Stay Calm and Invest On

Okay, so the market averages all posted their largest single-day point drops in history today. Worried that the sky is falling?

Don't be. The Curmudgeon is here to allay your fears and put your mind at ease, armed with the medicine he always prescribes: the facts.

First, while a 1,175-point drop in the Dow is indeed the largest single-day point decline in the average's history, remember that we started from a very high number, historically speaking. On a percentage decline basis, the Dow was down 4.60% today, which ranks 14th in history.  Hardly the Armageddon the doomsayers would have us believe it is.

Over the last two trading days, the Dow is down 1,840 points. That's a combined 7.1% decline. And since the market peak on January 26 of this year, the Dow is down a total of 8.5%.

Time for some definitions. A bear market is traditionally defined as a 20% decline in market averages from a peak. A correction is defined as a 10% decline, and a pull-back is defined as a 5% drop.

So we're not yet even in correction territory, and certainly nowhere near a bear market. (Note that the other major averages, the S&P 500 and the NASDAQ, are down by less than 8% from their recent highs.)

One fearmonger was noting the fact that the VIX, a gauge of market volatility, was the highest since the Brexit.  Well, the Brexit vote occurred in June 2016. One month after the vote, the VIX had fallen by more than half. The VIX is always high when prices are moving fast. The Dow was up a respectable 13.4% in 2016, by the way.

Now, let's think about the word "correction." Normally, we correct something when it's wrong, and the intent of the correction is to get it back on the right track. The market had made a huge, rapid upward move since the 2016 election, with an even sharper upward trajectory since the passage of the tax bill became a foregone conclusion last December.

In short, the market was overheated, and it had gotten ahead of itself. So a correction isn't necessarily a bad thing - in fact, most market participants were expecting it, even hoping for it, as corrections present opportunities to buy stocks at lower prices.

Having said that, market valuations today aren't unreasonable. Declines through certain percentage-point levels - 5%, 10%, 20% - tend to be driven by computer-generated trades based on technical analysis. Technical analysis focuses on charts of the price movement of a stock or index. When the price falls below a given threshold - a percent decline, an x-day moving average, a previous low, or some other level - the computer programs trigger sell orders.

But see, those technical factors aren't what drives a stock's price. Stock prices (which, in aggregate, create index values) are based on the underlying fundamentals - earnings, sales, cash, debt, etc. - of the underlying companies, as well as broader economic fundamentals.

Don't get me wrong, there are technical analysts, or chartists, who make a lot of money trading on that basis. But the Curmudgeon suspects that their success results from a self-fulfilling prophecy: if enough technical traders sell when those levels are breached, the selling pressure will drive stock prices lower. And a lot of unsuspecting investors will follow, selling exactly when they shouldn't, out of panic.

So what of the fundamentals?

The economy is strong by any measure. GDP growth is trending above 3%. Unemployment is at very low levels. Incomes are growing. Manufacturing indicators are all positive. Housing is strong. There really isn't one sector or indicator I can point to (and I look at more than 80 indicators on at least a quarterly basis) that suggests weakness on the horizon.

And companies are doing well. Corporate earnings are growing. Companies are hiring and investing, buying back their own stock and increasing dividends. They're flush with cash, and now they have a significantly lower tax burden. An Apple or an Amazon or a Boeing is no different today than it was two weeks ago, when all those companies' stocks were peaking.

So why the pull-back?

Well, other than the fact that a correction was probably due, and thus investors were looking for an excuse to generate one, there are a couple of factors at play since the market opened last Friday, sparking the two-day sell-off.

Friday morning, the jobs report for January was released. And it showed that A) average hourly earnings were up 2.9% year-over-year, the most since 2009. That led to B) an increase in the yield on the 10-year Treasury note to 2.84%, the highest since 2014. And that caused some market participants to become concerned about C) higher inflation going forward. Which raised fears of D) more aggressive tightening (increasing short-term interest rates) by the Fed, which would rein in inflation but would also threaten continued economic growth. The overriding concern was that the Fed would get ahead of the market.

Okay, let's unpack all that.

A. Average hourly earnings being up is a good thing. Wage growth has been stagnant since the recession, and that served to dampen economic performance and market returns. So if low wage growth is bad for the economy and the market, how is healthy wage growth suddenly also bad? It doesn't make sense. People make more money, they buy more stuff, the companies who make or sell that stuff do better, their stock prices go up, GDP growth increases.

Yeah, too much of a good thing is ... well, too much of a good thing. But we shouldn't get too concerned about wage growth leading to runaway inflation until average hourly earnings are up more than 3.5% year-over-year on a consistent basis.

B. The fearmongers have been raising concerns over low 10-year yields signaling an imminent recession. This is a false narrative. While it is true that a flat or inverted yield curve (where long rates are lower than short rates) has often occurred prior to a recession, that is a coincidental, not a causal, correlation. And an inverted curve typically precedes the onset of recession by about two years. (The Curmudgeon can explain this in more detail, but let's not get too far off-topic here; if any reader wants to request it, I'll explain it in another post).

So low 10-year yields had the doomsayers worried, but now that long yields are rising, they're worried about that? Again, it makes no sense. And it's not like long yields are skyrocketing. A 10-year yield of 2.84% is still very low, historically speaking. In fact, from the beginning of 1962 to the end of 2008, the 10-year yield had never been that low.

And the 10-year yield today is just a half-point higher than when the Fed began raising short-term rates in December 2015, during which time the Fed has raised rates by more than twice that. Really, the 10-year has been very well-behaved for a tightening cycle.

C and D. A higher 10-year yield could indeed signal higher future inflation. But inflation is also quite low, below the Fed's target of 2%, at which they had said they would begin raising rates. They're raising them anyway, but very modestly. Two weeks ago - even two months ago - both the consensus of market observers and the Fed's own guidance called for three rate hikes in 2018, of a quarter-point each. That's one less rate increase than last year.

That hasn't changed since Friday morning.

In fact, an even better barometer of the Fed's future course of action than the 10-year yield or the stock market is the Fed funds futures market. In December, that market had priced in about a 33% likelihood of two hikes in 2018 and a 33% chance of three, with only a 15% likelihood of four increases.

Today? Guess what - virtually no change.

As for the Fed getting ahead of the market, folks, that hasn't happened since Paul Volcker was Fed chairman in the 1970s. And Volcker's drastic action of sharply raising rates was necessitated by double-digit inflation brought on by OPEC-driven oil shocks. We're nowhere near that today.

Since then, the Fed has erred on the other side, only moving aggressively when they're cutting rates. They famously got behind the market in 1994, and that caused long yields to move sharply higher.

And the new Fed chair, whose first day on the job was today (which I'm sure he loved), is exactly who we want steering monetary policy. The last two Fed chairs, Ben Bernanke and Janet Yellen, were pure academics. Like the Curmudgeon (and unlike most Fed chairs), new Fed chairman Jerome Powell doesn't have a PhD in Economics. He has, however, worked in banking, the capital markets and the U.S. Treasury. He understands the markets and the financial system like Bernanke and Yellen never could.

So don't panic. This correction - if it becomes one, and it probably will - was overdue and necessary. That's okay. The markets have experienced corrections in the past, only to pick up steam and finish the year strong. There is nothing in the economic or corporate fundamentals to suggest that this year will be any different from those prior years.