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Napa Valley Wealth Management - St. Helena, CA

Stock Market Crash or Correction?

| February 08, 2018
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Stocks have fallen quickly in recent days. The Dow's 1,600-point drop Monday1 was the worst intraday point decline in a trading day in history. With so little market volatility in the last two years, many investors have been scrambling, fearful that this everyday-a-new-all-time-high market is jumping into its next downturn. 

What Happened?

Stronger than expected wage growth numbers were published Friday. Both wage growth and inflation have been lagging during this economic recovery, and signs of a substantial wage uptick triggered concerns of rising inflation and the likelihood of faster rates increases by the Federal Reserve during 2018.

There’s No Fundamental Reason for a Bear Market

Though markets sharply declined Friday to Monday, and have bounced today, we do not believe it signals the end of this bull market, which started in 2009. Here are five reasons why.

It Was Time for a Market Correction

We consider the current dip to be a normal market correction (more than a 10% decline). Historically, the market will correct by 5% twice per year and by 10% every 2.5 years. Our last correction was January 2016 (spurred by reactions to China’s economic slowing and correction in their stock market, which had been in a bubble); therefore, this is normal timing.

To put recent declines into perspective, though it was the largest trading-day point decline in history, the percent decline has been within parameters of a normal market correction.

Underlying Corporate Earnings

S&P 500 corporate earnings have been growing at a healthy clip since 2016. Projected economic growth and large corporate cash balances will both fuel continued earnings—and earnings not only bode well for stock prices, they also support continued equity growth. 

No Historical Bear Market Triggers

Conditions that prompted previous bear runs are not currently present. These include:

  1. a recession. All key economic indicators point to a growing economy for 2018. No fundamental indicators point to the U.S. GDP slowing down.
  2. commodity spikes. Oil prices, though recently gaining traction from international renewed demand, are still well within normal trading ranges and well below modern peaks.
  3. aggressive Fed tightening. Until now, the Fed has increased rates very cautiously and has signaled no plans for aggressive tightening.
  4. extreme market valuations. Investors are concerned the market could be overvalued and in a bubble. S&P 500 valuations (forward price-to-earnings [P/E] estimates) are higher than both 25-year averages and their peak in 2009. But in this low interest-rate environment, the market looks about average in valuation terms—not extreme. Foreign markets are still somewhat undervalued as well. The latest tax law changes are also fueling slightly lower forward-looking P/E ratios, as earnings are expected to benefit from the new code.

Wage Growth and Inflation Are Still Low

Wage growth has lagged in this economic recovery, which has kept inflation tempered. The Fed has been waiting to see improvement in both areas before steadily increasing rates.

While Friday’s wage growth report sparked concern, it’s good to consider the recent numbers in context. Wage growth’s 50-year historical average is 4.2%; numbers reported Friday, though higher than expected, are still only 2.9%. The graph below shows us that wage recovery has significantly lagged its rebound compared to the economic recoveries of the last 50 years.

The main point: While both wages and inflation are slightly increasing from historical lows, it does not appear there are significant drivers to propel either beyond reasonable levels in the near future. 

Strong Support for Foreign Stocks

Foreign equities are currently at their 20-year P/E averages, and those stocks are not expensive. Recovery in foreign economies continues and will continue to create additional global demand, further supporting our earnings forecast. Forecasts for manufacturing across almost every emerging and developing market are currently at or above 50 PMI (Purchasing Managers Index), signaling that manufacturing in most every territory is advancing (Source JP Morgan, Guide to the Markets, 1Q2018).

What’s Next?

Given the factors above, we believe the fundamental economic driving forces behind the markets are sound and are poised for further healthy growth. No inherent triggers are present that would spark a recession or a bear market.

The stock market should enjoy the benefits of a continued strengthening in our economy in the long run, but short-term volatility may indeed create some negative returns in the near future. Negative short-term runs can be expected when holding stocks, and the measure of return should be calculated during the entire holding period. Many of the stock positions we hold today have made substantial gains that have not been erased by the last few days’ trading.

Tactical Portfolio Management During Volatility

Seasoned investors expect volatility. Corrections, expansions, and recessions are all part of the market and business cycle.

As tactical investment managers, our portfolios are built for market ups and downs. Using asset allocation strategies, we construct portfolios with a diversified mix of asset classes that respond differently to market changes. This helps maximize returns while minimizing risk.

As part of our ongoing asset management process for our clients, we are constantly reviewing their individual portfolio and evaluating the changes needed to protect their principal and to achieve their long-term goals.

During market dips, we proactively review their allocations in relation to their Investment Policy Statement and Financial Plan. We then make the adjustments necessary to not only reduce risk during volatile swings, but to also increase expected income.

While there's always the possibility for a black swan event that's not related to the economy, we foresee little to trigger a bear coming out of hibernation in the next few quarters.

>> Read more about our tactical investment strategy.

>> The primary benefit of using tactical asset allocation is to reduce volatility in your portfolio. Read more. 

>> Read more about The New Tax Bill & What It Means For You


1 Source: Yahoo Finance real-time and historical data: https://finance.yahoo.com/lookup.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. Asset allocation does not ensure a profit or protect against a loss.

 

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