Uncategorized, Weekly Update

A Wall of Worry Is Building

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Published February 23, 2018


A recent commentary from the folks at Schwab provides a good overview of where markets stand right now. We have pointed out in recent weekly blog posts the sharp rise in interest rates that has occurred since September. Further fuel was added to the interest rate uptrend when the monthly jobs report showed wages growing at the fastest rate in years. Wages are the largest component of inflation. Expectations for higher inflation triggers a rise in interest rates. Stocks, after basking in the glow of a corporate tax cut in January, reversed course in February as investors shifted to worrying about inflation. Now, the stock market stands at the intersection of a seemingly inexorable rise in interest rates (negative for stocks) and global corporate profits that are also rising swiftly (positive for stocks).

The red circle below shows the February pullback in stock prices (the blue line). Note that stock price has created a disconnect with global earnings (the orange line), which thus far remain strong. The current disconnect differs from where we were at the last stock market correction in early 2016. In that correction, circled in purple, global earnings were sliding, in part related to weakness in the energy sector.

Stocks prices have disconnected with earnings as they did two years ago

This time, it appears that stock prices are blowing off some steam after a non-stop rise in 2017 and adjusting to a world where interest rates are approaching “normal” levels. The rise in interest rates should abate at some point, assuming wage growth doesn’t accelerate much further. The financial conditions index is shown below, with lines marking rollovers before prior bear markets in stocks. At least so far, there seems to be little cause for concern from this metric, which shows improving conditions worldwide.

Financial conditions show few signs of deteriorating as they did in 2008 and 2011

Higher interest rates can ultimately be a bull market killer. Wage growth is the primary driver of ramping inflation. The chart below shows the uptick in wages. As long as global growth remains strong with corporate earnings rising solidly, the stock market should be able to weather a modest pace of interest rate hikes. However, we need to see interest rates calm down after almost six months of almost straight up movement. Until that point, the rise in rates is building a wall of worry that could fuel the next move higher for stocks.

Employment Cost Index (year-over-year %-change)

Market Update

After last week’s strong rebound off the 200-day moving average, investors looked to hold on to that swift recovery in the face of new information from the Federal Reserve this week. Coming back from President’s Day, stocks were under pressure early Tuesday. Disappointing earnings from Wal-Mart (WMT) tangled with a solid report from Home Depot (HD) to fight for investor sentiment. A weak auction of 2-year Treasury bonds kept the spectre of rising interest rates on the table. Stocks ultimately finished lower by -0.6%. Another -0.6% came off the S&P 500 Wednesday. This time it looked nastier, however, as stocks were higher by over +1% during the day. The selling commenced when the Fed’s meeting minutes were released. Those minutes showed the committee’s resolve to hike rates in response to expected building inflationary pressures. The minutes sent 10-year Treasury rates upward near 3%, a level some view as likely to damage stocks. No surprise that stocks sold off on the news. However, yields backed off in Thursday’s session giving stocks some breathing room. However, once again, the market indexes failed to hold a rally, closing up only +0.1% after being ahead by as much as +1%. The inability of the market to hold gains and overcome resistance at the 50-day moving average is seen as concerning to bulls. But stocks rallied on Friday, turning what was a disappointing week into a modest success.

Though the tone was negative through much of this holiday-shortened week, stock indexes managed to hold on to the bulk of their rebound from February’s sharp selloff and finish the week strongly. For this week, the S&P 500 (SPY) and the small-cap Russell 2000 (IWM) finished slightly positive with 0.57% and 0.77% respectively. The Friday strength powered the Nasdaq 100 (QQQ) upward by  +1.95%.

Warm wishes and until next week.