Market tremors and the financial laws of motion

The recent stock market sell-off have been virulent and widespread, which raises the question of whether we are witnessing the end of the longest bull market in history, or just another transitory market tremor.

The correction can be seen as a due response to long-term interest rates ratcheting up since the beginning of the year, which conversely are a reflection of the US economy running at full steam and a build up of inflationary pressures.

After all, our limited knowledge of the behavior of financial markets tells us that higher interest rates should affect negatively the stock prices, as future cash flows have to be discounted at higher rates, and corporate earnings are burdened by a larger interest expense.

However, market dynamics have more to do with plate tectonics rather than the motion of celestial bodies. Market jitters observe a “stick-slip” behavior, as pressure (fears) can build under the crust without any apparent manifestation, until the energy is suddenly released in the form of an earthquake.

In this respect, the tax reform in the US has served to alleviate pressure, as the growth in corporate earnings has largely overcompensated for the increase in interest rates, but evidence of wage growth and a seemingly undeterred Fed have added stress back to the system.

At this point, the question is whether this is just a “healthy” market correction, or the beginning of a bear market. Unfortunately, predicting market turning points remains as elusive as the timing of earthquakes, but what is in our hands is to ensure that we rest in solid foundations.

Both in the case of stocks and bonds, this means buying insurance and investing on quality companies that have business models and balance sheets that can withstand the economic cycles. After all, in the long-term, interest rates and economic growth tend to revert to the mean, and it is the compounding of earnings and coupons what make portfolios grow over time.

We also need to keep monitoring “early warning” signals (spreads, PMIs, confidence indicators, etc.) that may indicate a turning point in economic activity. Beyond its length, we have hints that we are at the late stages of the current cycle (leverage, rising rates), so a conservative stance is here warranted.

Diversification is the other prudent measure. In earthquakes proximity to the epicenter determines the severity of damage. Pressures are building in the US as a consequence of a withdrawal of liquidity, but this is not yet the case in Europe and Japan where valuations are also more attractive. Unfortunately, unlike plate tectonics, financial markets are much more prone to contagion; and here, our number one concern remains China.

To sum up, we all feel the unease of investing in equity markets in the knowing that, like the seismologists who monitor the San Andres Fault, the “Big One” is largely due. However, we need to remind ourselvesthat we are not dealing with a physical system; and thus avoid the fate of Newton, who after being bankrupted,bitterlyaffirmed that “he could ‘could calculate the motions of the heavenly bodies, but not the madness of the people”.

 

Fernando de Frutos, MWM Chief Investment Officer

 

* This document is for information purposes only and does not constitute, and may not be construed as, a recommendation, offer or solicitation to buy or sell any securities and/or assets mentioned herein. Nor may the information contained herein be considered as definitive, because it is subject to unforeseeable changes and amendments.

Past performance does not guarantee future performance, and none of the information is intended to suggest that any of the returns set forth herein will be obtained in the future.

The fact that MWM can provide information regarding the status, development, evaluation, etc. in relation to markets or specific assets cannot be construed as a commitment or guarantee of performance; and MWM does not assume any liability for the performance of these assets or markets.

Data on investment stocks, their yields and other characteristics are based on or derived from information from reliable sources, which are generally available to the general public, and do not represent a commitment, warranty or liability of MWM.

Leave a Reply