The stock market is concerned about growth. You probably heard that a lot this past week, with explanations wrapped up in nettlesome trade headlines and the eye-opening action in the Treasury market, which featured some inversions along the yield curve and the narrowest spread between the 10-yr note and the 2-yr note since 2007.
Those concerns didn't just pop up, however. Some pundits will suggest they hit home at the start of October when the stock market started to unwind. The fact of the matter is that the growth concerns have been hitting home all year.
Hindsight is 20-20
It all makes sense in hindsight. Then again, most things do.
Why, though, would the market have been concerned about growth hot on the heels of the fiscal stimulus plan?
The answer could be concerns about tariff actions, the Federal Reserve raising interest rates, and/or the slowdown seen in foreign economies.
We have said all year that rising interest rates would pose a headwind for the market -- and they have. The fear comes not just from rising interest rates. It also stems from continually rising interest rates.
There is some reason of late to think that the fear can abate. Specifically, several Federal Reserve officials have been talking a more conservative book, which is to say they seem to be making a concerted effort to sound less confident in their approach to raising interest rates.
We pointed out last week how Federal Reserve Chairman Powell changed his tone just enough in a speech before the Economic Club of New York to give the market some hope that the Federal Reserve is seeing a basis to refrain from raising the target range for the fed funds rate as many as three times in 2019, as is currently assumed in its interest rate projections.
This week, Atlanta Fed President Raphael Bostic (FOMC voter) suggested the fed funds rate is within shouting distance of neutral while Dallas Fed President Robert Kaplan (non-FOMC voter) shared his view that the fed funds rate is a little bit below neutral but approaching it. St. Louis Fed President James Bullard (a 2019 FOMC voter), meanwhile, said the Federal Reserve could consider delaying a December rate hike due to the narrower yield curve.
The change in tone, we can only assume, is informed by some incoming data of late that is starting to convince the Federal Reserve that it needs to be patient with its tightening action.
For example, housing data has been weak; light vehicle sales are solid but appear to be moderating; initial jobless claims have started to pick up, albeit from very low levels; business investment has been lacking; and wage growth has been relatively slow to respond to a near 50-yr low unemployment rate.
The Price Is Not Right
One of the less talked about reasons in the panoply of growth concerns isn't even an economic factor. It's a price factor.
Basically, we think it boils down to underlying concerns about valuation.
In early December 2017, the S&P 500 was trading at 18.1x forward 12-month earnings. That was less of a problem at the time when the 10-yr note yield was just 2.38% and the target range for the fed funds rate was 1.00% to 1.25%.
It became more of a problem, though, as the 10-yr yield kept rising in 2018, hitting 3.23% in October, and the target range for the fed funds rate was increased four times to 2.00% to 2.25%.
The other problem, which has hit hard in recent months, was a concentration problem. That is, everyone it seemed was favoring the same small group of mega-cap stocks, which culminated eventually in Apple (AAPL) and Amazon.com (AMZN) sporting market capitalizations in excess of $1.0 trillion!
An unwinding of those crowded positions has weighed heavily on the broader market, driving the S&P 500 down 9.6% so far in the fourth quarter and the Nasdaq Composite down 13.4%. We warned of this concentration risk in a May 2017 column entitled A High-Five for the Market.
In any event, there has been a collective de-risking in these mega-cap stocks and most stocks in general.
Bringing things full circle, that de-risking has been a byproduct of concerns about the economy and earnings being at, or near, peak growth.
What It All Means
A lot of price damage has been done beneath the index surface. Remarkably, that happened at a time when the S&P 500 recorded its best quarter of earnings growth (+25.9%) since the third quarter of 2010.
The result is that there has been multiple compression. In early December 2018, the S&P 500 is trading at 15.1x forward twelve month earnings, which is 8% below its five-year average of 16.4x, according to FactSet.
That's a more reasonable multiple, especially if the interest rate trajectory is going to slow. What remains to be seen, however, is if earnings estimates are going to be marked down in a meaningful way from here.
It will take some time for the market to get comfortable with the idea of this not happening, which is why it could spend some added time trading in a volatile sideways range.
This year hasn't been easy because there has been a forlorn understanding that the easy money has been made. That has led to the blowback of rising interest rates and it has been the message of the market throughout a year that has been filled with growth concerns that had been apparent before the October sell-off.
The homebuilders didn't peak in October; they peaked in January.
The financials didn't peak in October; they peaked in January.
Ford (F) and General Motors (GM) didn't peak in October; they peaked in January.
The semiconductors didn't peak in October; they peaked in March.
Copper prices didn't peak in October; they peaked in June.
The Russell 2000 didn't peak in October; it peaked in August.
The transports didn't peak in October; they peaked in September.