Market in a Correction, Not a Bear Market


Century Management Investment Advisors, February 2018

  • S&P 500 index increased more than 57% over the past two years without an intra-period decline of more than 5.6%. We believe the recent market decline is part of a normal bull market correction, and not the beginning of a long, protracted market decline or bear market
  • What changed?
    • We believe the overall market had been pricing in low volatility, stable interest rates, low economic growth, and sub-2% inflation. As economic growth in the US and abroad has picked up, wages are on the rise, up 0.3% for January and 2.9% y-o-y. At the same time, fed funds rate is increasing as the Fed tries to stay ahead of inflation
  • What do we expect at this time?
    • While a bull market correction can be sharp and painful, it is generally characterized as being short-lived, typically between 3-4 months, before making a recovery and trending higher
    • Market corrections are generally short-lived because they typically occur during times when there is no economic recession. In other words, economy is generally stable or doing well
    • Over the long term, a 10% pullback in stock prices occurs about once a year
    • What would concern us more would be the onset of an economic recession, which could then lead to a prolonged downturn more indicative of a long-lasting bear market
  • How can we tell the difference between a bull market correction and the beginning of a bear market?
    • Going back to the 1950’s, recessions typically occurred after the Fed finished hiking interest rates. Today, after nearly 7 years of keeping the fed funds rate at ~0.25% to help stimulate the economy, the Fed appears to be in the early stages of trying to bring rates back to a more normal level. To put this into perspective, 30-year monthly average at 2.3x the current fed funds rate, it would appear to that the Fed has more to go before ending its rate hikes and we believe the chance of a recession and protracted bear market do not seem likely at this point
    • Since 1985, there has never been a recession until we have seen an inverted yield curve. In other words, the fed funds yield is higher than the 10-year Treasury bond yield. As of 2/6/18, the fed funds yield is 1.42% and the 10-year Treasury bond yield is 2.75%. Difference is 1.33% – once this number turns negative, we typically have 18 to 30 months before a recession begins
    • Another important sign that would suggest we are near a market peak is when the spread between the CSI Bar Cap Index yields over 10-year Treasury bond yields widen. On average, this spread ranges between 2.25% and 4% during normal healthy markets. Today, this spread is 3.3%. It is not until this spread widens over 4% that we would be concerned
    • While it is true you can have a decline in leading economic indicators and have no recession, it is important to remember there has never been a recession without the leading economic indicators first going negative. As of 12/31/17, The Conference Board’s latest report shows that the Leading Economic Index is currently strong and is trending up. History shows that once the leading economic indicators start to decline, there is typically a year to a year-and-a-half before the onset of a recession
    • Economic growth is not just occurring in the US but around the world. According to IMF’s January 2018 update, global economic activity continues to firm up. Global output is estimated to have grown by 3.7% in 2017, which is 0.1% faster than projected in the fall and 0.5% higher than in 2016. Global growth forecasts for 2018 and 2019 have been revised upward by 0.2% to 3.9%
    • According to Bloomberg, with roughly 42% of the S&P 500 companies having reported 4Q17 earnings, 81% have exceeded their estimates, the highest in 7 years. At the same time, 75% have increased their fiscal year 2018 EPS projections
    • According to Bloomberg, CPI inflation is currently at 2.1%. While we believe there are better measurements of inflation, we would not be too concerned about CPI inflation until it reached 3% to 3.5%. At this level, we would see it as a warning sign because our research shows that once CPI inflations gets to 4%, the P/E multiples on the stock market would have a significant pull back and would likely lead to a severe and potentially long lasting market correction
  • To summarize:
    • This is a short-term market correction and overall economic and company fundamentals are generally positive and doing well
    • Inflation appears to be increasing, but at its current levels we do not see the Fed tightening so much as to cause a recession
    • We are likely to see an increase in market volatility going forward, but this should provide investment opportunities
    • As we look out over the next 12-18 months, we believe value-based and commodity-related stocks should benefit the most in this environment

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