Market Update 9.30.2018

Before discussing the third quarter, I need to address the recent volatility in the market.  The market has experienced significant volatility last week reacting to higher interest rates.  Interest rates are rising, but they are still at historical lows. 

We have experienced very low interest rates for over nine years.  The latest volatility in the market started when the 10 year bond rate went over 3%.  The long term average is 6%, so we are a long way off from the average.  The speed at which rates rise is an issue, but rates are not spiking. 

High interest rates are generally an indicator of inflation which is an indicator of an oncoming recession.  None of the major recession indicators indicate a recession is near or likely.

There is evidence of some inflation, but it is modest.  Inflation has been almost zero for many years now.  While that means prices are not rising, it also means wages and incomes are also not rising.  Wages and income have been flat for many years now.  Part of a healthy, growing economy is growing wages and income.  As with interest rates, the speed at which prices, wages and income increase is an issue, but none are spiking.

Both rising interest rates and mild inflation are to be expected at this point and represent a growing, healthy economy and market.  The volatility of the last week is not based on any major underlying issue.  The fundamentals of the economy are very strong and holding.  Same with the stock market, earnings are strong and stocks are not over-priced.

Two technical issues arose this past week that had an effect on the market downturn.  First, when stocks drop below certain price (support) levels, the computer driven algorithms that run some large hedge funds, trigger the funds to sell stocks.  That occurred on Monday, when a 300 point drop suddenly became an 800 drop.  It is important to note that the same phenomenon occurs in the reverse during a market rally.  The second issue occurred on Tuesday.  Margin calls caused the market to drop midday.  Investors who buy their stocks on credit must put up their stocks up as collateral.  When the value of their stocks drop below stated minimums, they must deposit more money or investments in their accounts or stocks are automatically sold to cover the drop.

The market ended the week showing signs of stabilizing and bouncing back, although the market lost some ground today.  Third quarter earnings announcements have just begun.  Earnings are expected to be positive, however, companies’ outlook for the next quarter may create some volatility. 

Now back to our regularly scheduled program: the U.S. stock market had an amazing third quarter, increasing 7.22% for the quarter.  That is the strongest quarterly increase in nearly five years. 

The third quarter began with very strong corporate earnings reports with the vast majority of public companies beating consensus earnings estimates.  Tax cuts continued to support corporate profits.  But the Fed’s interest rate hikes and US – China trade tensions exacerbated volatility.

Although trade is an issue, the U.S. made positive strides during the quarter with a preliminary re-negotiated trade deal with the EU, a finalized deal with the South Korea, and a re-negotiated deal with Mexico and Canada.

Highlights from the quarter:

• GDP growth boomed to 4.2% on an annualized basis during the second quarter of 2018.
• Interest rates rose across the yield curve, with the biggest increases coming in the three years and below range. This caused the yield curve to flatten, which has historically been a sign the economy is going into recession.  But that is not the case now.  The flat yield curve has more to do with the Fed keeping short term rates artificially low for many years and now selling the bonds they bought as a part of quantitative easing.
• Inflation increased slightly
• Employment – job growth has been solid in 2018. The unemployment rate has dropped below 4%.
• Housing market continued to do well.

Looking forward, we are heading into the fourth quarter which is one of the best quarters historically.  Experts expect the economy and market to continue to perform well.  You will hear lots of talk regarding the issues the market will have be facing next quarter and next year.  There are definitely “headwinds” facing the market: higher interest rates; higher wages; and higher costs related to tariffs.  But, again, we have had historically low interest rates, no inflation and no wage growth for many years.  These things must increase.  It is the speed with which they increase that could be an issue.  Trade tariffs are a tactic being used to obtain better trade agreements and in the case of China, to also stop them from stealing our technology and intellectual property which costs the U.S. billions every year.  The tariffs have achieved results and show signs that more trade deals will be done.  You hear a lot about tariffs increasing costs, which is true, but in all my research I have yet to hear of another tactic that has any chance of obtaining better deals and stopping the Chinese from stealing our technology.  Tariffs take time to achieve their goals.  The stock market in China is down over 20% since the tariffs started.  The Chinese government has had to artificially stimulate their economy to stabilize it.  The Chinese government also controls public discourse so no one complains which gives them time to hold out.  But their economic situation is not good because of the tariffs and shows no signs of improvement.