What’s causing the recent volatility and
what does it mean for the stock market?
Along with the rest of the world, many of you are probably asking yourself that very question.
Does it give you déjà vu to February and April of this year? Our guess is that it probably does.
There are a multitude of factors that play into the stock market and why it moves the way it does. In this blog we are going to try to shed some light on 4 of the major factors we believe are involved in the recent moves. Keep in mind this isn’t exclusive to what is at play, but are certainly what we believe are the primary drivers.
Once again “uncertainty” is a huge driver of these recent moves and this blog will serve as a reminder of some things we mentioned and anticipated back in April.
The “uncertainty” can be tied into these 4 factors:
1. Rising interest rates
2. VIX and Algorithmic trading
3. The death of journalist Jamal Khashoggi
4. Trade war with China
Rising Interest Rates (this is the BIG one):
The yield on the 10 yr Treasury Note rose dramatically at the end of September and particularly so in the first week of October. See the chart below:
The yield on treasury bills and notes are closely scrutinized by investors for several reasons. Most notably, the 3 month T-bill is typically used by investors to determine the “Risk-Free Rate” and the 10 year Note is a used as a proxy for many financial calculations, such as mortgage rates and other lending rates.
To make wise investing decisions we always need to consider the why, before reacting to anything. So let’s consider, why are treasury yields rising? Ultimately, it’s a result of the Federal Reserve raising the federal funds rate – the rate at which banks can lend to other banks overnight. Before walking through the chain reaction from this we need to consider why the Fed is raising the fed funds rate.
Unemployment has been gradually falling since April of 2010. Which is a good thing – the expanding economy results in more jobs and thus, lower unemployment. Recently the unemployment rate has gone from 4.1% in October of 2017 to 3.9% in August 2018. Then in September it dropped to 3.7%. This was a significant drop and brought unemployment to the lowest levels since 1969. With unemployment at record lows, the labor pool is tightening and employees are able to negotiate higher salaries – simple rule of supply and demand. These extra dollars are then passed through to the consumer and this ultimately causes inflation. The Federal Reserve is tasked with the job of keeping inflation under control, which they’ve been doing by gradually raising rates the past couple of years. When a number like 3.7% unemployment comes out, that spooks investors, thinking it may cause the Fed to raise rates at a higher rate than previously anticipated to keep inflation from getting out of hand. This is partly why investors are hanging on and reacting to every word that comes out of Jerome Powell’s mouth, as he is the Chairman of the Federal Reserve.
The other impact of rising rates as we previously mentioned is the “risk-free rate”. This is used in many risk/reward calculations (ex. Sharpe Ratio) that are vital to some money managers. Massive funds have rules that govern the underlying investments and don’t allow for certain levels of risk. Because the risk-free rate is a vital metric when calculating the trade-off between risky and risk-free investments. A rise in the risk-free rate causes re-calibration across the market because some funds are forced out of riskier investments, which typically are high-growth stocks.
VIX and Algorithmic Trading:
This part may be a review from our April posting. The VIX (volatility index) is frequently referred to as the “fear index”. Investors use this metric to gauge the level of fear within the market. There are some financial instruments that place a “guarantee” on investment performance and as a result, certain limits are placed on those instruments. One of which is forced selling when the VIX reaches certain levels in order to “preserve” capital. The trouble with these algorithmic trading rules is that it factors out rational thinking and then triggers panic throughout the market. This is when we see such violent moves in the market, as fear takes hold and rationality fades. These swings tend to cause overreactions and that is why we have alerts on individual stocks. So we can make prudent and specific decisions rather than react broadly to what may or may not be going on. On the other side of the coin, as the VIX settles, this triggers buying by the very same instruments which causes the huge upswings we have been experiencing throughout the year as well.
The Death of Journalist Jamal Khashoggi:
The death of journalist Jamal Khashoggi in the Saudi Arabia consulate, rattled many around the world. This unfortunate event came shortly before “Davos in the Dessert” a Future Investment Initiative conference that’s happening in Saudi Arabia. Many top CEOs pulled out of the conference at the last minute. All of this simply added to the “uncertainty” that’s prominent throughout the market.
Trade War with China:
This has been ongoing throughout 2018 as our President negotiates with many countries, not just China in an effort to create better trade deals for the United States. The U.S. does have the upper hand when it comes to the negotiating table and this has played out in the markets so far this year. The Shanghai Composite is a good example having fallen over 21% this year, while the S&P 500 has fluctuated throughout the year being up over 9% at one point and currently sitting at a relatively flat level.
Guidance from companies has been mixed recently, with some companies citing tariffs as having an adverse impact on earnings, while others continue to raise guidance and their outlook. This is something we are monitoring on an ongoing basis as tariffs can have real impacts on company performance.
Something Worth Noting:
The P/E Ratio (Price to Earnings) has actually decreased in 2018. This shows us that stock prices haven’t moved in tandem with the earnings that companies are producing. With earnings coming in at double digit growth – prices haven’t reacted accordingly which is what is causing the P/E ratio to decline this year. See below for some historical and recent PE Data:
Again why is this happening and why are investors not reacting to the excellent growth seen in earnings. Once again it boils down to all of the “uncertainties” we have been highlighting. We need to be patient right now – likely won’t see the price moves in relation to the earnings companies are actually producing until the air clears and more clarity is brought to the market place. It’s worth noting that the inflated prices relative to earnings are well below levels seen in in 2001 and 2002 and are nowhere near the levels seen in 2008 and 2009. As a firm we have taken advantage of this pullback to re-balance our portfolios.
We continue to work diligently and thank you for the trust you have placed in MFG Wealth Management, Inc. We take our responsibility seriously and remind you that our money is invested alongside our clients. We would also encourage investors to remember that investing is a longer term action than a few weeks, this is essential to keep in mind at times like these.
Authored by: Michael McCracken CFP®, ChFC and Jeffrey Gardner, Financial Advisor The information presented above has been prepared for informational purposes only and the commentary represent the opinions of the author and are subject to change at any time due to market or economic conditions or other factors.