As Volatility Returns, Are You Prepared?

by Catherine Trinder Miller, February 9, 2018

As equity market action in the past week painfully reminded investors, volatility in the stock market was too low for too long.  An increase was inevitable.  Of course, that inevitability did not make the experience of the past week any easier.  Inflation concerns driven by an increase in wage growth took the market by surprise.  As we've shared in previous missives, neither the occurrence nor the absolute level of that wage growth (+2.9% in the last year) are cause for alarm. 

What you likely did not see in this week’s headlines was the “weather effect” on that wage inflation figure.1 Due to weather, 1.8 million salaried employees worked part time which drove average hourly earnings up. Weather impacts are seasonal in nature and should not be extrapolated. While we should expect wage increases at this point in the economic cycle, provided these increases are modest and driven by strong economic growth, the Federal Reserve can be gradual (yet consistent) in raising interest rates.

As equity market volatility increases, investor sentiment can also shift as emotions overcome logic in decision making. Therefore, it is essential to review the investment case for stocks, and specifically the economic fundamentals supporting asset prices. The economic regime supporting higher equity prices over the past year has been one of modest economic growth, low inflation and low interest rates. What has changed?

As we look around the world, economic growth is strong with nearly all world economies – 99% on a GDP-weighted basis – enjoying positive growth, and 56% accelerating over the last twelve months.2 This is extremely rare. In our opinion, financial conditions remain easy and fiscal stimulus is accelerating, particularly in the U.S., spurred by tax reform and deregulation. U.S. equity valuation has retraced to more normal levels. As of today’s close, the S&P 500 Index is trading at 16.8x analyst consensus earnings expectations for 2018.3 For perspective, the median price/earnings multiple for the S&P 500 since World War II is 16.7x.4 If earnings are strong, this is not an overvalued market. Of the 337 S&P 500 companies having reported 4Q earnings as of today, over 76% have beaten estimates, with earnings up 17% from a year ago.5 Equity valuations outside the U.S. are perhaps even more compelling.

Higher interest rates and inflation are a byproduct of a stronger economy and should be expected at this point in the economic cycle. The key is the pace at which both rise. There is nothing in the news of the past week that leads us to conclude the pace and magnitude of Federal Reserve interest hikes will be anything other than gradual. Credit conditions are a long way from being tight and corporate balance sheets are stronger than they’ve been in decades.5

Low market volatility experienced in the past year is abnormal. More normal levels of volatility are likely here to stay. Yet we must remember -- market corrections are healthy. Investors with diversified portfolios, properly positioned to meet their specific needs and goals, should not fear market volatility. It resets asset prices to more reasonable levels and can be viewed as opportunity, rather than fear, for long-term investors. You can’t predict, you can prepare. With a clear investment plan that you can stick with, you will be prepared.

1 Dr. David Kelly, JP Morgan Asset Management, Five Keys to a Continued Rally, 2/6/2018
2 Goldman Sachs, Market Know How 2018
3 Thompson Reuters
4 Jeremy Siegel, The Future for Investors, Data from 1954-Present
5 Brian Wesbury, Chief Economist, First Trust

The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Catherine Miller and Teri Benson and not necessarily those of Raymond James. Investing involves risk and you may incur a profit or loss regardless of strategy selected. No investment strategy can guarantee success. Past performance may not be indicative of future results. Investing in the energy sector involves special risks, including the potential adverse effects of state and federal regulation and may not be suitable for all investors. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor results will vary.

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