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U.S. Stock Market Illustrates Investors Should Always Be Prepared

As anyone who has had the misfortune of riding out a severe storm knows, the time to prepare is before the event, not during. Likewise, preparation for inevitable market corrections should be looked at while the skies are clear, because storms can come up quickly. There were several contributors to this early October’s rout; not least being U.S. Treasury yields breaking out to multi-year highs, causing consternation among equity investors and contributing to the sharpest two-day pullback in equities that we’ve seen in months.

We do believe we have passed a threshold of sorts with regard to the relationship between bond yields and stock prices. During deflationary/disinflationary periods—like the one we’ve been in since the financial crisis—bond yields and stock prices tend to be positively correlated. But once disinflation gives way to higher current and expected inflation, the correlation between bond yields and stock prices tends to move from inverse to positive. This is what we are recently seeing. We do not think this warrants that investors flee for the equity exits, but our more cautious stance over the past year keeps us in the camp of recommending that investors have no more than their normal long-term allocation to equities (hence our “neutral” rating on stocks). At a more tactical level, we recently moved to a more defensive stance from a sector perspective, and believe health care may be a good place to look for potential opportunities in the current environment.

Prior to this correction, stocks were at all-time highs; with support coming partly from the massive amount of cash being returned to shareholders by companies through buybacks and dividends. S&P reports that through the end of the second quarter, buybacks were up 49.9% from the year ago level while also setting a record for any 12-month period. Additionally, during the second quarter, dividends for S&P 500 companies totaled $111.6 billion—a new record and up over 7% from the first quarter. The rub to this market support is that it will inevitably begin to fade as we move into 2019.

But the economy still looks good!

It’s a common refrain we hear from investors who have pushed back against our more cautious stance. But we’ve seen that the best stock returns tend to come when economic data is weaker, not stronger—remember the stock market is a forward-looking mechanism. Stocks have an uncanny ability to figure out when the data is at or near its peak and just beginning to roll over (i.e., stocks tend to discount inflection points). Stocks rarely “wait” for the data to deteriorate meaningfully.

Clearly, we are living in the far right bar presently with the unemployment rate dropping to 3.7% in September, alongside non-farm payroll growth of 134,000 jobs and prior month upward revisions of a combined 87,000 according to the Department of Labor. The unemployment rate is now at the lowest level since 1969. But stocks have been reflecting this improvement throughout the bull market; while the likelihood the rate moves significantly lower from here lessens with time.

Despite the tight labor market, wage growth remains relatively contained, with average hourly earnings rising 2.8%, a tick lower than the previous month’s reading. However, several key leading indicators of future wage inflation, such as the NFIB survey noting a record number of responders reporting raising compensation, suggest the path of least resistance is higher. That’s great news for Main Street, but less great news for Wall Street as it likely means tighter profit margins along with tighter monetary policy. But the earnings picture looks so good!

That’s another refrain we hear from investors who have questioned our more cautious stance. We don’t disagree that earnings are important drivers of stock prices, or that expectations for the upcoming third quarter earnings season are a strong 21% according to estimates from Thomson Reuters. But that’s a high bar to meet, while expectations heading into next year are for a significant slowing in growth, which could take some of the wind out of the bulls’ sails. Remember, once we move into the first quarter of next year, earnings will be compared to the first quarter of this year, which were provided a hefty boost from corporate tax cuts. Quite simply, the year-over-year growth rate math gets much more difficult in 2019.

Aside from earnings releases, we’ll also be keenly focused on corporate managements’ commentary on the impact of tariffs and trade on their outlooks. There was some relief that the old NAFTA deal was renegotiated and renamed to the catchy United States, Mexico and Canada Agreement (USMCA). The deal doesn’t look like a real game changer, but was seen as a positive in that it removed some uncertainty. But the big whopper of a trade dispute appears to be worsening. The United States and China continue to trade both harsh words, new tariffs—and in the case of China, other forms of retaliation—with little sign of improvement. We haven’t seen a large impact on the actual hard data at this point, but we’ll be listening to company executives for signs that they are pulling back on the reins given the ongoing uncertainty with regard to trade. Even in advance of earnings season, we have already begun to hear from large global companies about their concerns; and this appeared to play in to the brutal market action in early October.

Fed throwing a wrench in things?

We have pointed out tighter monetary policy and financial conditions, but also the possibility of a monetary policy “mistake” from the Federal Reserve, as key risks facing the market. In a recent speech, Fed Chairman Jerome Powell noted that he thought the central bank was still accommodative, despite dropping that word from the most recent Federal Open Market Committee (FOMC) statement. Most notably though, he expressed the view that interest rates are a “long way from neutral”—indicating there could be many more hikes to come than what is currently expected. Markets heard this as a more hawkish tone and turned to worrying about the risk that the Fed goes too far and chokes off the recovery. We remain optimistic that the Fed is not on track toward more rigidity; but will remain data-dependent, flexible and cautious. However, as is nearly always the case, higher volatility as a result of monetary policy tightening is likely to persist.

So what?

Stock market action recently illustrates again why it’s important for investors to remain disciplined and diversified in a way consistent with their risk tolerances and investment goals. The bull market may have more legs, and upside surprises are possible, but risks have been rising over the past year or so, leading us to be more cautious and recommend that investors limit the risk in their portfolios.

 

Important Disclosure

Investment involves risk. Past performance is no indication of future results, and values fluctuate. International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market, economic or political conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Diversification and rebalancing a portfolio cannot assure a profit or protect against a loss in any given market environment. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events may be created that may affect your tax liability.

Past performance is no guarantee of future results. Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.

The S&P 500 Composite Index is a market capitalization-weighted index of 500 of the most widely-held U.S. companies in the industrial, transportation, utility, and financial sectors.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

About the author:
Liz Ann Sonder, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
Jeffrey Kleintop, Senior Vice President and Chief Global Investment Strategist
Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research

Content provided by Charles Schwab, Hong Kong
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