Sell-Off Overlooks Solid Long-Term Trends

U.S. stocks

Sell-Off Overlooks Solid Long-Term Trends

The current sell-off is overdone, notes Investment Strategist Jeff Schulze: inflation fears have been heightened by investor complacency, and the market can handle higher rates if the rise is not too rapid.

  • The current equity sell-off has been triggered by fears of higher inflation and higher interest rates that have been exacerbated by investor complacency.
  • We believe the selling is overdone and that the market can handle higher rates if the ascent is not too rapid.
  • Long-term volatility measures suggest investors are willing to look past short-term price swings and focus on solid economic growth as a driver of equity performance.

Treasury yields have been steadily rising since September -- and until late January, equity markets had been digesting this move with little trouble. However, a spike in interest rate volatility over the last two weeks, exacerbated by strong wage inflation data from the January jobs report, has led to the largest equity sell-off in two years. Average hourly earnings came in at 2.9%, the highest level since 2009, causing some to question if inflationary pressures are about to rise, and whether the Fed may be behind the curve.

In our view, the market has overreacted to these events. We believe the real culprit behind the recent sell-off has been investor complacency. Prior to last week, the market had not seen consecutive daily declines for 310 days. Further, the record streak of days without a 5% correction was only broken yesterday. These types of streaks are rare and are typically followed by heightened volatility as fear begins to percolate back into investor minds. 

To put in perspective how content investors had been acting, it’s best to look at sentiment surveys like the Investor Intelligence Bull/Bear Ratio.  Last week, this measure was at 5.24, its second highest reading of all time. 

With complacency the real driver behind the equity sell-off, we believe the market can handle somewhat higher rates in the coming months as long as the ascent is not too rapid.

Our 2018 outlook highlighted rising interest rate and equity volatility as key themes. We felt that interest rates would rise for several reasons, including a doubling in Treasury issuance from 2017, rising inflationary pressures, stronger economic growth (with a tailwind from tax reform) and a wind-down of the ECB’s QE program. Since bottoming in early September, 10-year U.S. Treasury yields have risen 80 basis points. Despite rising interest rates, the S&P 500 has risen 16.4% during the previous six periods since 1990 when short-term rates have increased by 125 basis points or more since 1990. 

Stocks Can Withstand Higher Interest Rates (S&P 500 Average Rolling 1-Year Performance Based on Treasury Yield Change)

US Stock Sell-Off

 Source: BMO Capital Markets, Bloomberg, Federal Reserve Board. Based on monthly data from Jan. 1, 1990 through Jan. 31, 2018.

While volatility has spiked, with the VIX rising to its highest levels since 2011, it is important to distinguish between short-term and long-term volatility. While the VIX has surged, derivative contracts for longer-term volatility have seen a much more muted move. This tells us investors are willing to look past the short-term market action and expect volatility to fall from current levels as the market re-focuses on stronger economic growth in the U.S. and abroad.

Implied S&P 500 Volatilities by Time Period, 2/6/18 vs 1/15/17

 

S&P 500 Volatilities

Source: Bloomberg.

 

Top

IMPORTANT INFORMATION: All investments involve risk, including loss of principal. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not  take into account the particular investment objectives, financial situation or needs of individual investors.