Strategy: Another Panic Attack. I am once again channeling Robert Langdon, the “symbolist” in Dan Brown’s 2003 mystery thriller The Da Vinci Code, which was turned into a 2006 movie starring Tom Hanks. On March 6, 2009, the S&P 500 hit an intra-day low of 666 (Fig. 1). A few days later, I explained why I thought that devilish number might have marked the beginning of the latest bull market—and that turned out to be the case. Now “666” is in the headlines again: It’s the amount by which the DJIA fell on Friday.
So not surprisingly, Friday evening I received several emails from our accounts wondering if the 666-point drop in the DJIA might have marked the top in the bull market. The short answer: I don’t think so.
Of course, in percentage terms 666 isn’t what it used to be. It amounted to a 2.5% decline on Friday. During the previous bear market, the DJIA plunged 7617 points from October 9, 2007 through March 9, 2009. The last 666 points of that decline amounted to a 9.2% drop (Fig. 2).
The S&P 500 is down only 3.9% from its record high of 2872.87 on January 26. It is still up 3.3% so far this year. Nevertheless, I accept responsibility for contributing to last week’s sell-off when my commentary last Monday was titled “Don’t Worry, Be Wealthy.” While very few investors give any weight to symbolism and numerology, we all know we should beware when everyone is bullish. After last week’s action, many investors are likely to be less so.
While the title of last week’s commentary turned out to be a good short-term contrary indicator, the third story in that piece was titled “1987 All Over Again?” The simple answer: I don’t think so, but Black Mondays tend to occur on Mondays, so let’s see what happens today. I doubt this will happen, but I can’t rule out an ETF flash crash, which I’ve previously suggested could cause a meltdown much the way that portfolio insurance did on Black Monday, October 19, 1987.
Whatever might be the short-term follow-up (or -down) on Friday’s drop, I remain bullish because the outlook for earnings remains very upbeat. Industry analysts have raised their consensus S&P 500 earnings estimate for 2018 by $9.00 per share over the past seven weeks to $155.26 during the week of February 2 (Fig. 3). That’s mostly on guidance provided by managements during January’s Q4-2017 earnings season about the very positive impact of the corporate tax cut enacted late last year. The actual Q1 earnings season is still ahead, starting in April. By then, corporations are likely also to report that the weak dollar (down 7.7% y/y) has boosted their earnings (Fig. 4).
Nevertheless, the latest panic attack isn’t about corporate earnings. Rather, the fear is that wage inflation is making a comeback and that the Fed will respond with more aggressive monetary tightening.
Initially, higher inflation and interest rates could depress valuation multiples, as happened on Friday (Fig. 5). Eventually, tighter monetary policy could cause a recession directly by tightening credit conditions or indirectly by triggering a financial crisis. The following two sections examine these issues that are starting to unsettle the market.
US Economy: Wage Inflation Rising? Wage inflation may finally be picking up, but not by much. Shortly after she was appointed Fed chair four years ago, Janet Yellen said she expected that the Fed’s easy monetary policies would boost wage inflation from around 2.5% to 3.0%-4.0%. It may be about to do just that now that she has left the Fed. However, the markets may have overreacted to data on wages released Friday morning in the Employment Report. Consider the following:
(1) Average hourly earnings (AHE) for all workers rose 2.9% y/y through January, the highest since June 2009 (Fig. 6). However, the AHE for production and nonsupervisory (P&NS) workers rose by 2.4%, which is roughly where it has been for the past few years. P&NS workers account for 82% of all private-sector payroll employment (Fig. 7).
(2) Quarterly data through Q4-2017 show that the Employment Cost Index (ECI) for wages and salaries in all private industry rose 2.8% y/y (Fig. 8). Somewhat more subdued were the ECI including benefits (2.6% y/y) and hourly compensation (2.4%), as reported in last week’s productivity report (Fig. 9).
(3) Finally, as Debbie and I have noted often, higher wage inflation won’t necessarily mean higher price inflation. In highly competitive global markets, companies’ rising costs may also be offset by boosting productivity or absorbing the costs in the profit margin.
The Fed I: Testing the New Chairman. The FOMC statement released on January 31, following Janet Yellen’s last session chairing the Fed’s monetary policy committee, contained 13 instances of the word “inflation.” The word “gradual” appeared two times. The federal funds rate was left unchanged. The prior statement, following the December 13, 2017 meeting, mentioned the word inflation 14 times and “gradual” two times. The Fed raised the federal funds rate to 1.25%-1.50% (Fig. 10).
There was little response in the bond market to the tightening late last year. Since the start of this year, there has been a significant tightening tantrum in the bond market, with the 10-year US Treasury bond yield rising 44bps to 2.84% through Friday. The comparable TIPS yield rose 26bps to 0.70% (Fig. 11). Expected inflation as embodied in the spread between the nominal and real bond yield jumped 18bps to 2.14% over this same period (Fig. 12). That all set the stage for the stock market’s huge tightening tantrum on Friday.
Fed officials have been saying that the markets should expect three rate hikes this year. Incoming Fed Chairman Jerome Powell will preside over the March 20-21 meeting of the FOMC and have his first press conference right after it. Odds are, he’ll continue to stress that monetary policy remains on course for gradual normalization. He certainly would rather not start off with a calamity like the one Fed Chairman Alan Greenspan had to deal with just two months after he started his new job on August 11, 1987.
The Fed II: Don’t Have a Tantrum. Just by coincidence, as the stock market was having a major tightening tantrum, FRB-SF President John Williams gave a speech on Friday titled “Expecting the Expected: Staying Calm when the Data Meet the Forecasts.” He is a voting member of the FOMC this year and reportedly being considered for the post of Fed vice chairman by President Trump.
He said the Fed should not “have a knee-jerk reaction to all this positivity” about the economy. “I expect continued moderate growth, with no Herculean leap forward,” he added. Raising rates too rapidly could knock the expansion off track “and that’s the last thing I want to see happen.”
He concluded by saying: “But while the outlook is positive, it’s not so strong that it’s driving a sea change in my position. For the moment, I don’t see signs of an economy going into overdrive or a bubble about to burst, so I have not adjusted my views of appropriate monetary policy. So my message to those concerned about a knee-jerk reaction from the Fed is that, as always, we’ll keep our focus on the dual mandate and let the data guide our decisions.”
Outgoing Fed Chair Janet Yellen told PBS NewsHour’s Judy Woodruff in an interview Friday that the job market and the economy are growing stronger and at a healthy pace as she wraps up her four-year term. The interview was recorded before the stock market closed. Yellen warned that stock market valuations are elevated beyond their usual historical levels. She stopped short of saying the market’s rise in recent months is a bubble, as former Fed Chairman Alan Greenspan recently said.
Even as the market was diving, Yellen stressed that the financial system is more resilient now than it was during the financial crisis of 2008. Still, she said, “investors should be careful and, I would say, diversified in their investments.” That’s good advice.
Sadly, she said she would have welcomed another term as Fed chair and was disappointed when she wasn’t reappointed by President Donald Trump. I’ve frequently called her the “Fairy Godmother of the Bull Market.” I meant that in an appreciative and respectful way. I will miss her. We are about to find out if the bull market can stay calm and carry on without her. My bets are on the bull.
Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.
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