October 11, 2018

The major stock market averages opened higher but quickly gave way. The Dow is now down 230 pts and the S&P 500 Index (SPX) is down 1% on the session. This is follow-through from yesterday’s rout, when the SPX gave up about 3%. Unlike yesterday, however, the tech sector is actually up slightly, whereas utilities and real estate sectors are down well over 1%. The energy sector is down 1.6% in early trading as oil prices retreat. The SPX is now about 6.6% off of its all-time high of about 2940. This morning, the index pulled back to a long-term support level of about 2,745. If today’s low holds, this will be viewed as a very orderly mini-correction.

The VIX Index—a common measure on fear among traders—spiked to nearly 24 this morning—the highest level since early April. To put that into perspective, I’d point out that during February’s stock market correction, the VIX briefly reached 37. VIX November futures are trading around 18.6, telling me that most traders believe this correction will be short-lived. The dollar is a bit weaker today following a pretty tame inflation report (see below). Gold is up 1.5%. One would have expected gold (as a safe haven trade) to spike yesterday, but it didn’t. So this is a bit of a delayed reaction. Gold is still down nearly 7% on the year. WTI crude oil is trading down around $71.40/barrel.

The bond market—not surprisingly—is catching a bid. Treasury bonds are typically viewed as a safe haven trade, and we’ve seen some buying interest there. But I need to be clear that bond prices are up two days in a row because 1) they’ve sold off quite a bit over the last five weeks, and 2) today’s CPI report allayed investors’ fears about inflation. The 5-year and 10-year Treasury yields backed down to 3.01% and 3.16%, respectively.

President Trump Tweeted yesterday afternoon that the Federal Reserve is “going crazy” and he directly attributed yesterday’s stock market selloff to actions by the Fed. He is likely referring to Fed Chair Powell’s recent comment (highlighted in my October 4th Market Update) that interest rate hikes will continue for some time because the economy is so strong. Mr. Powell also said that the Fed may end up raising rates past the “neutral” level, and this is what caused the stock market to selloff last week. Investors are very sensitive to monetary policy because most business cycles are brought to an end by rising rates (think high mortgage/auto loan/credit card/business loan rates).

The Consumer Price Index (CPI), which measures retail inflation, slowed down in September to the surprise of economists. CPI had been running at a 2.7% to 2.8% rate since May, but decelerated to 2.4% last month. In addition, Core CPI, which excludes food & energy—held steady at 2.2% annual growth. This likely means that the Federal Reserve’s preferred measure of inflation—Personal Consumption Expenditures (PCE)—also slowed last month. Once again, this is evidence that inflation is well under control, but will it convince the Federal Reserve to pause further interest rate hikes? Not likely, because we really haven’t seen the full inflation effect of planned trade tariffs. This remains a big question mark.

As I pointed out in my October 8th Market Update, there are a million different ways to view rising interest rates and the resulting impact on investments. Leuthold’s Jim Paulsen sees this market correction as necessary because economic growth can’t be sustained at the current level. That is, GDP growth of 3-4% is likely to moderate toward a range of 2-3%. So it’s natural that the stock market would adjust to that deceleration. Remember, stock prices today are a reflection of future expectations. So stock market valuations need to be reset to a lower level. Crucially, Mr. Paulsen doesn’t sense any panic in the market and he doesn’t predict an economic recession or bear around the corner.

Blackstone’s Byron Wien says, “We had to knock some complacency out of the market, and I think we’re doing that now.” He expects a post-mid-term election rally, and sees buying opportunities in technology, healthcare, industrials and FAANGs. “The economy is ploughing ahead” and therefore the Fed is going to continue raising interest rates. He thinks the economy is strong enough to withstand a normalization of short-term interest rates toward 3%. The 10-year Treasury yield “will go somewhat higher,” but won’t spike too high because inflation just isn’t that much of a problem. He concludes, “This is a correction in an ongoing bull market.”

Morgan Stanley’s Mike Wilson says this is a “tipping point.” Tighter monetary policy (both by the Federal Reserve and the European Central Bank) is beginning to impact the stock market. Looking back over the course of 2018, he says we’re in the midst of a “rolling bear market” because financial conditions are tightening, and growth is peaking this year. In other words, different sectors of the market are correcting at different times. And this is all part of a regime change from low interest rates to higher interest rates. This type of transition causes volatility.

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