Wall Street – where good news can be seen as bad

Not a great week for the markets.
A week ago last Thursday, the S&P500 hit its all-time high. Last Thursday, the same index was down by about 2%. I think it’s fair to say the latter got a bunch more attention.

While a 2% drop is hardly noteworthy in the grand scheme of things, such moves have been pretty infrequent in this market year…but not so in the past. Matter of fact, according to FactSet, as of 23 Jan this year, “the S&P fell 2% or more in a day an average of once every 30 trading days in the thirty years from 1982 – 2013.” Almost anything can set the market off like that so I recommend against trying to read any major meaning from the drop.

There was some more weakness last Friday, which, combined with Thursday’s numbers, caused the Dow Jones to lose what gains it had made since the first of the year.

The cause of all this? Why it was the dreaded employment cost index (ECI), of course. You say you’ve never heard of it. Well, not many had until last week. The ECI is a quarterly economic report prepared by the Bureau of Labor Statistics (BLS) which details the changes in the costs of labor for businesses in the United States economy.

The report for the second quarter showed labor costs had their largest increase in more than 5 ½ years. Many suggest that this means that an increase in wage growth is close upon us.

So, how does making more money, an act which most of us can certainly support and see as a good thing, along with a monthly jobs report signaling a trend of continued hiring growth – become bad for the stock market? Let me attempt to explain.

Connecting some dots

Some context first. In the minds of a great many people, the market’s huge move of these past few years has been directly related both to easy money and artificially low interest rates. To them, an interruption in the status quo in either policy is a sure sign of pending market drops.

One other consideration is that the vast majority of daily activity in the markets is attributable to short-term trading strategies. These are very sensitive to, and heavily driven by, daily headline news. This is one reason why daily market results can be so varied – and should be given low to no significance.

So, when this higher than expected increase was reported, here’s what generally happened on the trading floors.

Presuming this report is, in fact, indicative of more growth in wages across the economy, this could – operative term – then cause the Fed to speed up their decision to hike interest rates “sooner than expected.” With that could come a rise in inflation. Right now, the house money is on the Fed raising rates sometime next year – second quarter seems to be the consensus.

The trader’s thinking then goes something like, well, if those rates are going to be raised “sooner than later”, that means this bull must soon be starring as a Big Mac so I better close my trading positions right now! Hence, we got those quick drops in the past couple sessions.

Will the selling continue?

It really makes little difference for now. In the meantime, here’s what I see.

The ECI could be indicating more inflation but one report does not a trend make. I think it’s too early for that to be a major factor in our strategy. Traders are beyond sensitive to inflation issues so even a whiff can set them off.

As to interest rates, let me call on Barry Ritholtz. Writing in his Big Picture blog last week, he offered the following which I find quite interesting.

Regarding interest rate movements on the S&P500, he offered this. “During the past century or so, on 86 occasions, interest rates changed significantly during the course of a calendar year. Almost three-fourths of the time when rates were rising, stocks tended to rise as well.”

“During these periods of rising stocks and rates, we found that the 10 year (US Treasury) note yield averaged 5.11% (it was 2.49% Friday), the price-earnings ratio of the S&P500 averaged about 15 (16 is the S&P forward PE now) and inflation as measured by the consumer price index was more than 4% (about 2% now). The average S&P500 increase during these periods was almost 21%.”

“When rates rose and stocks fell, the S&P dropped almost 16%, on average. The 10 year note averaged more than 6%, the PE ratio was a historically low 12.57 and inflation was high, averaging 6.8%.”

I think a reasonable conclusion to this is that when inflation is high, and rates are rising from already higher levels, the effect on share prices is going to be negative. However, as is the case currently, when inflation is moderate and rates do start to rise from low levels, the effect on share prices tends to be nicely positive.

And we’re worried about rising rates because??? Rising rates also occur when an economy is growing and demands more money to do so.

Preview of coming events

I think the future could hold a bit of what we saw Thursday. By that I mean how I think the markets will react when the Fed actually indicates that they’ll be raising rates. Big selling will likely happen for a while because those folks who think the Fed is all that’s been moving the markets would now see it all coming to an end.

I heartily disagree. I think the major driver of our increasing stock values has, for the most part, been the continuously increasing corporate profits. This applies to both trailing and forecasted profits. Most have been, and seem set to continue to be, at record levels. This trend of solid, growing economic reports, in my mind, will continue to support this appreciation.

Contrary to all the talk of the Fed’s easing, I believe that these profits have been, and continue to be, supported by real growth in manufacturing, exports and energy production.

A relevant closing thought from William Bernstein, noted financial author. He said that, “It makes little sense that we should care about a bad day or a bad year in the stock market if it provides us with good long-term returns.”

My view is that, for an investor, the markets still look good. Maintaining a strategy using a well allocated, diversified portfolio will stand you in good stead.

Cheers!

Mike

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Securities and Investment Advisory Services offered through KMS Financial Services, Inc.

To get an overview of economic conditions, use this link. It’s updated monthly.http://www.russell.com/Helping-Advisors/Markets/EconomicIndicatorsDashboard.aspx

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