Stock market volatility is back.
What happens next?
We’ve got some answers.
In this special Hedgeye webinar, Liz Ann Sonders, Chief Investment Strategist at Charles Schwab joined Hedgeye CEO Keith McCullough for a pro-to-pro investing discussion. They discussed recent market turbulence and what may lie ahead.
Below are three key takeaways from the conversation. CLICK HERE to watch this webinar in its entirety.
1. WHAT CAUSED RECENT VOLATILITY
"In our 2018 outlook we said the investing landscape is changing to one that is more inflationary. With tighter monetary policy would come higher volatility for fundamental reasons but also because of the absence of volatility," Sonders said in this webinar.
As Sonders explains, one precipitating factor which partially caused this selloff was a spike in the 10-year yield to above 2.8%. Following the recent labor report, investors priced-in a faster pace of Fed rate hikes. Average hourly earnings rose to 2.9% year-over-year, the highest rate of growth since June 2009. Sonders thinks the landscape for wage gains will ultimately translate into higher inflation, but the severity of the market move may have exaggerated the impact of wage increases.
Still Sonders explains that two factors augur well for both mildly higher wages and the inflation outlook:
- The “output gap” (the spread between actual and potential economic growth) has moved from negative to positive meaning the economy is now operating above potential.
- Second, nominal gross domestic product growth (GDP) is now higher than the unemployment rate.
2. STOCK PULLBACKS LIKE THIS AREN'T THAT UNCOMMON
As stocks continued to hit all-time highs, Sonders watched investor complacency reach its zenith. "I spend a lot tremendous amount of time on the road doing client events. Last fall there was this quick and odd 180 degree shift," Sonders said. "Everyone usually asks me, 'What’s the next Black Swan?' But there was a big shift. People were asking about cryptocurrencies and marijuana pink sheets. That was when this little voice said 'Something's not right.'"
In the interview, Sonders and McCullough discuss at length investor psychology and how a lot of investors aren't old enough to remember a higher volatility market environment.
Key takeaway? Don't freak out. It isn’t unusual to see stock pullbacks like this. As Sonders and colleagues wrote in a recent Schwab research note:
“The peak-to-trough drawdown in global stocks so far this year, at about 8%, is only about half of the average annual pullback of the past 37 years. That could mean there is more to come, either for the current pullback or additional pullbacks over the course of the year. Global stocks have fallen from peak-to-trough by more than 10% in two-thirds of the years since 1979; yet most of those times still posted a gain for the year, as you can see in the chart below.
The pullback in stocks that began last week is different from every other pullback that preceded it over the past eight years, since it was likely triggered by fears of too much growth and the return of inflation, not too little growth and deflation. An overheating global economy could mean a more rapid shift by central banks to rein in stimulus, often a precursor to recession. Yet, we still believe a recession is not on the near-term horizon.”
3. THE TREND IS (STILL) YOUR FRIEND
Most investors pile into stocks (or any asset class for that matter) after the best days are behind it. On this point, Sonders' analysis sounds a lot like how we analyze markets, on a rate of change basis. "When things start getting worse or better that's typically your launching point," Sonders said. "Most investors say, 'I'm only going to invest when the data is great.' But by the time the data is great you've probably missed most, if not all, of the bull market."
Remember, Sonders explains, we're still in the later stages of this economic cycle. We're now 105 months into this economic expansion with no recession. That's the third longest expansion going back to the 1930s. The max expansion is 120 months versus the mean of 59 months.
In other words, stock market volatility has returned as a consequence of these late-cycle dynamics but earnings and the economy remain strong, Sonders says. "Ultimately we believe fundamentals should reconnect with prices," she says.
Here's a final key takeaway: This recent round of volatility should remind investors that markets do not go up forever. Corrections are normal and healthy. "Discipline, diversification and rebalancing in particular, is key," Sonders says.