It was a nice run, wasn’t it? Over 200 days without a 3% drop in the S&P 500 Index and then, suddenly, WHAM, a market correction.

The correction happened quickly. Not as quickly as the May 6, 2010 Flash Crash where stock prices dropped more than 9% within minutes. In terms of speed, a correction over the course of a few days felt more like a Sloth Slide than a Flash Crash, although to many investors, watching the stock tickers fluctuate each day was a jarring experience. So let’s make some sense out of the chaos, and talk about how to rebuild after surprising market events.

Implications on corporate profits

A lot of fingers are being pointed at the January Employment Situation Report as the catalyst for the sell-off. The argument is that the report showed an increase in wage inflation. That reset investors’ expectations of how quickly the Federal Reserve (Fed) might have to hike interest rates. That, in turn, sent Treasury yields higher. And, looking at the equity market implications, higher inflation can also be a problem for corporate profitability from two angles:

  • Wage inflation may signal a turn in the profit cycle. Reason being: Businesses cannot often raise prices for goods and services as quickly as their input prices rise for variables such as labor. In economics, we say that there is not 100% pass-through of input price increases to output price increases.
  • When yields rise, this also typically results in an increase in discount rates applied to a company’s expected future cash flows. That means the present value of those future cash flows is less, resulting in an adjustment of prices downward.

A macro non-surprise?

A macroeconomic surprise, like inflation, can cause a market reaction, as we’ve written about before. While the wage inflation data in the Employment Situation report may have been a surprise, I actually think investors might be surprised to find that surprise was unwarranted, for three key reasons:

  • First, it’s a little early to say the increase in wage growth is here to stay. Between minimum wage increases in a number of U.S. states and one-off wage increases by individual businesses in response to corporate tax reform, it’s likely the January employment report was a bit of an aberration. While private sector hourly wages rose 2.9% year-to-year, weekly earnings only rose 2.6%. Average hourly wages of production and non-supervisory employees only rose 2.4% year-to-year.
  • Second, even if wage inflation is picking up, it’s uncertain whether the Fed will need to alter its plans for how quickly to hike rates, or their plans for what level the federal funds rate will settle at. For years, the central bank has been hanging their hat on the idea that a low unemployment rate would lead to faster inflation, but that didn’t play out that well. They may need a lot more confirming evidence to re-embrace that view.
  • Third, while a higher discount rate would—mathematically—lower the present value of future cash flows from owning stocks, just because Treasury yields rise does not mean the discount rate needs to rise. The discount rate is the sum of a nominal Treasury yield and a risk premium (extra return expected by investors for bearing risk). The risk premium can move around—a lot. There are no mechanical linkages between the movement of Treasury yields and the required return on owning stocks. From my perspective on the Multi-Asset Solutions team, we were impressed with how resilient the high yield bond market was to the recent sell-off, and—worth noting—high yield bonds have a closer correlation with equities than Treasuries do.

The good news: The surprise data wasn’t pointing to a slowdown

There have been, and will continue to be, arguments over whether the recent market slide was due simply to a whiff of faster inflation, or a sudden rise in yields, or valuations that were stretched. But the fact is, whatever happened, it likely wasn’t because the economic data was pointing to a slowdown. As long as earnings expectations continue to rise, I believe the equity market may continue to follow suit, albeit now in an environment of higher volatility than what prevailed over the past year.

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Index definitions

From a factor standpoint, the correction was a reversal from the previous year’s gains. Here’s how the factors played out in 2017 (Jan. through Dec.):

  • Large beat small
  • Growth beat value
  • High momentum beat low momentum, and
  • Quality beat low-quality (By the way, I think we need a more polite way to refer to low-quality.)

In contrast, here’s how the factors played out during the recent correction, as indicated in the chart above. During the decline from the close of trading on 2-01-18 through the close of trading on 2-08-18:

  • Small held up better than large
  • Value outperformed growth
  • Low momentum beat high momentum, and
  • Low-quality beat high quality.

What investors can keep in mind

What’s the takeaway for investors? By diversifying across factors and not just asset classes, portfolios may be a bit more resilient to market sell-offs than they otherwise would be.

From my perspective on the Multi-Asset Solutions team, I think it’s important to be on the look-out for surprises, but it’s equally important to recognize when the market’s surprise is likely an overreaction. That—we believe—is currently the case with the market sell-off. It’s also important to look at portfolios from multiple angles to assess how diversified they are. Merely looking at whether a portfolio is diversified across styles like value and growth, or by size, is not sufficient. Considering sectors, geography, and factors can also potentially help build a better portfolio.

 

Dr. Brian Jacobsen, CFA, CFP, is a Senior Investment Strategist with the Wells Fargo Asset Management Multi-Asset Solutions.

Asset allocation and diversification do not ensure or guarantee better performance and cannot eliminate the risk of investment losses.

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