Oct 11, 2018

Why is the Market Taking a Tumble?

By Gene Balas

Photo credit: Getty Images

Generally speaking, looking past near term risks that we’ll discuss further, we have a constructive outlook over a longer horizon on the market. A strong economy could continue to propel stocks higher as long as earnings – not just actual realized profits, but the outlook, too – continue to grow. But that doesn’t mean that the stock market will go straight up, especially over the short term.

Speaking of the economy first to determine influences on the trajectory of the market from here, we know that the federal tax cut has helped companies’ bottom lines, improved measures of consumer confidence, and allowed consumer spending to continue apace. But how much do markets expect from these events to continue ever into the future? The tax cut was a one-time event; tax rates aren’t going to continue to be cut every quarter. So, now that we’ve reach a higher level of profits and consumer spending, do investors expect that the growth rate will continue at the same pace as it did from the one-time fiscal impulse?

We certainly can measure what analysts expect for profit growth going forward. But what we can’t measure is not what is expected, but that which is hoped, as hopes may not be quantitatively defined. Some investors may note what analysts expect, but nonetheless have their own views about whether actual results will beat, meet, or miss expectations.

The answer to this somewhat-rhetorical question will be in coming weeks as we progress through earnings season. Part of it is the usual assessment of earnings in the past quarter measured against the yardstick of analysts’ EPS forecasts going into the quarter. But the more important part of this earnings season is, however, not what companies did last quarter, but what they think about the outlook going forward. We might not get a quantified EPS number down to the penny in this part of earnings calls, but we’ll get to a more subjective assessment of what companies are seeing on the ground with their customers.

A positive outlook can allow stocks to continue on the base-case trajectory that is consistent with a robust economy, but a risk is that companies’ views on the future may not quite match investors’ hopes for the future.

Risks to the market

One risk, as we just mentioned, is that investors’ hopes may not quite match companies’ more objective views of current and projected conditions. However, this risk factor is driven by more “squishy” emotive causes rather than hard calculus.

A risk that can be more quantitatively measured, though, is that a spike in longer-term interest rates, such as on the 10-year Treasury, can cause investors’ to slash valuation multiples for several different reasons. We are currently seeing this risk play out in the markets, as yields surged recently on longer term Treasury bonds, such as the 10-year Treasury note, which is an important benchmark for both homebuyers and corporate bond issuers. This is arguably the primary reason for the market’s tumble.

One adverse effect is that higher rates can slow the economy, beginning first with rate-sensitive areas such as housing (where we already see sky-high housing prices squeezing affordability in a number of markets) and autos, to name just two rate-sensitive consumer sectors. That can have ripple effects.

A second reason is that rising rates can make corporate capital more expensive, limiting companies’ ability to continue to borrow at very low rates. Corporations already have significant debt on their balance sheets, so rolling over debt into new, more costly bonds at maturity can curtail their intentions to expand and/or cut into their profits. See the nearby graph that shows the ratio of corporate debt to nominal GDP.


And a third way higher interest rates can crimp valuation multiples. This is a result of simply the math of discounting earnings or dividends at a higher rate will equal a lower current value of those future profits. Technology companies, for example, along with other fast-growing enterprises with income streams far off into the future tend to have a greater sensitivity to this type of risk.

Why might we expect higher rates?

A rise in rates may be expected, as real yields now are unusually low. Consider the fact that real yields – subtracting out inflation expectations, using the TIPS yield as a benchmark – are quite a bit less than they historically have been, as seen in the nearby graph. A repricing of real yields, not even considering any added inflation expectations component to yields, to higher levels consistent with our current strong growth means that yields may indeed rise.

An offset to this, though, is that there some investors have large short positions in longer term Treasuries, in data according to Bloomberg. If bond prices rise instead of fall, we might witness a “short squeeze,” as investors scramble to buy bonds to cover shorts, sending prices up and yields down. On the other hand, though, central banks globally are lessening stimulus or are already tightening, and we don’t have historical precedent to show how this might play out.

Here is a graph showing real yields (subtracting out the compensation for expected inflation) over history:


And to further illustrate why Treasury yields may have room to rise further is the 10 year term premium. This is the extra return long term Treasury investors demand to undertake the greater risk of investing long term vs. simply rolling over a series of one year bonds. This compensation for the risks that interest rates might rise, such as if inflation accelerates, or perhaps if the Fed might tighten policy more, is usually positive. Historically, a higher term premium has been associated with stronger economic growth several years ahead.

In the nearby graph, consider how low it now is, especially given that we have strong economic growth. Either the bond market is overly pessimistic about growth and bonds simply yield too little for current conditions, or the bond market is right and we may see much weaker economic conditions than forecasts indicate.

Conclusion

Any way you look at it, higher rates may be on the way, or perhaps I should say, more “normalized” rates given the data above. Stocks could be vulnerable if rates continue to rise. But a correction in the stock market is just that: it “corrects” the valuations of stocks to reach levels that are more consistent with current conditions. It’s not necessarily a harbinger of doom, and assuming you are invested in accordance with your long term plans, these events (which used to happen much more frequently than in this bull market) don’t necessarily require any action. After all, this is a reminder that undertaking some risk is why investors may be compensated in the first place, nothing more.

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