Anatomy of a Correction

On Monday morning, the S&P 500 bounced off its lowest level of the year for a second time. The first bottom occurred on February 8th at a level that just barely qualified as a correction (10% below the S&P 500’s all-time closing high of 2,873 on January 26th). The second bottom was last Friday, March 23rd, at roughly the same level as the February 8th bottom. On Monday morning, though, stocks opened sharply higher. Therefore, we can say, in Wall Street parlance, that we successfully tested the February 9th correction low. This was an important technical indicator as failure to hold that initial bottom could have brought more downside. As it currently stands, stocks appear poised for second test of those February 8th lows. So are we out of the woods or not? Maybe.

The interesting thing to note about the two market swoons thus far in 2018 is that they were caused by starkly different factors. As we noted in our February 8 Market Commentary, the selling in late January and early February was triggered by fears that inflation may be rearing its ugly head. We had just received two data points that suggested wage inflation, which had been the missing ingredient in the nine-year-old economic recovery, appeared to be accelerating. The fear was that higher inflation might cause the Fed to raise interest rates more than expected, acting as a brake on the economy. These fears manifested in simultaneous drops in stock and bond prices (bond prices move inversely to their yields). Indeed, the chart below shows that the first swoon in stock prices corresponded to a meaningful increase in the 10-year Treasury yield.

Source: Bloomberg

The second stock swoon, however, was not a reaction to inflation and interest-rate fears. How do we know? Several reasons. First, we have received several inflation indicators (including wage data) in more recent weeks that suggests the abnormally high wage growth we saw in January may have been an anomaly. More recent inflation indicators suggest that core inflation remains below Fed targets. Second, the yield on the 10-year Treasury bond has been steady to lower throughout March. And finally, we can see in the chart below that the Utilities and Real Estate sectors, which are among the most yield-sensitive of the S&P 500 sectors, were also among the best performing sectors between the first bottom and the second bottom. All this evidence suggests that investors were not concerned about rising interest rates as the market fell to the second bottom.
More likely, the second sell-off was a response to both valuation concerns and trade-war fears as the Trump administration made public its intention to slap tariffs on steel and aluminum. The chart below also shows that the worst performing sectors from the first bottom to the second bottom (Feb 8 – Mar 23) were sectors that generate a lot of their revenue from exports. And if we look at the entire duration, from the market peak on January 26 to the second bottom on March 23 (represented by the gray line), the best performing sectors are interest-rate sensitive and the worst-performing sectors are more internationally focused.
Source: Bloomberg

Over the past couple of weeks, we’ve also seen a sharp correction in the high-flying “FANG” stocks. We include Tesla in this group. The table below shows that these stocks have dropped by an average of 18% from their 52-week highs. To us, this suggests valuation concerns for the darlings that have led the markets higher for so long.
Source: Bloomberg

Caution remains warranted. There is an increasing amount of uncertainty on a number of different fronts. Now is the time to own companies with great balance sheets, high revenue visibility, great track records and strong management. Sometimes defense is the best offense.