Volatility has returned to the stock market, and with it we have seen some significant short term declines. Cetera Investment Management recently authored a brief article on the declines, citing rising interest rates and challenging earnings comparisons as two reasons for the move downward. We continue to recommend that our clients focus on their long term goals and evaluate whether or not their personal situation has changed. However, we did want to share this analysis as an explanation for what has been happening in the market.
Equity Markets Decline; Search for Direction Ahead of Earnings
Major market indices saw sharp declines on October 10th with the S&P 500 and Dow Jones Industrial Average falling roughly 3.25% and the technology-heavy Nasdaq Composite falling around 4%. Markets are falling for two primary reasons. First, investors are starting to fear higher borrowing costs as bond yields have jumped sharply this month. Ten-year Treasury bond yields started the month a little over 3% and have risen to nearly 3.25% in a short time period. Adding to these fears around bond yields, companies have just started to release their earnings for the third quarter. Analysts already expect these earnings to be good, so meeting those expectations are more difficult.
The fear of rising rates has been a concern for some time now. The Federal Reserve (Fed) has been raising short-term interest rates from near zero to over 2% now and is expected to raise them to around 3% by the end of next year. Many fear that this pace is too fast and even President Trump recently expressed this concern. The Fed has less control over longer maturity bond yields, but those have been moving up recently due to strong economic growth prospects that could lead to an uptick in inflation. GDP growth was 4.2% in the second quarter and the Atlanta Fed is currently predicting the same for the third quarter. This is the best growth we have seen in nearly four years. In addition, consumer sentiment and small business optimism are very high. In a report released on Tuesday by the NFIB, a survey of small business owners, showed small business optimism was near a 45-year high. However, the single most important business problem cited by 22% of small business owners was finding qualified workers. Thirty eight percent of the respondents reported job openings they could not fill in the current period, which ties the record from August. This is something that we have been watching for some time now. We have pointed out in previous commentaries that there are currently more job openings than unemployed workers. At some point, this tight labor market will translate into wage inflation, costing businesses more money as they compete for labor. Something we have not seen lately.
Another concern around higher interest rates may not be as intuitive. There have been many non-natural buyers of equities, especially of companies paying dividends. With low bond yields, traditional bond investors looking to meet return objectives have taken more risk and jumped into equities. With high quality short duration bonds paying a yield of over 2.5%, high grade intermediate bonds yielding around 3.3%, and higher risk bonds, “junk bonds,” paying around 6%, these investors have started to reverse course and return to bonds.
With the backdrop of a jump in bond yields, companies just began releasing third quarter earnings. As the economy grows, expectations are getting higher for these companies. Valuations, such as price to earnings ratios, are already priced in these expectations. While consensus expectations call for earnings to increase around 20 percent, keep in mind that companies not only release current earnings, but also provide guidance about their expectations for future earnings. These expectations may be subdued by the prospect of higher borrowing costs, wage inflation and higher input costs from tariffs.
So while the current sell off is predominantly due to higher bond yields and earnings jitters, a trade war with China and a budget showdown with Italy and the European Union also looms in investors’ minds. We discussed many risks in the market, but we also want to remind investors that some of these risks are due to positive economic data. The fears around inflation and rising bond yields are due to strong economic growth prospects. The fears around not meeting earnings expectations are due to expectations that companies will do well. We predicted this year that volatility would pick up as the Fed becomes less accommodative and market forces prevail. We are seeing this now. While we do not know what direction markets will go, we continue to be optimistic about economic growth, labor markets and company earnings. However, diversifying against risks in the market is increasingly important.
This report is created by Cetera Investment Management LLC
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Glossary
The S&P 500 is an index of 500 stocks chosen for market size, liquidity and industry grouping (among other factors) designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe.
The Dow Jones Industrial Average is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the NASDAQ .
The NASDAQ Composite Index includes all domestic and international based common type stocks listed on The NASDAQ Stock Market. The NASDAQ Composite Index is a broad based index