Whither the market? Over the past few days, the market has embarked on a rollercoaster ride as investors, perplexed on a number of different fronts, try to acclimate to the new uncertainty. The market seems to be returning to the vicissitudes of the first quarter. The S&P 500 has lost most of the year's gains on fears of the effect of recently imposed tariffs on steel and aluminum products. Additionally, there is the worry, once again, about a trade war with China, especially after President Trump imposed tariffs on some $50 billion worth of Chinese goods. In response, stocks were down sharply on Tuesday.
At the start of the year, volatility engulfed the market as the Federal Reserve started to hike short-term rates — the first time in a decade. After 10 years of unprecedented low interest rates, this deviation from the norm acted as a body blow to investors long acclimated to the comfort of quantitative easing.
There are some signs, nonetheless, that bode well for the stock market. The tax law changes helped push profits up dramatically, with some analysts looking for a second-quarter earnings increase of 19%.This is in addition to the 25% increase from the first quarter.
The problem is these favorable factors were already factored into the market's rise shortly after the new year. Scant attention was paid to the reality of the end of the Fed’s easy monetary policy, which many investors had not anticipated and those who did were caught off guard when the Fed announced recently it was raising rates four times, instead of the widely-held consensus of three. Not only did investors fail to anticipate the alacrity with which the Fed has implemented its rate hikes, but, after the recent meeting, it stated that it is thinking about two additional increases.
The Fed’s response to creeping inflation has driven the yield on the 10-year Treasury note from 2.88% from 2.41%. The 10-year rate probably could have been higher still if it weren’t for slowing economic growth outside the U.S.
The new chairman of the Federal Reserve, Jerome Powell, is not an academic econometrician. He is an attorney, who had made it known that he favors a more practical, rather than a strictly doctrinaire, approach to monetary policy.
One of the sacred cows of Federal Reserve economic forecasting, that in part forms the basis for its interest rate fine-tuning of the economy, is the idea, accepted for decades as almost sacrosanct, that low unemployment and inflation always occur in tandem. Powell has stated that in the 21st century economy, that correlation may not always hold. This willingness to deviate from decades-old economic modelling theory has some investors on edge, as it adds additional unpredictability on the direction of the yield curve and predicting overall Fed response to its inflation expectations.
The collective impact from all of these significant and unanticipated factors has led to a lowering of expectations, as reflected in the current 16.6 price-earnings ratio of the S&P 500 versus 18.2 at the start of the year. The five-year average is 16.2, but it should be noted that during that period of time, there was a zero-interest rate environment.
