Likely more pain before any gains

The Sunday Times headline, “stampede into stocks may signal the end of bull run”, sums up what many suspects as they noted that investors poured their cash into global stocks at a record rate in January. Was this the time that we had reached the point of euphoria that signals the peak in a bull market? What happened last week, as the S&P 500 lost 3.5% from its recent highs, was a reaction to a change in sentiment in the bond market. The Vix index closed the week at 17, a rise of close to 50% on the week. Over the past few years, once the index reading has reached above 20, this has been the point at which equity prices have stabilised.

The extended valuations that US equities have enjoyed have been large as a result of the low bond yields, if this is to change the then valuations for equities also needs to readjust. 
The catalyst for the latest selloff for US Treasuries was the wage data on Friday. We did highlight this piece of data as one that could impact investor sentiment. US earnings grew 2.9% year on year, well ahead of expectations. As wages rise so will expectations that inflation will do the same, and bond yields need to rise to reflect this change. Assuming analyst’s forecasts are correct for the year ahead and the S&P 500 earnings per share for this year will be circa $150 a share, and if 10-year bond yields were to settle around 3%, an earnings multiple of 17x would suggest a further correction of circa 10% could be on the way for US equities. That’s the unwelcome news, the good news is that this correction is built upon an improving economic backdrop, not a weakening one, which would be far more painful. 

Central bankers have been at pains not to raise interest rates too quickly and derail the economic recovery, the Federal Reserve and the ECB reaffirmed this view in only the last week. If sentiment does change that they are behind the curve, then this again will put more pressure on stock prices. A correction had to come, and it will provide opportunities. 

Looking to the week ahead, the focus will remain firmly on economic data and moves in the bond market. The week starts with more Purchasing Manager surveys, this should report that the economic outlook remains positive. We do get speeches from several members of the Federal Reserve during the week, economists and investors will be looking to see if the tone is turning more hawkish. 

We have had the ECB and the Federal Reserve meetings, it’s the turn of the Bank of England this week on Thursday, along with the quarterly inflation report. There is no expectation the Bank will look to raise interest rates again, but the tone of the meeting will be of interest. Sunday futures trading suggests the equity markets will be under pressure again on  Monday morning. 

Posted on February 4, 2018 .