The turbulence continues

This is some serious turbulence. However, it’s still not close to historical records by proper measurements. Please be very careful when you hear references to the number of points the indices have moved. It is irrelevant for comparison purposes. Percentage change is what matters. A 500-point drop in 1987 was 20%; today it is 2%. It makes for good headlines but is a disservice to concerned investors. It reminds us of the popular newspaper satirist Finley Peter Dunne’s fictional character Mr. Dooley, who famously said, “the job of a newspaper is to comfort the afflicted and afflict the comfortable.” The 24/7 news cycle has once again shown all humor is just the truth slightly stretched. Depending on when you read this update, domestic stock markets are down somewhere between 5%-7% compared to the highs for the year. They are still up 25% over the last year and 300% from the lows of 2009. That doesn’t mean we shouldn’t be concerned. We are. Here is our current view on what is going on. We don’t believe valuation is a problem. Historically low inflation and interest rates justify today’s relatively higher P/Es. The stock market certainly doesn’t have an earnings problem. Some argue that the cut in the corporate income tax is a one-time benefit to earnings, in the form of a lower tax expense, and that benefit has now been accounted for. Therefore, they believe earnings won’t continue their current growth path. We disagree, improved earnings are due to revenue growth that has picked up because of the strength in the global economy. Revenue growth for the S&P 500 is up 5% year over year (YOY) as of the last Q3 reading. More importantly, sales are up 8% YOY in their latest reading. Consensus revenue and earnings numbers for 2018 are also higher. This sell off appears to be a reaction to higher interest rates and the fear of inflation. Looking at prior periods where economic growth accelerated and the Fed announced tightened monetary policy, we see a very similar pattern. The important conclusion is that improved earnings and growth should overcome the offset in valuation due to higher interest rates. After the initial “tightening tantrum,” investors refocus on the fundamentals and markets once again move higher. It usually takes 12-18bs of higher interest rates to actually start slowing the economy down. We don’t believe the bull market is over or that we have seen the all-time highs. We believe the markets will rebound and eventually make higher highs over the next year. Before declaring markets are fine, we looked long and hard into whether we are missing something. While we couldn’t come up with another 2008 scenario, when investors overlooked the massive amount of leverage and debt in the system, there is something we are concerned about. We also think it helps explain the ridiculous intraday movements. There are somewhat new ETF instruments that allow investors to profit by taking inverse positions to the volatility index (VIX). It’s an easy way to make a little money so long as volatility remains low. It’s often been marketed as a safe bet. Investors in these instruments have gotten hammered, some losing 80% of their money. As the losses mount and investors sell, they’re no longer tracking the index as closely as promised. This is causing even more selling. Credit Suisse and other investment banks have declared they will no longer participate in these vehicles, causing a further run for the exit. We don’t think these instruments are the reason for the sell-off and we don’t think they create systemic risks long term. However, we do believe they are partly responsible for the intraday volatility of markets. As of today, we believe portfolios are properly positioned. More aggressive investors may want to consider adding equity at this time. We expect markets to be higher a year from now, but the next few weeks may be bumpy. The GreenPort Team