It’s Windy Out There

Key Points

  • Volatility eased somewhat but the tug of war between positive and negative stock market signals continues. We believe the U.S. equity market remains in a secular bull market, but stocks will remain “windy” and we can’t discount the possibility of retesting lows seen earlier this year.

  • Political uncertainty is contributing to the volatility, with trade fears and midterm elections on one end, and tax cuts, deregulation, and repatriation on the other. This uncertainty could keep the Federal Reserve more cautious, although gradual rate hikes are likely to continue.

  • Military conflict concerns have also risen, but history suggests that unless they become protracted conflicts with economic implications, they have typically had short-lasting impact on markets.

Winds are picking up

It’s been a crazy spring weather-wise for much of the country, and the stock market is dealing with windy conditions as well, making it more difficult for investors to get a clear picture of market direction. Stock market indexes have now had a successful retest of the early-February lows, but selling pressure may not yet be exhausted. In our experience, the average corrective phase historically has brought more duration and still-sharper declines. Geopolitical conflicts, trade worries, debt/deficit concerns, tighter financial conditions, a softer first quarter for the economy, elevated earnings expectations, and midterm elections are some of the things that could push stocks temporarily lower, while a positive resolution to some of these issues could charge up the bulls.

Additionally, investors have expressed concerns about the flattening yield curve; although it’s typically only well after an inversion do risks of a recession become heightened. As you can see below, a break below 50 basis points in terms of the difference between the 10-year and 2-year Treasury yields doesn’t always lead to recession; and in fact has been historically accompanied by positive equity market performance.

A flatter yield curve doesn’t tend to spell doom for stocks

10-yr minus 2-yr w peaks and troughs

As of 4/25/18. Bps=basis points. Source: Bloomberg, FactSet. Past performance does not guarantee future results.

Temporary reprieves?

VIX short-term

A positive side-effect of three months of volatility is that investor sentiment has moved into the range that is associated with the best annualized gains for stocks, according to the Ned Davis Research Crowd Sentiment Poll.. And there are plenty of tailwinds that can also help to elongate the bull market; with tax cuts for both consumers and businesses coming into effect; a solid corporate earnings picture, with year-over-year growth for the S&P 500 currently expected to surpass 20% this year, according to Thomson Reuters; still relatively low interest rates; and inflation that is tame enough—albeit rising—to keep the Federal Reserve from having to tap the brakes more strongly.