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Thoughts on the Market Correction

North American stock markets had a tough day, following a noteworthy decline on Friday. Overseas markets are following suit tonight. Unfortunately, corrections can sometimes be self-feeding in the short run as crowd sentiment shifts. Given that investor sentiment indicators were elevated following a long period of low volatility, we are bracing for the possibility of more downside before the market stabilizes. Nonetheless, we don’t believe there is reason to panic and alter investment plans. 

In our view, the latest market action is not the beginning of a bear market. Rather, we see the recent decline as a healthy and normal pull-back following an extraordinary run. Before the recent setback, the broadly based U.S. S&P 500 Index had gone a record 448 days without a 3% decline. According to analysis by Bespoke Investment Group, at no time since 1927 has that happened. 

The good news, or what provides comfort, is that this setback seems to be driven by good economic news. In particular, a pick-up in wage inflation in the labour market report last Friday seemed to be the trigger for the sell-off. Expectations of higher inflation have pushed bond yields higher. The worry is that the Federal Reserve will tighten interest rates further and ultimately kill the economy. We think such worries are premature. U.S. 10-Year bond yields are still below 3% and not at a level that we believe will upend the economic expansion. The rise in bond yields may slow the expansion, but will not kill it. Furthermore, the yield curve is still positively sloped (long-term interest rates are higher than short-term interest rates). Recessions typically happen 12 months after the yield curve inverts. And the stock market normally keeps rallying for six months after an inversion. An inversion of the yield curve is a warning sign that we pay attention to; we are simply not at that juncture.  

Some argue that stocks are too expensive and needed to correct. In our view, valuations are not a major concern. Stocks are reasonably priced relative to growth prospects and interest rates. Volatility had been abnormally low for an extended period of time, and a return to normal levels of volatility is not something to fear. Equity investors should always be prepared for volatility and regard it as a necessary evil in the pursuit of wealth creation.

We don’t see the sort of widespread excesses in the stock market or economy that would cause us to worry. Moreover, credit and currency markets were well behaved today, and that is also comforting.