A pro-cyclical correction and regime change

What is happening in the markets now. Change is sometimes uncomfortable.

It’s been too long since we have had a correction, so one was due. We are off more than 5% from the recent high. A 5% correction is a must and needed event to take the speculators out. We typically get two corrections of this size per year. Interestingly, it has been over 400 days since we have had one. Good opportunities begin to present themselves upon these downlegs, but a 10% or more correction could clearly be in the cards given the extent of this previous move. That said, there is already quite a bit of consternation about this sell off and it did seem as though this was already feared. That usually bodes well for the depth and duration of an event.

There was creeping speculation and a bit of a “blow off” sense to the last couple of weeks. In particular following a strong Q4, the first month of Jan was up 5 %. The market went up nearly every day. It was reminiscent of Jan 2000.

Crypto matters. But it matters because most of the buying pressure seems to have come from money flowing out of China(and to a lesser extent broader Asia). The question is why? Why so much capital flight? Is there something happening over there in the system in China that may bode ill for something larger? This feels like something to watch for possible contagion. Secondarily, the huge move is also symptomatic of the excess liquidity in the system. If the FED takes the punch bowl away too quickly, that liquidity drying up could cause a larger spasm in the broader markets.

The Bond Market. Something has changed materially. We have seen a flattening curve for months. In fact, in 2017 the return on the 30 year bond was nearly double digits. Now, the markets are realizing that the fiscal, regulatory and tax reform are indeed driving growth. The curve is quickly steepening again, and from a much higher short rate baseline. This is frankly just a “normalization”. Keep in mind that this is a reflection of improving economic fundamentals. This is generally good for stocks. But it is a regime change. We are indeed seeing wage pressure that we have not seen in this economic cycle. There are budding signs of inflation in the system. There is also a growing unfunded set of liabilities with more spending to come(infrastructure?)for the bond market to consider. The interest rate framework must account for all of this. It appears that we could see 3.25 to 3.5% 10 year in this cycle. The chart below shows the generic US 10 year going back to 1960. Clearly, we have broken out from the previous, long established downtrend.The green line is 3.42 yield

Politics: I think we all realize this one will not go away, at least for a while. The Nunes memo is a material that the markets appear to be taking into account. It has the feel of the beginning of something instead of a non-event or the end of something. Look for much more around this one on both sides. This week we have the Continuing Resolution coming up. With this level of distrust between each side of the aisle, can they come together to keep the US government funded? We shall see, but the markets must discount this as well.

Valuation: Again, we are all well too aware that markets are elevated. But, keep in mind there is no correlation to high values and forward 12 month returns. But, what is indeed correlated is that if and when the markets turn, there is far more room on the downside. What matters is whether or not the economy and thus earnings are getting better or worse and clearly they are currently getting better. Secondarily, how much of that improving fundamentals is priced in is what determines where we are in the cycle. The confluence of these two perspectives are key to watch.

Back to “de-regulation” In spite of that clearly being the direction these days, the Friday news of the 2018 CCAR & Dodd Frank Stress Test rules from the FED actually tightening balance sheet controls by the banks came as a surprise on an otherwise bad day. This was then followed up by the Feds sanctioning Wells Fargo for to their bad behavior, they cannot attempt to grow?! This is something new that the market needs to digest.

Earnings: The reports thus far have been rather robust. Revenue growth is strong and the outlook by management teams has been generally upbeat. Thompson Reuters I/BE/E/S reports that nearly 80% of companies reporting exceeded revenue estimates. This is more than 20% above typical quarters. Estimated S&P earnings are likely to be up more than 18% to $156 or more. While there has certainly been some large stock price moves, this may be an effort by the markets to “digest” the big run up. Keep in mind that in 1994 S&P earnings were up a similar amount but the market was flattish that year as the bond market sold off (while the FED raised rates). Below, you will find the latest Bloomberg estimates for S&P earnings:

The takeaway, is that this is that there is a lot for the markets to digest as the market regime changes but is also much more of a more typical market action. There need not be any rush to jump in as this may take a bit of time to resolve itself. Volatility like this happens in both Bull and Bear markets. It is appropriate during these periods to make sure that risk is measured and overall allocations are structured properly and there is some dry powder to take advantage of the next set of opportunities as they present themselves.