Volatility was the word of the week as we saw broad-based selling for three consecutive days to start last week. The Nasdaq led the drop, although all the major equity indices were down in the neighborhood of 4%. Fears of inflation, coupled with a terrible jobs report from the previous week, made for some serious head scratching by investors worldwide.
We mentioned last week that markets were due for some pause as investors try to decide where we go from here. Earnings have been nearly unanimously positive, the country is reopening, and normalcy is around the corner, but equities are priced at 22 times earnings (S&P 500). That means that earnings are expected to grow – big time. If they don’t, that would indicate that stocks are overpriced relative to historical norms and we are likely to see a significant correction down the road. So, with that, what might keep earnings from growing big time? Rising interest rates caused by commodity inflation. If inflation rises faster than anticipated, and on a sustained basis, interest rates will rise and companies’ borrowing costs will increase thereby dropping margins and earnings. That is a current concern facing investors. That is one major reason why we are seeing equity markets fall on the same day that bond yields rise. Rising yields are typically evidence of strength and result in rising stock prices. At this point, however, the strength has been priced in over the past six months and investors are looking for yields to subside as evidence that inflation is controlled, and growth can continue unabated.
In my opinion, this is a transient condition and will resolve one way or the other over the next few weeks and months. For now, it makes for turbulent markets and days, like last Wednesday, when there was no place to hide. Stocks fell, bonds fell, real estate fell, commodities fell, gold fell – everything fell! On Thursday and Friday, stocks and bonds bounced and retraced two-thirds of the previous days’ losses. Today, stocks and bonds are down again. I suspect that we are in for more of this whiplash where good news is bad news and bad news is good news. Strong economic reports mean rising inflation and a drop in equity prices. Weak economic data means contained inflation and a jump in equity prices. Stock and bond prices have become highly correlated. This occurs intra-cycle periodically and typically at economic crossroads.
For now, it is important to recognize these underlying issues at work and understand that they will be resolved over time. Earnings are growing and now positive year-over-year. By these metrics we are in a bull market and stock prices reflect that. How long it lasts and whether prices have gotten ahead of themselves is anybody’s guess.