Was that the top of the bull market?

  • Dow Jones fell 665 (-2.54%) points on 2 Feb
  • Dow Jones fell 1175 (-4.60%) points on 5 Feb

By now you’ve probably seen all the media headlines such as “Australian shares set to join global tumble” or “the World is ending, Sell everything” and you might be feeling a little concerned. And rightly so. On Thursday night your portfolio will have been well in the black. But looking at it today, it’s not only a lot lower but it’s swimming in a sea of red. What on earth’s going on? Our message is, Don’t Panic. Breathe.

First, let’s have a look at what’s happened. Off the cuff, it looks like a lot of positive news. It all started on Friday night. US Treasury yields spiked, the 10-year bond yield hit a four-year high of 2.843% on the back of a stronger than expected payrolls data report. That’s positive. The US recorded its biggest annual wage increase since 2009 in January. Wages are finally on the mend as hiring rose across the board despite unseasonably cold weather. That’s positive too.

So what does this mean? It means that a tightening labour market and a pickup in wage growth will help boost inflation. As inflation increases, wage growth also rises as the two are correlated. And that is welcoming news for the US Federal Reserve who are now more than likely to push that red button. The increase interest rates button. Fed officials who have long been worried about benign inflation now expect annual inflation to “move up this year and to stabilise” around the Fed’s 2% target. The Fed has forecast 3 rate increases this year after lifting borrowing costs three times in 2017. But after reading what most economists are saying, that number is more like 4-5 times.

  • US Private sector wages and salaries rose 0.6% in the fourth quarter.
  • 10 Year US Treasury yields rose to 2.83%
  • US Federal Reserve is tipped to raise rates 4-5 times this year.

Am I missing something or is all of this positive news?

And that’s just it, it is positive news. The US market had been doing so well, that it got ahead of itself and become overcooked. When the market gets ahead of itself, it needs to readjust. The US market rose close to 20% last year, it just got overbought. So triggers such as rising inflation, were enough to bring the market back to reality. That’s really what caused the fall on the Dow on Friday night. Shares came under pressure because the Fed’s rate hike expectations had increased, reflecting higher wages and bond yields. Then on Monday night the Dow fell over again, falling another 1175 points marking its biggest fall in history. But here are some of the other reasons why investors and traders are selling:

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PE expansion

The US Market has been trading on a very high PE multiple. The S&P 500 PE ratio broke 26x on 18 January driven by a huge rally leading into earnings. The rally was pricing in the flow-through of Trumps US tax benefits and these benefits won’t yet be seen in 4Q17 earnings. The correction we’re seeing now is a PE correction. The S&P 500 PE has dipped back to 24.74x.

Bond Yields

As we mentioned above, bond yields have spiked on the back of a robust jobs report which showed that wages had increased. In turn this means inflation is rising and US Federal Reserve rate increases could be more than first thought. Since the relationship between bond and equities are the inverse, when bond yields rise the stock market falls. That’s because bonds become more attractive and stocks less attractive. Hence money moves across into the bond market.

It’s likely that Friday’s pullback, caused by investors adjusting to the Fed tightening, was largely exacerbated by quant and algorithmic traders. Listening to Chief Economist at Clime Asset Management John Abernethy, he believes the PE correction has the knocked the market off its perch and its now trying to work out where fair value is. He points the finger for Monday’s massive sell-off at Algorithimc traders which had a swift impact on markets. Currently ETF’s represent about 70% of the trading in US markets on any given day. For last 12 months these ETFs have been net buyers. But as soon as they go to being net sellers, the Algos and front runners jump ahead of them. What has happened is that these traders have realised that the ETF world was about to turn on the Sell button and went in front and sold. Algo and front runners jumped ahead and sold their positions. They then bought back from the ETFs. You can see it on the chart below, the ‘flash crash’.

Selling on the Dow fell off a cliff at around 3pm New York time before markets ripped back to recoup these losses. Analysts have even said the reason for the abrupt flash crash was a combination of a calling in of margin loans, quant funds and automated Algo traders selling then buying back.

Don’t Panic

We don’t think this is the start of a new bear market. It’s a correction. Technically it had to happen. The US market had been running red hot for quite some time. Economic growth was supported by monetary policy and cheap money on record low interest rates. So a 10% correction isn’t a surprise or anything to worry about. What has to happen is Central banks need to have a co-ordinated response to the excess they’ve built up in markets through QE and the excessive cash flows pumped in equity markets funded by record low interest rates. This has brought about a volatile period. This isn’t like Brexit or the GFC. European economies are back with a vengeance, the US economy is powering ahead with low unemployment and inflation is on the rise. The only wildcard that could be a potential problem is a Chinese hard landing.

This is just a little wake-up call to de-risk and buy safe investments. You might hear that the VIX Volatility index is or “fear” gauge” have risen 76% to 38, the most in two years. That’s expected when you get such a huge fall on the Dow. However, few are actually seeing real panic in the market. This sell-off isn’t based on fear due to an underlying global thematic such as Brexit. The underlying global economics are fundamentally strong. The move is more an adjustment between equities and bonds.

For that reason, we are billing this correction as healthy correction not a fearful correction. It may last a few days but we can’t see it starting a new long term downtrend. The Dow Jones chart is still in uptrend and so is the ASX 200 Index. For it to enter bear market territory, we’d need to see the index dip back to 5400 and that’s quite a while away.

So, once the market has stabilised, we think it’s more of a ‘buy the dip’ opportunity. One thing to note however is that individual small cap stocks on the Australian market tend to get hit rather hard. This is where stop losses come into play. If you’ve set up a tight trailing stop loss and it’s breached, then sell out. It’s at times like this that stock fundamentals come into play. The quality stocks will bounce back. It’s not a time to panic and sell everything. It’s not a time to convert everything to gold and hide it under your bed. It is easy to panic about the threat of loss of wealth. Now is a time to ensure your decisions maintain a long term view rather a sudden knee jerk reaction. Review your portfolio with your financial strategy and if you need proper financial advice please give our financial planners a call. They’re always happy to help.