 26 marked another record close for the S&P 500. The broad measure of U.S. stocks gained 7.5% in the first four weeks of the year. Just nine trading days after that peak, the S&P had fallen 10.2%, earning the official label of a stock market correction.

Typically, a correction comes from a shock to the system. Investors get overly worried about the direction of corporate profitability, stretched valuations or both. Major geopolitical issues can exacerbate such concerns.

While valuations have been stretched, corporate earnings forecasts have been improving. At the start of 2018, the full-year forecast for earnings growth was 12%. By the middle of January, that forecast had risen to 16%. It now stands around 19%. Based on those forecasts, the price-to-earnings ratio, or the price paid for a dollar of earnings, had been getting cheaper even as stock prices climbed.

Higher expectations for corporate profitability are an unlikely catalyst for a stock market correction. However, underlying the rosier outlook is rising optimism about the economy, which has fanned fears of inflation. To be clear, inflation remains below the Federal Reserve’s target of 2%, but the potential for accelerating inflation appears greater than it has in years.

The prominent inflation fear is rising wages. The unemployment rate is near 4%, and more employees feel confident leaving their jobs to find better prospects. Conditions that historically have led to higher wages have been building for years, but so far, wages have grown only modestly. In its most recent meeting minutes, the Federal Reserve monetary committee cited no clear signs that wage inflation is rising.

Ultimately, investors fear inflation because it often ends with the Federal Reserve raising interest rates to keep prices in check. That can be a double whammy for stocks: Making bonds a more attractive investment option while also lowering the present value of future corporate earnings. With stock prices already elevated, fears of inflation and the Fed’s reactions precipitated the stock market correction.

To date, markets have recovered much of the loss from the correction, with the S&P 500 now up more than 1.5% through Feb. 28. More noteworthy, we are finally seeing the return of more typical levels of volatility.

By many measures, 2017 was one of the calmest years on record for stocks. Day-to-day price movements were minimal, and the overwhelming direction was up. This year has brought the return to normal volatility that we spent much of 2017 preparing for. That return reminds us to focus on the duel forces behind the long-term movement in stock prices: Earnings and interest rates.

Inflationary pressure could temper expectations for stock returns by raising interest rates. It also could contribute to earnings forecasts by allowing corporations to finally raise prices.

A return to more normal levels of volatility don’t necessarily signal the end of the stock market’s latest run. While strong earnings point to continued optimism, the return of volatility suggests a market that is trading more on data and less on euphoria. Long-term investors should welcome that but also prepare for bigger moves across investment categories as winners and losers emerge.

Appropriate balance will be the key to success, allowing investors to take advantage of opportunities afforded by a strong global economy while also managing the accompanying risks.

Kyle Tetting is director of research and an investment advisor at Landaas & Company.

Learn more
The ups and downs of volatility, a Money Talk Video with Steve Giles
Earnings, interest rates and valuations, a Money Talk Video with Brian Kilb
Market corrections: Always be prepared, a Money Talk Video with Brian Kilb and Marc Amateis
Seeing how your equities are balanceda Money Talk Video with Kyle Tetting
Beginners Guide to Asset Allocation, Diversification and Rebalancingfrom the U.S. Securities and Exchange Commission
Rebalancing Your Portfoliofrom the Financial Industry Regulatory Authority

(initially posted March 1, 2018)

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