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Volatility Rises, Correction Likely Near the Bottom

| November 05, 2018
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                                                                            Volatility Rises, Correction Likely Near the Bottom

                The S&P 500 has now experienced two corrections in less than ten months. The uncertainty of the outlook for earnings and revenue growth is a major cause of the volatility. Earnings growth moderated in the third quarter, although it is still historically strong. As of November 2, 2018, the S&P 500 has seen revenue and earnings increase 8.71% and 26.51%, respectively, according to Bloomberg. These numbers are impressive, but they are less than their growth in the second quarter. Moreover, many companies warned that fourth quarter earnings growth would decelerate. One main reason is cost pressures. The labor market has become extremely tight after close to nine years of improvement. The unemployment rate stands at 3.7%, and this has led to increased employment costs. Additionally, many companies are getting hit by tariff costs while the strengthening dollar leads to lower revenue growth when measured in dollars.

                The resolve of the Federal Reserve to raise interest rates has also contributed to a choppy market. Despite the insistence of Chairman Powell and other Federal Reserve Governors that short-term rates needed to rise to reach “neutral”, investors were skeptical. It suddenly dawned on them that the Federal Reserve was serious about normalizing rates while the economy grows. This helped spook the markets for two main reasons. For one, market participants are worried that over-tightening will lead to a recession. The other is that higher bond yields make equities less attractive on a relative basis and lead to lower valuations. These concerns are valid, but we think they have been overplayed as valuations have fallen and expectations for earnings and revenue growth remain positive.

                The reduction in the Federal Reserve’s balance sheet and the expectations of reduced quantitative easing in Europe are also contributors to the rise in financial market volatility. Most analysts believe that the bond buying programs of global central banks contributed to lower interest rates and dampened market volatility. As quantitative easing gets unwound, we expect volatility to stay higher than it was the last few years. However, this does not necessitate negative returns moving forward. The domestic economy continues to impress, and most international regions are still growing. Until a recession occurs, a sustained downturn in equities is unlikely.

               Markets usually rally once mid-term elections are completed. We think the pattern will hold in 2018. We doubt the Democrats retaking the House of Representatives will be perceived negatively by the markets. Many investors are uneasy about Trump, and a check on his power would likely contribute to a stock market rally. If the Republicans maintain control of the House, it will be perceived as business as usual which would probably please the market if the trade war does not escalate from here. Additionally, November is the start of the most seasonally favorable part of the year. A rally from here is not a given, but we are cautiously optimistic.

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