This week February 10, 2018 on Money For the Rest of Us Plus, we look at how frequently market corrections occur. We analyze how the current sell-off has impacted market internals, such as trend, momentum and the level of fear.
Then we look at fundamental data such as earnings and inflation to see if there has been any deterioration to justify further market declines.
We look at data from Jack Bogle’s expected stock market return model to see that over a 10-year period the stock market outcomes are not perfectly predictable, but one can still derive reasonable assumptions.
Finally, we look again at how stocks perform during periods of high inflation.
190-91 Plus
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Transcript
Welcome to “Money for the Rest of Us Plus”. This is the companion episode to Episode 191, Has the bond bear market begun? It is Saturday morning, February 10th. What a week for the stock market. The S&P 500, a measure of US large company stocks, ended the week down 5.1%. It could have been worse. It was almost the worst weekly loss since 2008, but given the rebound, really in the last few minutes on Friday, it was the worse weekly loss for the S&P 500 since January 2016. Now we’ve had a 10% correction in US stocks. It hasn’t quite been 10% in non-US. Overall, the MSCI All Country World Index is down 2% year-to-date. US is down 3% year-to-date.
There was a discussion on the member forum in terms of how often do we get draw downs like this. I’ve mentioned this repeatedly in the Investment Conditions Reports how long it had been since there was a correction of more than 5% for US stocks and for global stocks. We effectively hit records for that. Now we have more normal volatility, and so we’ve had a 10% correction. But here’s some data. This is from Ned Davis research. It’s based on the MSCI USA Index, which is comparable to the S&P 500 or the Russell 3000. It’s a US-based benchmark. The data goes back to 1969, and this is based on market days, it’s not calendar days, so there’s about 250 market days in a calendar year.
Frequency of Market Corrections
Since 1969, a 3% correction occurs on average every 23 market days, about once a month. A 5% correction occurs on average every 53 market days, so roughly every two, two and a half months. A 10% correction occurs on average every 236 days. That’s about once per calendar year. A 15% correction, which we’ve not achieved to this point, about once every 485 market days, so roughly every two calendar years we get a 15% correction. And a correction greater than 20%, on average every 950 market days, or close to every four calendar years.
Market Internals
So a 10% correction, about once every calendar year. We’ve not had one, really, since 2015. We were due, and we’ve had it. Now it’s time to sort of assess and say, Is it going to get worse? Now, we don’t know exactly. All we have are our indicators. We have what’s going on with fundamental data in terms of the economy. What about some of the market internals or technical data? Clearly from a valuation standpoint the US stock market was overvalued. We’ve mentioned that in the Investment Conditions Report. First off, when we look a potential bear market, 20% or more, one of the signals we look at is a spike in volatility. Generally, bear markets have been associated with the measure of VIX, the implied volatility of the US stock market, S&P 500 Index, greater than 28.5.
Right now we’re at 29. It got upwards of 40 a week or so ago, and at some point during this week it was, so that’s a little disconcerting, but that’s just one signal. You can’t make judgments based on one signal. Overall, other measures of market internals have held up fairly well. We have 28% of markets are now above their 50-day moving average. So from a trend standpoint, we’ve had some deterioration. Obviously, the vast majority of global markets and stocks are below their 10-day average, but we’ve generally, normal market downturns will see markets and stocks, most of them fall below their 50-day moving average.
For bigger damage, we want to see how about the longer-term trends, the 200-day moving averages, which, as we pointed out, is almost, not quite, but almost one calendar year. Maybe ten months and from that standpoint, we currently, this is as of the end of the day Thursday, we’ve had a rebound. So, after that big loss on Thursday, we have 51% of global markets and 52% of stocks still above their 200 day moving average. That’s a good sign. You have not had a large percent of markets fall below their 200 day moving average. And 87% of markets still have the slope of that 200 day average that is still rising. So, from a market internal perspective, the long-term uptrend within a cyclical bull market is still the intact. Still positive.
Momentum data, that’s the rate of change in direction, as I look at those measures that came out this morning produced by Ned Davis Research. That’s neutral. When we look at other measures of market internals, a level of fear and greed based on survey data, based on options activity, investors are really bearish right now. They’ve not hit the extremes from early January 2016. That’s when we’ve had this very strong market rebound, including 2017 with 20% plus returns, but we’ve not hit that extreme yet, but pretty close, pretty close. So investors are fearful, they’re shaken, and that fear is actually a good thing. It’s good for markets to be somewhat fearful.
Fundamentals
Now, when you have a market downturn like this, some deterioration in market internals, we always want to look at the fundamental data. What’s the economy doing? What about corporate profitability? Are you seeing a deterioration there? What about the defaults in terms of bonds? Or spreads widening, the incremental yield you get for non investment grade bonds? Is there some fears regarding the economy? Generally not.
81% of S&P companies have had earning surprises this quarter. About half have reported their earnings so far and that surprise level is the highest since 2010. So you had positive earnings surprises, 78% of global companies, as measured by the all country world index have had positive earnings revisions. That’s the highest in a number of years, and so earnings look good, positive surprises, upward revisions. The economic data, PMI data, as we saw in the investment conditions report, suggest very low risk of recession, as do other leading economic indicators.
Inflation
What about inflation? Because the selloff according to some analysts was started because the employment report showed that average hourly earnings for hourly workers rose 2.9%, the highest since 2009. It was actually concentrated in the supervisor management positions that are paid hourly. They were up 3.8% from a year ago. Non-supervisor workers, which make up 80% of the labor force, only rose 2.4%. So that was really the only data point on inflation that is a little disconcerting. We’ll have to wait until next month, they can be volatile from month to month. But last week the US productivity report came out showing how productive workers are, and one of the aspects of that is something called the unit labor cost. What is it costing to produce a unit of goods, in terms of the actual labor component, and that only rose 0.2% for the year ending December 31st 2017.
So not very high, and that unit labor cost, there’s a very high correlation between that and the core personal consumption expenditure price index, which is actually the Federal Reserve’s preferred measure of inflation. Part of the GDP calculation, but it’s called the core personal consumption expenditure. So what are households buying? The things that they buy, what has been their price increase year to year? And right now it’s still under 2%. But there’s a very high correlation between unit labor costs and that CPE price index. So this is indication that there are not huge inflation pressures right now.
Ned Davis does an inflation pricing model, forward looking. Looks at forward indicators of inflation. It’s actually at the moderate disinflation level, which when the models been at that level, CPI, the consumer price index, over the next year has actually declined 1%.
What’s Going On
So what’s going on here? We have good fundamentals, one bad data point, in terms of the rise in wages, we’ve had high evaluation, that really strong January, now the market’s corrected. We’ve had a spike in volatility, and I’ve pointed out before that volatility tends to clump together. Like being on an airplane and you hit turbulence. If you hit one bump of turbulence, more than likely you’re going to hit more turbulence, and the reason why you get these periods is because the narrative changes.
Back in Episode 73 I was talking about why you shouldn’t trade, I quoted Ben Hunt from Salient Partners, I think he’s the Chief Risk Officer, might be the Chief Investment Strategist now,
Here’s his quote; “The market equilibrium today is like a marble sitting on a glass table. It is extremely unstable.” Now he wrote this back in, I believe, late 2015, or mid 2015. So this is not recent, but we’re sort of in the same position. So, “It’s like a marble on a glass table, it is an extremely unstable equilibrium because the informational barriers that keep that marble from rolling a long way in either direction are as low as they have been in the past five years.”
So, just think of a marble on a table, it’s informational barriers, it’s the narrative. The story driving the market. The story driving the market was low inflation, good profitability, coordinated global expansion, expectations for future or the path of short term future interest rates for the Federal Reserve is going to be continuing to increase rates slowly. That was the prevailing narrative. But now, he goes on, “Even a very weak signal is enough to push the marble a long way in one direction.” So now the informational barriers are low because the market participants are saying, “Well, what if inflation does come higher?” Maybe, we talked about that in Episode 191, this term premium, what are investors demanding as compensation for inflation coming higher than expectations? Or the Federal Reserves or other central banks producing accommodation, raising rates faster than perspectives.
That’s what the market is dealing with, that’s the narrative. It’s not showing up in the fundamentals yet, in terms of the economy. There’s been a little bit of increase in high yield spreads, about 0.4% or so, but not much, and the economy is sound.
Closed End Funds
So one of the questions on the forum, Robert asked, “Is anybody buying? And what are you buying?” I’m not, I’m just holding the course for now. I’m observing to see if there’s further deterioration in market internals, I’m looking to see if there are any other indications of inflation. When I have a big correction like this, or selloff, the first thing I go to closed end funds. Closed end funds are like mutual funds but they trade on an exchange, so they can sell at a discount or a premium to the value of the underlying assets. During market selloffs, because closed end funds are mostly held by retail individual investors, they panic and they sell.
Now, closed end funds, generally they’re expensive, they shouldn’t exist, there’s a module on Money For The Rest Of Us Plus on closed end funds, but they do exist, and they are a vehicle that I like when markets are in turmoil to see and potentially take a position. You can sometimes get a position in a low duration bond fund at a 15% discount. Now, they also use leverage, so you have to mindful of that, but we’re looking for discount greater than average, and as I’ve gone through the list, I get it on a website called cefconnect.com, and I’ll sort by daily pricing, and I’ll sort and I’ll just look at the discounts. What I’m seeing is discounts are greater than they have been in a year, but they still have a ways to go before they get to the level of discount you saw in early 2016.
So investors, at least in closed end funds, have not panicked enough that I’m willing to take position, but I’m waiting and seeing. So that’s kind of an update on the market.
Speculation versus Asset Evaluation
Question from a member was, “How much of the stock market is speculation, versus true asset evaluation?” In other words, how much of the price movement can be attributed to economic realities? In the short term, not much. We just saw that really the economic fundamentals haven’t changed, but we’ve had a 10% correction. That’s emotion, that’s story, that’s narrative, that’s investors, the market, the marble on a glass table, low informational barriers. It’s the predominant narrative changing, and that leads to periods of volatility that’s normal. That’s not fundamental. Over the long-term it is fundamentally driven. It’s what’s going on with, well, the long-term returns are driven by the income. What’s the dividend being paid in terms of cashflow? How are those dividends growing? Are corporate profits growing? At what level? And then they raise the dividends. That’s the primary math of stock investing.
Now, a member pointed out and he referred to, and I’ll link to it in the show notes, a paper by Jack Bogle, it was called Occam’s Razor Redux. So he wrote the original paper 25 years ago, he updated it, it was a simple model, similar to what we use on Money For the Rest of Us Plus, to estimate the ten year returns for different global stock markets. It’s based on the math of investment; start with a dividend yield, and you layer on estimate for dividend growth, and that’s sort of the basis. So if there’s no change in valuations for the stock market, then the return over the next decade will be the dividends, and how fast those dividends grow on an annual basis. That will be the return. What changes is what investors are willing to pay for that dividends trading, or for a dollars worth of earnings in terms of the price to earnings ratio.
So they did this analysis, and a member pointed out, and he actually sent me a chart that he had put together looking at the data from this paper, really the wide range of returns that you get with this model. And he pointed out that we had to recognize that. We do put together assumptions, ten years for various stock markets around the world and other asset classes. Bonds are easy, that’s driven by math. It’s the current yield to maturity, that’s your best estimate of fixed income returns over the next decade. Stocks are harder. And so he took this data, and based on Bogle’s model, this was data from 1925-2014, looking at their model, the prediction. The beginning of the decade here’s what we believe stocks will do, here’s what stocks actually did. The correlation was 0.67, which is pretty high. If the model was perfect, it would be 100% correlation. If it’s 100% imperfect, it would be a negative 1% correlation. Is was 0.67, which is pretty good for a stock model to come up with reasonable assumption. That’s why we use it.
But, when the model predicted a 0% return, the range over the next decade was negative 5, and positive 17. So that was wide, that’s wide. When the model predicted 5%, the returns were 0-18%, and when it had predicted 10%, returns were 5-19%. Now, this is not perfect correlation, but the higher the expected return, the range shifted. It was more of a positive range. The negative returns that occurred over a 10 year period, were during periods when the model was predicting very low returns. So it’s a pretty good model, but it’s not a perfect model, because there is no perfect model.
Bogle says, “In all it seems fair to conclude that the establishment of rational expectations for subsequent decade long returns on common stocks using the model has been effective. It’s principal flaw has been manifested during those periodic occasions when investor behavior was highly erratic, leading to sharp changes in PE multiples. And while such variations can magnify the inevitable volatility of short term stock returns, PEs have over time inevitably reverted toward the long term means. In fact, PE ratios are not wholly unpredictable. Our data showed that over the past century, when the multiple at the start of a given decade was 20 times or more, it was lower at the decade’s end 70% of the time. If the multiple were 12 times or less, it was higher at the end of the decade 84% of the time.”
So, a pretty good model, but not a perfect model, and so when we do asset allocation, don’t just focus on the expected return. Look at the range of returns, recognizing this is the best that we have, but markets are complex adaptive systems. Investors can be erratic, and we can have corrections of more than 10%, for no fundamental reason at all, simply based on fear and greed.
Now, one other question I had from a member was, “In what conditions can the stock market not keep up with inflation over a 5-10 year horizon?” He goes on, “As another retiree, I would assume that’s one of your top worries.” And so he’s wondering just, are there periods? And I’ll just circle back to what we discussed in episode 190. When inflation has come in higher, above 4%, then that actually has led to, then the stock market is measured by the S&P 500 has not kept up with inflation. It returned 1.2%, because what happens is valuations get reduced. Because typically, if inflation is running greater than 4%, that’s not normal. The Federal Reserve’s target is 2%. If it’s above 4% for long periods of time, then something is not going well with the economy, and we have to adapt in terms of our allocation and perhaps have more in real estate, or other inflation hedges, because stocks don’t necessarily protect against inflation in that environment.
Global Portfolio versus U.S. Centric Portfolio
His other question is essentially, “Would a world diversified portfolio behave any different than a US centric one?” Presumably during this inflation bounce. It’s hard to say. I didn’t have the data, but all things being equal, I want to be as diversified as possible. I want to have different drivers including global stocks, because their dividend yields are different, oftentimes their valuations are different, they could be lower like they are right now in some areas. Emerging markets are lower in valuations, more attractive valuations than US stocks, but there’s still a fairly high correlation between US stocks and global stocks, but I prefer to be a global investor. Particularly now, when US stock market is so much higher priced, higher valuation, than non US, and that’s when valuations are high in one area will emphasize areas that are more attractive.
So that is Plus Episode 191. Next week I’ll do a mid month strategy update, but I wanted to just give you a current update, given what a rough week it was, and we’ll continue to monitor and see how things develop.
