Is This The Market Correction We Have Been Expecting

The S&P 500 has gone about 1,030 days without a 10% correction, which is the third longest period without such a correction in 25 years. Of course, it is just a matter of time before we get a 10% decline in the broad equity indexes and when it comes it will be healthy for the markets’ continued run up. However, we shouldn’t be paralyzed waiting for stocks to drop – recall that between 1990 through 1997 equities went 2,573 days without a 10% correction and the market doubled in value from the 1997 peak. What makes the lack of such a correction now so surprising is that there has been no dearth of news that might serve as a catalyst for a meaningful market decline. The markets have taken in stride the events in Crimea, the downed passenger plane in Ukraine, escalating violence in the Middle East, concerns about China’s banking system, and ISIS in Iraq; any one of which might have frayed the nerves of investors and caused a wave of selling.

Within a few basis points one way or the other, the broad equity indexes declined 2.7% last week, the largest weekly percentage decline in just over two years. The S&P 500 is now down 3.2% from the July 24th record close. Not yet a 10% correction, but enough to get everyone’s attention. The market first began to slip last week with news of Argentina’s debt default and the ordered recapitalization of Portugal’s Banco Espirito Santo. However, Argentina has become a serial defaulter and the BES news was expected. So, more likely than not, it was economic data that supports an improving economy that was the catalyst for the market drop. In every economic recovery there is a point where good news becomes bad news, because good news provides a reason for Fed accommodation to be lifted. The Fed has been transparent with their intensions; they will continue to reduce and then terminate their bond buying program in October and they will maintain a zero-interest rates policy until such time as economic conditions warrant an increase in rates. Last week’s market drop registered investor fear that rates will rise sooner than otherwise expected.

However, investor concern over higher interest rates will dissipate as they come to the realization that rising interest rates are a sign of real economic improvement. Moreover, even though rates will rise in the months ahead, interest rates are likely to remain historically low. (See the most recent Telemus Quarterly Commentary.) Historically, the equity markets have performed well in rising interest rate environments, as long as the 10-year Treasury remains below 5%. We have very little concern that the 10-year Treasury yield will even approach 5% for years to come. Whether this market downturn will deteriorate to a 10% correction will prove itself over the days and weeks ahead. The cause of a further decline could be increased geopolitical tension or more concern for rising interest rates. However, the geopolitical situation will soften (as it always does) before it rears its ugly head again. As for interest rates, an improving economy will cause rates to rise, but for the right reason.

In the meantime, we continue to take action in client portfolios consistent with our view of the economy, our overall investment strategy, and client risk parameters. We have reduced our interest rate sensitive fixed income exposure and have increased our holdings to credit sensitive area of the bond market. The duration of our fixed income portfolios continues to be less than our benchmark because of our view that interest rates will rise. Global bond yields have actually decreased since the start of the year, so our shorter duration positioning has detracted from performance relative to our Barclays Global Aggregate benchmark. Given the improving economy and the likelihood of rising rates, we will maintain our shorter duration positioning.

Relative to our equity holdings, we continue to overweight international companies because of more favorable valuations than domestic stocks. However, economic growth outside of the US has been harder to come by and Russian sanctions certainly pose a risk to Euroland recovery. However, as the US economy builds strength there will be a spillover effect, which may mitigate some of the impact of Russian sanctions. In addition to last week’s strong GDP report, the existing homes sales number was very promising and the jobs report was decent, though it fell marginally short of expectations. Relative to jobs, the Fed is very focused on wage growth in determining interest rate policy and wage growth is likely to improve as corporate confidence builds and the jobs market tightens. Recent capital spending numbers have improved and M&A is robust, both of which signal strengthening corporate confidence. As always, economic fundamentals will drive the true direction of the markets and monitoring economic metrics will continue to be our focus.

We understand that short-term downturns in the market can be disquieting, so please feel free to reach out with any questions or concerns.