A number of factors appear to have contributed to the sell-off in equity markets that commenced early this month and picked up steam in a volatility-driven decline on Monday, 5 February.
While the decline was eye-catching, the 4.1 per cent drop was only the 25th-largest in the history of the S&P 500 Index.
Contributing factors
When considering why the market staged such an abrupt pullback, we must begin with valuations.
Over the past 12 to 18 months, a synchronised global upturn in economic growth, low inflation and low interest rates have helped support equity valuations, pushing them well beyond historical norms.
For 2017, trailing price-to-earnings for the S&P 500 Index was nearly 22x, significantly above the 10-year average multiple of 15.7x.
Stocks have been expensive for some time, and while earnings have been robust of late, price advances have more than kept pace.
Aside from lofty valuations, among the most pressing concerns for investors over the past few days have been growing signs that inflation pressures are beginning to build after a prolonged period of very modest consumer price increases.
The previous Friday’s US employment report showed a jump in average hourly earnings of 2.9 per cent on an annualised basis, the biggest rise since the early phase of the post–financial crisis recovery in 2009.
In addition, the prices paid components of the Institute for Supply Management’s purchasing managers' indices have surged as well.
The manufacturing reading came in at 72.7 in January while the non-manufacturing measure rose to 61.9, well above the demarcation line between expansion and contraction.
So with strong increases in both of these indices coupled with high readings for new orders and order backlogs in each series, investors are increasingly fearful that economic bottlenecks are developing, which could lead to higher prices and a potential overreaction by the US Federal Reserve.
As a result, bond yields have risen in recent months, with the rise accelerating since the beginning of the year. From around a 2.40 per cent yield in early January, US 10-year Treasury notes reached 2.89 per cent the morning after the correction.
However, accelerating equity losses set off a flight to quality that saw yields fall back to 2.70 per cent.
With yields having been so low for so long, bonds are suddenly providing some competition with equities at these higher yields levels.
A further major contributor to the rapid sell-off is a spike in market volatility. The Chicago Board Options Exchange Volatility Index (VIX) averaged 11.2 per cent over the past 12 months, an abnormally low level.
As equities have ground ever higher over the past year, very large short-volatility positions have been building in the markets – largely in volatility-targeting strategies employed by institutional investors and leveraged exchange-traded products geared toward individuals.
Once equities reversed, the VIX spiked as high as 39 per cent on 5 February and 50 per cent on 6 February, which led those who were short volatility to hedge their positions by selling shares in the underlying S&P 500 Index. This likely exacerbated the market sell-off.
One final factor that may be increasing market jitters is the arrival of the new Fed chair and several new governors and regional reserve bank presidents.
Most of the newly appointed officials are viewed as somewhat more hawkish than those they replaced. A few think the Fed is likely to make wholesale policy changes anytime soon, but at the margin, the new Federal Open Market Committee (FOMC) is seen as potentially more likely to raise rates quicker than last year’s voters.
Solid fundamentals
At the time, the pullback approached a correction, or a 10 per cent decline from the most recent market high.
During the correction, we were well short of a bear market, which is defined as a 20 per cent decline from the 52-week high. However, it is important to note that not all bear markets lead to recessions.
In the post–World War II era, there have been nine bear markets that did not subsequently trigger recessions. Eight other bear markets were followed by a recession shortly thereafter.
So bear markets have a decidedly mixed record in forecasting economic downturns. Given the broad, and in many cases accelerating, strength in the global economy, it seems unlikely that the recent downturn in prices is pointing toward an imminent recession.
Conditions don't appear to be in place for a prolonged market downturn. Corporate balance sheets remain strong, while fourth-quarter earnings have surpassed expectations.
Additionally, the credit markets aren't signaling that a major shift in risk appetite has taken place. High-yield bond spreads have widened, but only marginally, from historically tight levels.
Recent yield increases in non-investment-grade bonds have been driven more by rising Treasury rates than by growing credit concerns. That’s a source of comfort for equity investors.
In my view, the market decline is an opportunity for investors to reorder their portfolios and perhaps increase equity exposures. Historically, spikes in volatility have represented buying opportunities.
According to data from Credit Suisse, when the VIX moves above 20 per cent, the S&P 500 Index returns over the subsequent three months average 6.4 per cent. When the VIX moves above 25 per cent, subsequent three-month returns average 6.9 per cent.
Concluding thoughts
Market sell-offs like the one we experienced earlier this month are dramatic, but can provide opportunities. These opportunities are apparent as long as the market is not signaling the risk of an impending recession.
The markers of a coming recession have increased, but not alarmingly so. Credit spreads and forward orders are not pointing toward recession, but signs of late-cycle dynamics have increased.
Investors should be patient and prepared to add modestly to risk, especially in equities. Overall, it will be important to maintain a cautious balance with a pronounced tilt toward companies with proven and sustainable patterns of strong free cash flow generation and free cash flow margin.
The cycle is in its ninth year and the last recession has been forgotten by many, including much of Wall Street. But the next one does not appear to be looming.
So there is an opportunity this winter to modestly extend stock holdings. But remember that late cycle is a time to focus on capital preservation, not wringing every last penny out of the market.
James Swanson is the chief investment strategist at MFS Investment Management.
