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S&P 500 falls another 5%, in correction territory

The idea that a bell rings to signal when investors should get into or out of the market is simply not credible. After 50 years in this business, I do not know of anybody who has done it successfully and consistently. – John Bogle

The carnage continued on Wall Street last week as all three major stock averages tumbled over 5%. The Dow Jones Industrial Average and the S&P 500 Index have now fallen more than 10% from the highs set on January 26th, a drop that is the definition of a correction. After posting a year-to-date total return of 7.5% through January 26th, this benchmark is now down 1.8% for the year through the close of business on Friday. What seems to have triggered the broad sell-off in stocks since they peaked over two weeks ago was a slight increase in wage growth in the January employment report. This increase has ignited inflation fears and worries that interest rates would rise, providing a headwind for the economy and the stock market. The yield on the 10-year Treasury has risen to 2.83% after starting the year at 2.41%, a big move in a short period of time. But the increase in average hourly earnings in the employment report was offset by fewer hours worked. Higher wage growth may not necessarily translate into higher inflation. Minneapolis Federal Reserve President Neel Kashkari said that the Fed is a long way from raising interest rates due to higher inflation caused by labor costs. In addition to interest-rate fears, computer-driven trading, trading algorithms, levered fund products and risky volatility funds all contributed to the downdraft in stocks and exacerbated the market moves. The strong performance of the stock market in January was due to retail investors’ fear of missing out on further gains as mutual funds and exchange-traded funds (ETFs) took in $58 billion during the month, the highest amount ever over a 4-week period. This fear of missing out or FOMO can quickly turn to fear of losing money and many of these same investors may have sold their positions at the first sign of trouble. There were no significant economic reports last week that would have caused the stock market to swoon and fourth quarter corporate earnings reports continued to be stellar as the majority of S&P 500 companies have beaten analysts’ estimates on both the top and bottom lines. While there will certainly be more volatility and possibly more pain before this correction ends, there is nothing that indicates a recession may be at hand. The economy is strong, growth is poised to accelerate and earnings have been excellent with companies also upbeat on earnings guidance going forward.

Last Week

The U.S. trade deficit widened more than expected in December to its highest level since 2008 as domestic demand pushed imports to a record high. Weekly jobless claims fell by 9,000 to 221,000, lower than expected and the lowest level in 45 years as the labor market continues to tighten.

A government shutdown was avoided as the House and Senate passed a two-year agreement that increases spending by $300 billion, including money for defense and domestic programs. Another $90 billion was earmarked for disaster relief and President Trump signed the budget deal into law.

For the week, the Dow Jones Industrial Average dropped 5.2% to close at 24,190 while the S&P 500 Index also sank 5.2% to close at 2,619. The Nasdaq Composite Index slid 5.1% to close at 6,874.

This Week

Investors will get a good read on inflation this week as the producer price index (PPI) for January is forecast to increase moderately after declining last month while the consumer price index (CPI) is expected to rise modestly. January import prices are expected to spike after rising slightly in December as the weak dollar has made imported goods more expensive. Retail sales for January are forecast to record another moderate increase similar to the one in December as consumer spending remains strong. The preliminary reading for the Michigan consumer sentiment index should remain elevated again this month.

Among the most notable companies on the earnings agenda this week are MetLife, PepsiCo, Coca Cola, Applied Materials, Cisco Systems, Occidental Petroleum, Marriott International, CBS, Waste Management, John Deere and Consolidated Edison.

Portfolio Strategy

For the moment, the severe sell-off in stocks appears to be a long overdue correction within an aging bull market and not the beginning of a bear market caused by an impending recession. One of the best predictors of a recession is an inverted yield curve where the yield on short-term Treasury securities is higher than the yield on long-term Treasuries. As of Friday, the yield on the 10-year Treasury was 2.83% while the yield on the 2-year Treasury was 2.06%, a difference of 77 basis points. (A basis point is one hundredth of a percent).  Investors are concerned that the recent uptick in wage growth in the most recent employment report portends higher inflation, which would most likely result in higher interest rates. The Federal Reserve has forecast three interest rate hikes this year, which would raise the federal funds rate to between 2.00% and 2.25% by year-end and could put the 2-year Treasury yield on a par with the yield on the 10-year Treasury. The yield curve is fairly flat now, but these projected increases could make it dangerously close to becoming inverted. Each of the past seven recessions has been preceded by an inverted yield curve so this relationship bears watching. The Fed wants to tighten monetary policy by normalizing interest rates to give it some wiggle room for the next recession, whenever it may be. GDP growth was 2.6% in the fourth quarter but forecast to exceed 4% in the first quarter and inflation has been running at a modest 2% but poised to pick up. Given this scenario, the odds of a recession anytime soon are slim, but investors should keep a wary eye on the 10-year Treasury yield, the yield curve and inflation data for important clues.