Darrell Cronk, CFA®
by
President, Wells Fargo Investment Institute
Key takeaways
  • Last week’s equity-market correction led to concerns for investors about market volatility.
  • We believe that last week’s correction was technical in nature, and that it did not reflect any changes in the fundamental underpinnings of the U.S. economy or equity markets. Yet, we do expect more market volatility in 2018 than we experienced last year.
What it may mean for investors
  • We believe that this is an appropriate time to rebalance investments, to diversify holdings broadly and globally across all asset groups, and to capitalize upon improved equity-market valuations to add quality holdings to portfolios.Tax reform and the budget agreement may place more upward pressure on domestic interest rates, which may lead to more volatility in fixed-income markets as well.
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Last week’s equity-market correction led to a number of questions for investors. In today’s report, we provide answers to the questions we are hearing most frequently.

Was last week’s equity-market correction more technical than fundamental?
 
Yes. We do not view last week’s equity-market correction as reflecting a change in the fundamental outlook, but rather as a normal and healthy correction in an improving macroeconomic landscape. The S&P 500 Index fell 10.2% from January 26 through February 8, 2018. By comparison, the drawdowns of 2010, 2011, and 2015-2016 saw the index drop 16%, 19.4% and 14.2%, respectively. The 2450-2550 area remains a key support level for the index after testing and holding the 200-day moving average. Historically, markets often need to test the key support levels a number of times before consolidating—and then moving up to the next, higher level. 

Are corrections of this size and speed normal?

Yes, they are—as the economy enters latter stages of recovery cycles. For example, during the latter stages of the 1990s bull market, there were three corrections ranging in size between 10% and 20%. During the latter stages of the economic expansion in the 2000s, there were three corrections ranging in size between 8% and 10%.  In both cases, the S&P 500 Index still appreciated by 20% following the first correction. Investors who turned defensive after initial market corrections may have missed out on further gains.

Have we entered a new regime of higher equity-market volatility? 

We believe so. Once volatility is out of the bottle, it is very difficult to put it back in. What stands out most from this week’s rise in volatility is how quickly we have moved from near-term record lows in the VIX (CBOE Volatility Index) to what was one of the highest VIX levels on record (50.30) on an intraday basis on Tuesday.  During the second half of 2017, volatility across equities, interest rates and currencies maintained historically low levels. In our 2018 Outlook report, we discussed our expectation for higher volatility throughout this coming year. At this point, we would find it difficult to imagine that we will return to the prior record low levels of market volatility.

Will the Federal Reserve (Fed) raise rates too quickly?

We do not believe so. This is always a risk later in economic recoveries—as economic and earnings growth accelerates. The Fed is currently projecting three rate hikes for 2018, and recent upward pressure in inflation data and fiscal stimulus has the market wondering if more could be (or should be) on the table this year. We believe that we have moved solidly into the middle of the current rate-hiking cycle with a stronger economic growth backdrop domestically and globally than we witnessed during the elongated rate-hike pauses of 2015 and 2016. As growth accelerates and a new Fed chair takes the reigns, there remains a risk that the Fed will move too quickly on tightening monetary policy, but we do not believe that risk is material today.

When do 10-year Treasury yields become a problem?

We have viewed a 10-year Treasury yield range of 3.50-4.00% as a more challenging level for equity headwinds than a market environment with 3.00% 10-year Treasury yields. Recall that from 2010-2013, the 10-year Treasury yield was above 3.00%, and equities performed well. While 3.00% may be an important psychological level for markets to digest—in the near term, it will be more about the rate of yield increases than the absolute 10-year Treasury yield level that will cause equity-market consternation.

Has the recent equity correction reset extended market valuations?

Yes. This correction (while swift and strong) pulled nearly two full points of price/earnings (P/E) multiple off of the S&P 500 Index valuation as of February 9 (from 18.9x on January 26 to 17.2x on February 9). The correction has brought the S&P 500 Index to a more attractive level, compared to its 30-year average of 16.7x, and this means that the S&P 500 Index valuation has reached an attractive level, given 10-year Treasury yields that now are below 3.00%. Through this latest correction, small-cap equities have outperformed large-cap equities, which is a good sign that market expectations for inflation and interest rates are not direct threats to the economic expansion.
 
Have alternative investments helped or hurt portfolios during this correction?  

The short answer is that they have helped portfolios. They have protected on the downside as we would expect them to do, and they participated on the upside. Alternative investment strategies have the ability to be more nimble and to use tools that long-only managers do not have during down markets. This capability can offer these managers flexibility during turbulent markets. Additionally, alternative investments historically have lower correlations to traditional assets like equities and fixed-income securities than some other asset classes do. 

Has the federal government added too much fiscal stimulus in the near term, with tax reform and the new budget deal? 

We are in somewhat uncharted waters today, with two of the most sizable fiscal stimulus packages in recent memory having been inked in the past few months. Historically, it has been very unusual to add this much fiscal stimulus when economic growth is accelerating and when the U.S. economy is, by most measures, at or close to full employment. We believe that there are two important implications of last week’s budget package. The first is that there is likely to be upward pressure on U.S. gross domestic product (GDP) growth for 2018—as government spending will be higher than originally anticipated. The second implication is that there likely will be upward pressure on interest rates as widening budget deficits for 2018 and 2019 will cause a larger supply of U.S. Treasury securities to be issued to fund rising U.S. budget deficits.