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Economic Perspective

February 2018

After consistently reaching record highs over the past 15 months, the financial markets recently hit a long-anticipated bump in the road. Thomas Dillman, President of Mutual of America Capital Management LLC, takes a look at some of the key reasons behind the slide in stock prices and return of market volatility, as well as the strong underlying economic and corporate profit fundamentals that may bode well for continued growth during 2018.

After advancing 7% in January, the S&P 500® Index gave it all back and a bit more during the first three trading days of February. From a fundamental perspective, the consensus explanation for the downdraft in stock prices was the increasing investor concern over rising expectations of inflation and the consequent concern that the Federal Reserve would accelerate its program of gradual interest rate increases, thereby possibly prematurely ending the expansion and tipping the economy into recession. Warning signs were flashing for a few months, including rapidly rising long-term interest rates, a sustained decline in the relative value of the dollar and upward movement in key readings of investor opinions about the trajectory of general inflation.

Behind the Slide in Stock Prices

The spark that set off the slide in stock prices was the U.S. employment data for January, which showed a recent acceleration in year-over-year average hourly earnings to 2.9%, from an originally reported 2.5% December rate that was revised to 2.7% in the January report. Another indicator that labor costs are accelerating was the unit labor cost reading for the fourth quarter of 2017, reported at 2.0% versus an expectation of only 0.9%.

Rising labor costs are a concern because they can lead to businesses raising product prices to maintain margins and thereby boosting generalized inflation. On the other hand, if businesses cannot raise product prices because of competitive pressures, profit margins get squeezed and profit growth slows. Either outcome is a negative for stock prices.

Another explanation for the abrupt and steep decline in stock prices over such a short period of time relates to specific technical factors of the markets themselves. Volatility, a measure of the expected variability of stock price changes in the future, spiked dramatically with the market decline after the market had experienced one of its longest periods of calm on record. In response to historically low and stable levels of volatility, many investors made large bets that volatility would remain dormant. However, when volatility exploded on the upside, many of these investors were forced to reverse those bets, thereby adding fuel to the fire. Similarly, many who had invested in Index ETFs (exchange-traded funds) began to sell, either out of fear or because of forced margin calls (i.e., ETF sponsors were forced to sell the underlying stocks to liquidate sellers' positions). Finally, computer-based trading, which is triggered by market signals only, also played a part in the wild intraday price swings that accompanied the recent declines. It's important to note that in all three examples, the act of selling had little to do with underlying fundamentals. Investors just wanted to get out of a declining market as quickly as possible.

It is not particularly surprising that the stock market finally cracked. After all, stocks advanced 35% since the U.S. presidential election in early November, 2016, with almost no interruption and very little day-to-day price variation. Bull markets usually experience at least three corrections of 5% or more per year, but the current bull market had not seen a serious downdraft for 18 months.1

Multiple Reports Reveal a Strong Economy

More important, however, is that the underlying economic and corporate profit fundamentals remain very strong and appear sustainable. Almost all economic reports, both domestic and international, have been meeting or exceeding expectations. Corporate sales and earnings reports for the fourth quarter of 2017 are especially strong. As of this writing, with more than 50% of all S&P 500® companies having reported, almost 80% beat sales expectations, 73% exceeded earnings expectations, and nearly 60% topped both sales and earnings expectations. 2 These are the strongest results since records began in 2000.

We continue to believe that bear markets occur when recession is on the relatively near-term horizon. We monitor a variety of variables that generally precede recessions and, at this time, find few that suggest we are close to an economic reversal. Economies are strong, profits are accelerating, margins remain stable at historical peaks, the yield curve has been steepening recently rather than flattening (as it has always done prior to recessions), and business and consumer confidence remain robust. We believe the markets will work through this period of heightened volatility and refocus on the fundamentals.

1Savita Subramanian, Bank of America Merrill Lynch, "Market Pullback Through a Quant Lens," February 7, 2018.

2

Savita Subramanian, Bank of America Merrill Lynch, "Earnings Season Update, Week4," February 4, 2018.

The views expressed in this article are subject to change at any time based on market and other conditions and should not be construed as a recommendation. This article contains forward-looking statements, which speak only as of the date they were made and involve risks and uncertainties that could cause actual results to differ materially from those expressed herein. Readers are cautioned not to rely on our forward-looking statements.

Mutual of America Capital Management LLC is an indirect, wholly owned subsidiary of Mutual of America Life Insurance Company. Mutual of America Life Insurance Company is a registered Broker-Dealer.


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