March 23, 2018

The major stock market averages are slightly higher in early trading (Dow +34 pts; SPX flat) following yesterday’s rout. Energy (+1.3%) and industrials (+.7%) are leading the way. Financials, however, aren’t responsive. Some individual stocks are bouncing hard; Raytheon (RTN) is up 3% after a deal to sell missile defense systems to Saudi Arabia. A very strong durable goods report wasn’t enough to move the market much. The VIX Index spiked to 23 yesterday but faded to 22 this morning. WTI crude oil is trading up around $65.30/barrel, back to the high end of the trading range. Bonds are slightly lower today. The 5-year and 10-year Treasury yields are at 2.62% and 2.84%, respectively.

There is a lot of noise in the market today but most of it probably doesn’t matter. What matters is that the stock market is looking to test two important levels below where it is currently trading. The S&P 500’s 200-day moving average is at 2,585 (2.5% lower) and the February correction low is 2,532 (4.5% lower). Traders are watching these levels closely. 

Yesterday, the stock market pulled back sharply as a result of rising near-term tensions. The S&P 500 Index fell 2.5%, the Dow fell 2.9% and the Nasdaq fell 2.4%. Much like January’s correction, this one was sparked by traders reacting to headlines. But selling accelerated when the S&P 500 Index dropped below its 100-day moving average. That’s when the machines (i.e. computer trading algorithms) took over and doubled the day’s losses. Finally, just as with the last correction, yesterday’s session was clearly characterized by overreaction. 

We’re dealing with several different worries. Five to be exact. First, we have lingering fears among the investor class that President Trump’s new trade tariffs could spark a trade war. That is, our trade partners in China and Europe may decide to retaliate with tariffs of their own. Just this week Mr. Trump announced plans to slap additional tariffs on Chinese goods to compensate for stolen intellectual property. He said, almost as an afterthought, “This is the first of many.” Last night, Chinese officials indicated they may respond with tariffs of their own. Or they may reduce US Treasury bond purchases. Of course, that means more uncertainty in the near-term. US companies that do business in China saw their stocks underperform today. 

Second, investors are reacting to accelerating staff turnover within the Trump Administration. Over the last several weeks, the president has replaced, among others, his secretary of state and chief economic advisor, both of whom were very well respected on Wall Street. In addition, yesterday Mr. Trump fired his national security advisor. 

Third, Wednesday’s Federal Reserve policy announcement may have contributed to the selling. For the details, please see our daily market update posted on the website this morning. While Fed Chair Jerome Powell’s statement reassured us that the Fed won’t be overly aggressive with interest rate hikes this year, we’re not sure investors were prepared to hear about plans for another three rate hikes next year, and two in 2020. Yes, economic growth is strong, but investors are perennially worrying that the Fed could raise rates too fast and choke off growth. 

Fourth, there was some angst over the threat of another government shutdown. On that front, both the House of Representatives and US Senate voted to approve a $1.3 trillion government spending package, which until this morning looked sure to get the president’s signature. Within the last hour, Bloomberg reports the president is considering a veto of the bill because 1) it doesn’t fund the border wall, and 2) it doesn’t the DACA issue. 

And fifth, Facebook (FB) headlines regarding a 2016 data breach have raised concerns among all social media companies. Negative trader sentiment quickly spread through the entire tech sector. And of course, these stocks are vulnerable to profit-taking because they performed so well last year, and because they would suffer from Chinese trade tariff retaliation. 

We think most of these worries are either over-played or temporary in nature. What happened to stocks during the 2013 government shutdown? A very brief 4% pullback. Has it benefited any long-term investor to trade on Trump speeches? No. Has the Fed made a serious policy error during the nine-year bull run? No. We believe they will remain patient and decisions will be driven by economic data. And on the trade tariff front, we believe Mr. Trump’s bluster is part of a strategy to open negotiations, not start a trade war. 

Stepping back and setting aside the immediate causes, we think the return of volatility makes sense. Last year’s market was unusually calm and positive. Stocks likely reached fair value as the year ended. That’s why we expect increased volatility, including at least one 10% correction this year. We need a healthy pause to reset stock market valuations. And finally, the market’s sharp reaction to political or geopolitical uncertainty shows that investors aren’t complacent. That encourages us to believe that stocks can continue to climb wall of worry. 

None of these events has altered our fundamental investment thesis. The US economy, buoyed by strong housing & job markets as well as improving business investment, provide a great backdrop for the stock market. Corporate America’s revenue & earnings growth outlook is solid. And while the global economic recovery has admittedly lost a little steam lately, most regions of the world are in better shape than they have been in years. In other words, the critical longer-term trends are still moving in the right direction. 
 


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