Global Sell-off Continues, Markets Officially entered ‘Correction’
Last Friday’s weakness carried into this week and all the major indices officially entered ‘correction’ territory, which means they traded more than 10% below recent highs. The sharp rally late Friday technically pulled markets out of the correction as now the Dow and S&P 500 are roughly 9% below recent highs, but they traded as much as 11-12% below the highs earlier today. For the week, the Dow and S&P 500 both declined 5.2%. Even with the sharp down move, stocks are still at levels seen just two months ago in late November and early December. It’s possible we will continue to see volatility and downward pressure on prices in the coming weeks, but it was positive to see stocks rally late on a Friday heading into the weekend.
This is the first correction we’ve had since February 2016. Two years ago, the market declined just over 13%, peak to trough. Since then, the market has gone almost two years since experiencing even a 5% decline. That officially ended this week. Since the financial crisis, there have now been five corrections. In addition to this year and 2016, we experienced corrections in 2015 (-12.4%), 2011 (-19.4%) and 2010 (-16.0%). Historically, the market experienced one market correction per year on average. Since the financial crisis, we’ve had a lot more stability in the stock market, with a correction only every two years. This is likely driven from global central banks keeping monetary stimulus flowing over most of this time period.
Why do these things happen? There are always numerous drivers of these types of corrections. Over time, earnings drive the market. Earnings are the single most important aspect of the financial markets and earnings have been strong. However, what is always very subjective is how much investors are willing to pay for those earnings. Over the last 20-years, the average price paid for 12-month forward earnings has been 17.2x. That means that if a company expected to earn $1/share in the next 12-months, investors would value the company at $17.20/share, $1 of earnings times a 17.2 multiple. That multiple peaked a week ago at 18.5x and currently sits around 17.0x. For various reasons, investors decided they were no longer willing to pay the same multiple for future earnings.
Several factors over the last week helped convince investors a lower earnings multiple was reasonable. Interest rates increased rather sharply in a short amount of time. This led many investors to either decide they preferred fixed income investments or that enough other investors would make those allocation changes. Wage growth in the January jobs report was also at a multi-year high of 2.9%. That could be an early indication that higher inflation is coming. With the unemployment at 4.1%, the thought is higher wages will be necessary to attract and retain workers. On the whole, higher interest rates, higher wages and slightly higher inflation are a positive. They come out of a strong economy, but they can cause short-term disruption in financial markets as investors adjust to the new environment.
Overall, I made a few minor changes to portfolios this week and continue to believe the underlying economy is strong and that this correction will be relatively short-term in nature.
Oil decreased 9.2% this week to close at $59.23/barrel. The yield on the 10-yr Treasury moved slightly higher, to 2.85% from 2.84% last week. The average rate on a 30-yr fixed rate mortgage moved sharply higher to 4.32% from 4.22% a week ago.