“Kee” Points with Jim Kee, Ph.D.

  • Pullbacks and Corrections
  • Market Models
  • A Reiterated View

Pullbacks and Corrections

Expected but not predictable—that’s the nature of the stock market’s pullbacks and corrections. Failure to recognize this, or believing that pull-backs and corrections are in-fact predictable, is probably the biggest driver of disappointing long-term returns for investors. Markets had a strong surge on Friday (about one and a half percent, or 344 points on the Dow) but were down almost 10 percent from their recent (all-time) highs. This has all occurred amidst a back-drop of good economic data and with a majority of companies beating earnings estimates. The sell-off has also been pretty indiscriminate, with defensive and “low volatility” strategies (and international stocks) selling off pretty much in tandem with the market as a whole (Wall Street Journal). Noted investor Warren Buffett once said that “if you worry about corrections, you shouldn’t own stocks” (TheStreet,2015). But I prefer the Nobel Laureates’ take on this (Samuelson, Sharpe, etc.), that if the market is keeping you up at night, you are probably watching it too closely!

Market Models

Looking at market gains since the last big sell-off in 2011 (when Standard & Poor's downgraded US debt), about half of it has been driven by earnings (increases in profits), and half of it by “multiple expansion,” or paying more for a given dollar’s worth of earnings (Asian times). If you think about this in terms of discounted cash flows, then half has been driven by the “numerator” or cash flows part, and half of it by the denominator or “discount rate” part. I tend to view quick and broad-based movements up and down in the market as discount rate moves, which can mean anything from higher expected investor (dividend/capital gains) taxes, inflation, growth (underlying ‘real’ interest rates), or perceived risk (i.e. “risk on” or “risk off”). Included in that last part would be investor psychology, and after a year of almost no volatility or pullbacks, it doesn’t take a whole lot of expertise in psychology to expect some overreaction when volatility returns. That is particularly true when market valuation levels are at the higher end of their normal range, as they are today. Remember that the biggest gains tend to occur in the most volatile markets, and if stock markets never went down or fluctuated, then the returns to owning stocks would be similar to the returns of owning cash or a 3-month T-bill (barely positive).

A Reiterated View

HCWE economist David Ranson has pointed out recently that the US is once again being called the “locomotive” of the world, and that echoes the IMF’s belief that tax cuts in the US will help drive global GDP growth this year and next. But Ranson also points out that the excitement will be more about US growth than capital markets, which “had their big story in 2016 and 2017.” I continue to view this as the best way to think about 2018, i.e. “surprising growth, disappointing returns.”