“Kee” Points with Jim Kee, Ph.D.

  • Last Week’s Sell-Off
  • Causes and Consequences
  • Hedge Funds Rant

Last Week’s Sell-Off

“Based on recent trends, the market was desperately in need of a rest. The S&P 500 had gained 7.5% in just 18 trading days in 2018, putting it on pace to gain 158% this year.” I think that statement from Ben Levisohn in Barron’s says about all you need to know about the recent market turmoil. The Dow Jones Industrial Average fell 4.1% last week, with the S&P 500 off 3.1%. It’s been over a year (404 days) since the last 5%+ pull back, so this sort of thing was, in the words of MKM Partners strategist Michael Darda, “long overdue.” That 7.5 year-to-date gain put the market where strategists expected the market to be by year’s end. Expecting no pullbacks or corrections isn’t realistic, and while day-to-day market watchers might get caught up in a frenzy of fear, seasoned or professional investors greet this sort of thing with some relief.

Causes and Consequences

What really sparked the sell-off was strong economic data, particularly Friday’s payroll report, and the old good-news-is-bad-news interpretation that stronger growth prompts more rate hikes sooner, and perhaps with a pick-up in inflation driving bond yields higher. And bond yields have risen, and the growth data does warrant a Fed policy of continuing to normalize (raise) short-term rates from historically low levels. But the market had gotten a little ahead of itself, and short-term fluctuations aside I hold to the view that good news is good news. Volatility should be expected, and bearing risk (of which volatility is one measure) is a big reason why equity investors experience positive returns over time.

Ten-year Treasury yields have moved above 2.8%, but I don’t know how high the world will let them go. With yields in other developed countries just above zero, I would imagine that money will flow into US fixed income markets, driving up their price and lowering their yields or at least putting a cap on how high yields can go. Taking a step back, no real economist is happy to see interest rates this low, which - going back to Adam Smith’s day - is typically indicative of a languishing economy rather than a healthy one. An important point that is always missing from the media discourse is the fact that why interest rates are rising is a crucial piece of information. If growth and profitability are driving rates higher, bidding up the underlying “real” rate which has only recently moved off of zero, then it need not lead to lower valuation levels. In financial economists' terms, that would be discounting a growing or higher future earnings stream with a higher discount rate, which represents offsetting forces when it comes to valuation. That seems to be where we are now.

On the other hand, if growth and profitability are constant but interest rates are rising, say, because of higher inflation expectations, then that can lead to lower valuation levels or valuation “multiples.” Again, in financial economists’ terms, that would be discounting a given or unchanged future earnings stream using a higher discount rate, which lowers valuations. That doesn’t seem to be where we are now. Again, what we are seeing is strong profits and an uptick in inflation expectations. But I think that a real spike in interest rates would require a true unhinging of inflation expectations. What we are likely to see this year, when all is said and done, is more of a conviction that disinflation won’t be a problem than any real inflation. In other words, the positive growth story will ultimately be a more decisive influence on stocks than the "normalization of inflation" (as I would put it). As for the ongoing pullback, most would feel that even a correction (10% or more decline) would be somewhat healthy for the market at this point. A prolonged bear market, on the other hand, would be most likely if a recession was imminent, and that doesn’t seem to be in the cards right now.

Hedge Funds Rant

If you haven’t already read it, you would probably enjoy Illinois State Board of Investment Chairman Mark Levine’s rant against hedge funds in last week’s Wall Street Journal, “Why Illinois Got Out of the Hedges”. Can anyone explain why Illinois continues to own this hopelessly complicated bunch of hedge funds?” That’s the opening sentence, and Levine brings some rare common sense to the question of just why you would invest in complex, opaque, expensive, and often illiquid vehicles. My favorite line was the following: "Industry 'experts' suggested we keep these investments to diversify our holdings and reduce overall risk. Yet we already owned bonds for that purpose.” Exactly! Bonds and stocks have some drivers in common and some that are unique to each independent asset class. But a well-constructed, conservatively managed bond portfolio will mitigate interest rate risk by buying shorter maturity bonds and holding them to maturity. And it can mitigate credit or default risk (think recession) by focusing on high quality issues. Constructed correctly, such a portfolio of individual bonds has the qualities of being low cost, transparent, liquid, and ballast in bear markets.