What's behind the market pullback

Investors weigh rising rates and the risk of an overheating economy.

  • By Jurrien Timmer, Director of Global Macro for Fidelity Management & Research Company (FMRCo),
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Key takeaways

  • After a period of unusually high returns and low volatility, US stocks fell sharply in recent days.
  • Investors seemed concerned about rising rates and the potential for the economy to overheat.
  • While a pullback can be unsettling, these types of drops are more typical than the recent period of sustained low volatility we have experienced.

About the expert

Jurrien Timmer is the director of global macro in Fidelity's Global Asset Allocation Division, specializing in global macro strategy and active asset allocation. He joined Fidelity in 1995 as a technical research analyst.

After an epic run that saw the S&P 500® Index price rallying 59% from its February 2016 low of 1,810 to last week's high of 2,873 without so much as a 5% correction, I suspected that when a drop did come, it would be sharper than normal.

It finally happened. After gaining 5.7% in January, the S&P 500 fell 9%, or 259 points, from its high of 2,873 to an intraday low of 2,614 on February 6. The VIX spiked from its recent low of 8.9 to an intraday high of 49—before quickly subsiding near 25 as the market stabilized.

Of course, last week's sell-off still leaves the S&P 500 index 950 points above its February 2016 low and more than 2,000 points above its March 2009 low. But by Friday afternoon that context seemed to be missing as investors were scrambling for explanations behind the Dow’s 666 point decline.

Stocks are repricing the risk of higher rates

The reason for the sell-off seems simple enough: The stock market has finally started to pay attention to the bond market again. Bond interest rates are an essential piece of the equity valuation puzzle, as higher rates decrease the perceived value of future earnings and put pressure on profits.

Bond yields have finally gone up so much that they can no longer be ignored. Since the July 2016 low of 1.32%, the 10-year Treasury yield more than doubled to 2.84% as of February 2.

Until last week, the stock market had completely ignored this important part of the equity valuation equation, so much so that it conjured up memories of 1987. Back then, the stock market rallied 40% while bond yields also rallied 40%, leaving the "Fed Model" (the difference between the bond yield and the stock market's earnings yield) woefully unbalanced. That proved unsustainable, and the stocks experienced a dramatic sell-off known as "Black Monday."

Today's 2.84% bond yield is of course a far cry from more than 10% in 1987, but the link between interest rates and stock valuations remains. That's especially relevant now that equity valuations have expanded so much. Before last week's dip, the price-to-earnings (P/E) ratio for estimated earnings over the next 12 months had risen to 19.3. The 12-month trailing P/E had risen to more than 22, and the 10-year cyclically adjusted P/E (CAPE) was all the way up to 30x. Those were the highest levels since 1999.

Last week's correction ironically happened despite a dramatic rise in earnings estimates, with the consensus estimate for 2018 earnings growth now at +20%. Last August that number was +12%.

But in a way this is quite logical, because amid the euphoria of rising corporate earnings it has been clear that both the equity and bond markets were being too complacent about the other side of that trade: tax cuts could push the economy toward the overheating phase. If that happened, the Fed would likely raise rates with implications for interest rates in general.

For months I have been concerned that the market was underpricing the Fed's tightening path and that the sharp easing of financial conditions since early 2016, despite the Fed’s rate hikes, would likely prove unsustainable.

Back in August the bond market was only pricing in 1 more rate hike over the coming 2 years, well short of the 6 hikes suggested by the Fed's dot plot. And even just a month ago it was pricing in only 3 more. Now bond market futures imply 4.4 hikes (for a total of 9.4 for the cycle), which is still below the estimates in the Fed's own survey (suggesting 11 hikes in total), but certainly a lot closer than before.

So the good news is that the bond market's re-rating of the Fed's tightening path closer to the Fed's dot plot suggests that the 10-year yield is now a lot closer to "fair value" than it has been. That means we could be getting close to the end of this move in interest rates for a while.

The silver lining

The silver lining to the stock market now suddenly being held captive by the bond market is that it is much better for stocks to start paying attention to rising rates now, rather than keep ignoring them and suffering a much worse fate later, as it did in 1987.

Whether last week's correction continues for days or weeks to come is of course unknowable. My guess is that the market chops around for a while, perhaps several months, as typically happens after the economy reaches a momentum peak. For the typical investor, it's worth remembering that part of the value of the stock market is that over the long run, equities generate better returns than less risky investments (like money market funds or bonds) but that the "cost" of those higher returns is higher volatility. In that respect, nobody should view the 52% return for the S&P 500 over the last 2 years—amid record low vol—as normal.

So I for one am not concerned that the stock market is starting to behave like its normal self again. And for investors with an appropriate investment plan based on their risk tolerance, goals, financial situation, and timeline, short-term volatility shouldn't require any action. More active investors may actually welcome this volatility. I myself am relieved actually. Better a correction now than a bear market later.

Corrections are like vegetables in that sense. They don't always taste good, but they can be good for you.

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