The pullback we’ve been waiting on for more than two and half years has finally begun and may be nearing its end. After an 8% pullback over the past 30 days we’ve come as close as we have in a long time to a true correction. “Corrections” are considered any broad market selloff of 10% or more while a 20% decline is considered a “bear market”. Ten percent corrections are common and healthy, though they don’t feel that way while they’re occurring, and have generally occurred every 18 months or so throughout history. The current bull market has raged for the past 32 months without any real correction – a near record.
The primary causes for the correction, beyond the fact that one is long overdue, comes down to several events occurring all at once. In our opinion, the first is global growth concerns. The biggest concern is the fact that the Euro Zone may enter into a recession this year led by the likelihood that Germany’s GDP will shrink for a second consecutive quarter, which is the most widely accepted definition for a recession. Japan may be on the brink of a recession as well as new consumption taxes are taking their toll on consumers. Russian and Brazilian economies are stagnant if not receding and there is continuous fear that China’s growth continues to slowdown.
In addition to slower global growth, here in the U.S. the Federal Reserve is in the process of ending its latest Quantitative Easing program. The expectation is that their bond buying program will come to an end this month and that the Fed will begin to raise interest rates sometime next year. Due to expected rate increases, along with the likelihood for central banks around the world to begin or continue their own stimulation measures, the U.S. dollar has rallied more than 8% since May of this year.
Dollar Index Spot Exchange Rate
This rally has caused a dramatic sell off in commodities, such as oil, which are priced globally in dollars and makes them more expensive to any country whose currency is not linked to the U.S. dollar. In addition to the rising dollar, vast new discoveries through improved technology of oil and natural gas extraction have created a supply glut in the U.S. adding pressure on resources. Add in slowing demand due to the previously mentioned global economic slowdown and you have oil prices that have fallen in excess of 25% from its recent high in June of this year.
In addition to these economic issues there is a confluence of external factors not directly linked to real economic expectations but have the potential to cause negative impacts. Ongoing conflicts in Iraq, Afghanistan, Syria, and the latest perceived threat in the region, ISIL, have created unease in financial markets. In addition, Ukraine has yet to end hostilities with Russian-backed rebels along their Eastern border, which has created tension with Russia as the U.S. and the European Union have imposed sanctions against Russia pushing them to the brink of the aforementioned recession.
And to top it all off the Ebola epidemic in West Africa has made its way to U.S. shores as we now have confirmed cases that U.S. healthcare workers have contracted the virus while treating infected patients inside our borders. This exposure of large flaws in our healthcare system to adequately contain the deadly virus along with media hype have started to create a general sense of panic in certain areas of the country. Add it all up and you have the 8% pullback in the S&P 500 already mentioned.
Despite the 8% plus sell off over the past 30 days, the S&P 500 still remains positive for the year, up 1.67% to date. The U.S. economy continues to gain strength with a Q2 increase in real GDP at 4.6% and a jobless rate having fallen to 5.9%, the lowest rate since July 2008. In my view U.S. markets are not currently overvalued and in no real danger of a prolonged sell off.
The S&P is currently trading at a Price to Earnings ratio (P/E) of 18.6. The P/E ratio is a commonly used ratio to determine fundamental valuation of companies and can be applied to indexes as well. While the ratio is by no means the only indicator that can be applied and has its flaws, I believe it to be sufficient for our purposes. One year ago this ratio was at 18.32 yet the S&P index is up 8.19% over the same period. The large run up in stock prices while the P/E ratio remained essentially flat indicates that the stock market growth is being driven by corporate earnings and not speculation.
The S&P 500’s historic average P/E ratio is 16.5 with an all-time high of 44.0 during the Tech Bubble in 1999. While the current ratio is above its historic average, its valuation is in no way excessive and likely undervalued in today’s economic climate as we see continuously increasing corporate profits and historically low interest rates. With the Federal Reserve holding interest rates at low levels, investors are forced to seek out “riskier” investments in search of yield. During similar low interest rate environments in the past, the investments sought out have been stocks and it’s no different today. Additionally, P/E ratios tend to peak when 10 year Treasury rates are yielding between 5% and 6%. The current 10 year yield is only slightly above 2% today.
Again, in my view the U.S. markets are not currently overwhelmed and in no danger of a prolonged sell off. Global slowdown in growth is a legitimate concern but unlikely to last.
The European Union Central Bank (ECB) will take whatever stimulus steps necessary to kick start the Eurozone’s economy – ECB’s President Mario Draghi has said as much in recent statements. Russia’s economic pain is self-inflicted and unlikely to last with an increasingly disapproving Russian populace (though I have pretty consistently misread Putin the past). While it’s true that the Chinese economy is slowing, it is only slowing its rate of growth. The anticipated growth rate for China’s GDP next year has been lowered from 7.5% annually to 7%. A 7% growth rate is something the U.S. hasn’t seen since 1950 (the average U.S. GDP growth rate has been 3.25% since 1948).
Any negative reaction by the market in response to the Fed ending its QE policy and in anticipation of a rate hike is unnatural. These are events that should be viewed in a positive light and, in fact, always have been in the past. These Fed decisions indicate an improving economy that no longer needs support and can continue to grow on its own. Historically, when we’ve experienced a rising rate environment stock markets have initially rallied in line. It is true that a point will be reached where fixed income investments become a more attractive investment option than stocks, and as I mentioned previously, that tends to be when 10 year Treasuries are yielding above 5%. We are a long way from that point. The Fed will once again overshoot their mark leading to an economic slowdown but again we have some time before we need to worry about these things.
The strong dollar and oil supply glut, while initially damaging to some of our positions, is ultimately a boon for the U.S. economy. As consumers save money at the gas pump and on their utility bills they’ll have more to spend in other areas of consumption which will continue to boost corporate profits and create new jobs.
ISIL and the continued turmoil in the Middle East while a serious threat and important is nothing new. We’ve been involved in the current conflicts for over a decade now and still have had one of the largest bull markets in history. Taken from a broader view, the U.S. stock market has survived many conflicts and crises throughout history – two World Wars, The Great Depression, the Vietnam and Korean Wars, The Tech Bubble in 1999, the 9/11 terrorist attacks, and the Financial Crisis in 2009, just to name a few. Markets are and always have been resilient.
This article contains the opinions of the author but not necessarily the opinions of Vulcan Investments, LLC. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.