After peaking at over 26,000 as measured by the DJIA in January, US equity markets have experienced the return of volatility in a big way thus far this year. However, the volatility we have seen really falls within normal and healthy ranges of a typical market consolidation, especially on the heels of such an extraordinarily strong move up in 2017. In fact, 3 months ago there was some concern about valuations becoming excessive. But with the consolidation we have seen, coupled with a strong underlying US economy and strong corporate earnings, a market that was pressing towards 22x 2018 forward earnings is now trading at a much more comfortable 17x 2018 forward earnings. If the market continues to trade sideways as we expect, and earnings continue to surprise on the upside, we are expecting the forward PE multiple to fall even further in the next few months.
Certainly, the day-to-day barrage of headlines out of Washington DC is contributing to the volatility. However, the markets do seem to be acting more and more desensitized in the past month or so to the inordinate number of tweets and ordinarily jaw-dropping headlines we have seen out of Washington. Ordinarily, these types of political and/or geopolitical events, while somewhat nerve-racking in the extremely short term, do not usually carry much weight in determining stock prices, economic policy, the business cycle, and interest rates in the intermediate term. We do believe the market reaction to these news headlines will continue normalize and become less impactful on short-term market swings in the coming months.
Our opinion is that the much more influential factor weighing on stock prices since February is the move higher in longer term interest rates (see the chart below of the yield on the US 10 Year Treasury Note since 1994 for reference).
It is important to remember that interest rates have been inordinately and abnormally low for nearly a decade because of the extraordinary policies that the Federal Reserve and the US Treasury implemented in response to the 2008-2009 financial crisis. Essentially, we are finally witnessing the unwinding of that “easy money” era and, in my opinion, reasserting a normal interest rate curve.
This unwinding and normalization of interest rates and monetary policy is a very good thing for several reasons;
Our sense is that it will take a while yet for longer term interest rates to fully normalize in that 3 ½% to 4.0% range. The actual range that interest rates settle at will depend on about a million factors, but most notably inflation, unemployment, and growth. To the extent these 3 components can settle in at the targets that have been set by the Fed and the President’s economic council (specifically 2.0% inflation, 3.0% GDP growth, 4.0% unemployment), we expect the business cycle to continue a very sustainable path for several years.
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Mark P. Culver
Culver Investment Company, LLC
360 Interlocken Blvd
Broomfield, CO 80021
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