Since reaching a peak on September 24th, the stock market (S&P 500) has lost 9.6% of its value as of Friday, November 23rd, taking us back to where we started the year. Losses have been greatest in the technology sector among previous high fliers, but the selloff has been broad based. Even though it’s impossible to explain any market movements given the infinite number of factors that influence security prices, following is a list of potential explanations:
Trade War with China: China has been able to grow into the second largest economy in the world by adopting free market polices in combination with state-sponsored financing. This economic model relies on exports to the United States. The country also limits access to its market and has not protected the rest of the world’s intellectual property. China’s policies have caused tensions with the United States and the current administration has imposed significant tariffs to retaliate and change the terms of the economic relationship. As we discussed in our quarterly investment commentary, the world is inter-connected and trade barriers will slow economic growth throughout the world. This fear has put downward pressure on stock markets.
Peak Market Conditions: The US economy has grown at over 3% this year and corporate earnings have surged by over 25% compared to 2017. Europe and Japan have also grown faster than in recent years. The US tax cut stimulated this growth, especially in corporate earnings, and there is no encore to stimulate further growth. Therefore, investors have taken the market lower since future economic and earnings growth will be much slower than the recent peaks.
Exhaustion/Reversion to the Mean: As of the end of September, before the current downturn, the stock market had returned over 17% annually for the past 3 years, well in excess of the 10% historical rate. Therefore, this correction could be viewed as simply reverting toward the long term average.
Higher Interest Rates: Rates on the 10-year US Treasury Note have increased by 0.6% so far this year and shorter-term interest rates on the 2-year Note have advanced even more at 0.9%. Higher rates pose a number of challenges for the stock market. The first is that borrowing is more expensive, and that companies, governments and individuals may spend and invest less as a result of higher borrowing costs. The second reason is that investors may re-allocate some of their capital from stocks to the higher yielding bonds or money market funds.
Valuation: Certain sectors of the market, especially the more speculative segments of the technology sector, were overvalued relative to their future growth prospects. Capital has flowed from these richly valued sectors as investors realized that future growth prospects were not sufficient to maintain the speculative prices.
Behavioral Finance Principles: During periods of uncertainty, investors tend to react emotionally and to follow the lead of other investors, while subconsciously disregarding a more reasoned approach.
All of these rationales may explain why the market has corrected. There may also be other reasons which carry greater weight but will only be known in hindsight. The common theme is that there is an elevated level of uncertainty regarding economic activity and earnings growth over the coming years.
We do not view the recent correction as a foreshadowing of a major bear market as was experienced during the Financial Crisis. Bloomberg’s U.S. Recession Probability Forecast index suggests the likelihood of a recession in 2019 is 15%. Corporate earnings are expected to continue to grow, albeit at slower rates than in the past year. The banks and bond markets are also functioning well and have excess reserves to provide credit to the economy. Therefore, this downturn provides two opportunities. The first is to buy quality companies at lower valuations. The second is to realize capital losses to lower tax liabilities. The current holdings along with any additions should provide a foundation for better returns in portfolios over the coming years.