It has been an interesting and chaotic month in the U.S. equity markets. Very calm seas in the prior two years led many investors to believe that volatility was dead, and the stock market would continue its steady march upward forever.

The very long period of low volatility came to an end on Jan. 27, 2018, when fears of inflation reared its head for the first time in a long time. So many investors had bet on continued low volatility, that the resulting 10 percent market correction was exacerbated and fueled somewhat by dislocations in the volatility index (VIX) products, many of which declined more than 90 percent in value. A sleepy, low-volatility dream turned into a nightmare for many short-term speculators.

However, the clearing of the risky volatility market trades happened quickly, and the VIX index has declined from 50 at the high to 16 currently, and the stock market has resumed its climb upward.

We feel that equity gains have resumed after a very volatile month, for four very good reasons:

 

1

The economic backdrop for both the U.S. and global economies is still very positive. We are enjoying a period of synchronized global growth, where 192 out of 198 countries in the world are reporting positive economic growth, a correlation not seen since before the 2008 financial crisis.

2

Corporate profits in the U.S. were strong in 2017, and will be even higher in 2018. After seeing 17 percent growth in earnings for S&P 500 companies in 2017, we look for earnings to rise another 18 percent this year. That is very strong growth, so we see the continuing rise in equity prices as rational for that level of growth. Unemployment is very low, and consumer and business confidence remain high. Wages are rising, and inflation remains low.

3

The Tax Cut bill will drive both higher corporate profits and consumer spending this year. The tax rate for corporations has been cut considerably, from 35 percent to 21 percent. Consumers will see lower payroll withholding taxes as well, so will have more money immediately to spend.

4

New tax rules allow hundreds of billions of overseas cash holdings to be repatriated back to the U.S. this year, where the funds can be spent on capital equipment purchases, wage increases, mergers and acquisitions, dividend increases and stock buybacks. All of which inject cash into the economy, and can push stock prices higher.

Although the market goes through spasms of worry about impending increases in inflation, we have not seen many concrete signs of higher price levels yet. And looking at history, the stock market has seen its best years when the inflation level is between 2 percent and 3 percent, where it is now. History shows that stock multiples do not contract much until inflation nears the 4 percent level. “Good” inflation is an increase in wage growth, and “bad” inflation comes in the form of much higher prices for goods and services. So far, we are only seeing good inflation.

Westwood is forever vigilant in looking for excesses in the capital markets, and managing risks for our clients. We feel that the stock market rise has been very rational thus far and is based on many positive economic factors in 2018.

 

C.J. MacDonald, CFA

Senior Vice President, Westwood Wealth Management

 

 

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