Bracing for a Fed rate hike? You’re not alone. The US added 173,000 jobs in August, with the unemployment rate moving lower to 5.1%, and wages showing a 2.2% YoY growth – all signs that the domestic economy is alive, well, and prospering steadily. Still, major indexes finished down for the week, with the Dow off -3.2%, the S&P 500 off -3.4% and the NASDAQ off -2.9%. What’s worth noting is that China slowly receded from the headlines, and has been replaced by the Fed – for good reason, given that the September FOMC meeting and the interest hike decision is now less than 2 weeks away. What’s pretty certain is that market uncertainty will continue until that meeting. In the meantime, though, is there need to worry about the current market slide continuing into bear territory? Here’s why we’re thinking no:
The Fundamentals: The S&P 500 finds itself at a fair 16.5x forward earnings (Yardeni data). Corporate leverage remains at 20+year lows, operating profit margins continue to hover near record highs, and durable goods orders, capacity utilization, auto sales and housing trends are all showing robust improvement. Meanwhile, the consumer discretionary sector is now the best performer in the S&P 500, up over 2%, while the defensive utilities are -14% YTD (the 2nd lowest performer, followed by energy, at -20% YTD due to reasons surrounding the oil price decline). In any case, the sector returns show that investor sentiment is certainly not negative, or bent on calling an end to the rally. We see that small caps are neck to neck with large caps at a roughly -3% return, and growth has outperformed value. Earnings growth ex-energy was 8.5% in Q1 (JP Morgan data), and Wall Street is still looking for mid-to-high single digit growth in the year. All in all, while the indexes may be red YTD, the fundamentals and investor sentiment certainly don’t seem to be pointing that way.
The Yield Curve: The yield curve shows the rates offered by bonds with different maturities. While the Fed may control its short end, the long end remains in the market’s hands. Despite all the recent equity turmoil, the curve remains upwards-sloping – indicating positive expectations of growth and inflation in the long term. Currently, the long end signals a yield of around 3%; this may slightly change after the FOMC’s meeting, but it is very unlikely to slide – given that if the Fed hikes, their incredibly accommodative nature that investors have gotten used to will certainly signal a far more robust economy than what many had thought. Given improving economic data and the current slope, a recession is extremely unlikely for the next 18-24 months – in which case, equities should, in theory, provide positive returns – seeing no overheating in the fundamentals. History provides some clues here:
Past Bear Markets: Using JP Morgan data, we see that eight of the ten previous US equity bear markets occurred along with economic recessions (a contraction of GDP over 2 or more quarters). In 2008, housing overheating along with bad loans, etc. catalyzed the market and economic downturn, while in 2000, extreme valuations in the tech sector caused both. In fact, 1987’s flash crash was the most recent situation in which an equity bear market occurred without an economic recession. It was essentially caused by program trading and market overheating – the economy proceeded to do fine after. And if it makes you feel any better, stocks more than quadrupled in the following 10 years. Turning back to today, if we’re worried about aggressive Fed tightening, the recession to look to is 1980, where rapid interest rate hikes catalyzed the recession and bear market. However, it was done to rope in massive inflation – a far cry from today’s opposite problem of lack of inflation alongside an extremely accommodative Fed. To summarize, commodity upturns and inflationary pressures, poor credit quality, or bank behavior isn’t an obvious risk today; a US – or global recession – is unlikely given the points above. Corrections or bear markets that occur without recessions in sight may not be as bad as they may feel. A continued equity market collapse may essentially be based on emotions, and as a result, be providing quality stocks at discount prices.
What it means for you: While stocks may be falling, we don’t see the factors that caused previous recessions around at the moment. Of course, it’s worth recognizing that today’s environment is a never-before-seen combination of slow global growth, low inflation, and near-zero interest rates amid a near-full employment rate in the US. Investors have gotten addicted to cheap liquidity for over 6 years. And, since the March’09 bottom, US stocks have returned over double the historical average annual returns, alongside an average GDP growth of 2.2% – far lower than the 3%+ historical figure. Market corrections have occurred every 1.5 years (Bloomberg data) in the past, but we’ve not seen one in over 4.5 years. To summarize, some profit taking or emotional twists are bound to occur leading up to the rate hike decision – we’ve had lots of gains with relatively little pain. In times like these, we think it’s best to stay invested, pick up bargains based on fundamentals, and avoid getting injured by finding yourselves between uncertain bulls and bears on Wall Street until there’s clarity on where interest rates are headed.
