Hindsight bias is a powerful force in investing. Over the last few months, there was a strong consensus that global synchronized growth would push equities higher in a “melt up.” In fact, it was difficult to find many investment strategists that were not saying something along these lines (including us). After a 7.8% drop in the S&P 500 in six trading days (erasing all of this year’s gains), there was no shortage of strategists in the media now talking about how we were “overdue for a correction” and that this is a “healthy, garden variety” correction. Market events typically look much more predictable when viewed in hindsight.
The selloff appears at least partially due to concerns about the impact of rising interest rates (and rising inflation expectations) on risk assets. Strong global growth, higher-than-expected U.S. wage growth combined with the tax reform package recently in the U.S. has sparked fears of overheating and central banks potentially heading for the exits more quickly than expected. While we share some concern about the impact of rising inflation on the reaction function of global central bankers, we think this is unlikely to derail the strong global growth story.
The first question we ask ourselves in these situations is “Has the outlook for any of the four pillars of our investment process changed?” If not, there is no reason to change strategy. So far the answer has been “no.” Earnings have again come in strongly in the U.S., with S&P 500 earnings growth up almost 15% year-over-year midway through earnings season (above expectations for 12% growth). Economic growth has shown no signs of a sharp deceleration, with global PMIs continuing to come in strongly. Eurozone Composite PMIs released yesterday were the highest since 2006, and the U.S. ISM Non-Manufacturing Composite (also released yesterday) was well above expectations. From a valuation perspective, equities are more attractive than they were when we increased the overweight position in mid-December. Finally, from the behavior side (newest addition to our investment process), we note that volatility has picked up sharply, but equities have bounced off technical levels, at least in the short-term.
To put this all in context, the six day decline in the S&P 500 is similar to drops in January 2016 and August 2015. Both of these declines reversed fairly quickly.
It is very difficult to “call” a market correction and investors will likely do more harm than good by reacting emotionally to a sell-off after the fact. Short-term market movements are very difficult to predict and the volatility that we’ve experienced over the last two weeks speaks to a need for diversified portfolio that is in line with an investor’s long-term risk tolerance.
We remain modestly overweight equities as we don’t think anything fundamental has changed with respect to global growth and corporate earnings. Earnings, particularly in the U.S., have continued to surprise on the upside. We will continue to monitor developments in both interest rates and inflation expectations, but believe that it would take a much more significant backup in interest rates to derail the strong global growth story.