February has been an awful month on Wall Street. The S&P 500 entered correction territory as it pulled back by more than 10% from its January highs, and the S&P 500 Volatility Index (VIX) skyrocketed above 50 for the first time since mid-2015. However, while many a “Henny Penny” have been running around screaming that the sky is falling and the market is doomed, traders haven’t thrown in the towel just yet.
In fact, if you look at the Market-Based Probabilities chart from the Federal Reserve Bank of Minneapolis in Fig. 1, you will see that after all of the volatility the market has been experiencing during the past two weeks, Wall Street is only pricing in a 12% chance of a decrease of 20% or more in the stock market during the next 12 months.
Fig. 1 — Market-Based Probabilities Chart (Source: Federal Reserve Bank of Minneapolis)
This is a much lower level than the 17% chance Wall Street priced in during January of 2016 when stocks were testing multiyear lows or the 24% chance of a decline Wall Street priced in during September of 2011 when Congress failed to raise the debt ceiling and threatened to default on U.S. debt.
In other words, Wall Street has acknowledged the pain of the recent volatility, but traders don’t seem to be too concerned that the selloff is going to be protracted, at least for now.
So what is Wall Street still worried about? We believe Wall Street is worried about the following three things:
- Declines in earnings growth rates
- Slowdowns in share buybacks
While much of the focus in the financial media has been on the short-volatility trades that blew up last week as the VIX skyrocketed, it’s important to remember that the news that kicked off the bearish pullback was inflation-related. On Feb. 2, the Bureau of Labor Statistics (BLS) announced that average hourly earnings had shown a surprisingly strong annualized gain of 2.9%. This news sent bond yields higher and stock prices lower because if wages are rising, consumers will have more money to spend, which means that prices are likely to increase as an increasing amount of money chases a limited amount of products and services, causing inflation.
Inflation is a concern for Wall Street because as inflation rises, Treasury yields are likely to rise as traders anticipate that the Federal Open Market Committee (FOMC) will need to raise interest rates in an attempt to keep inflation from rising too quickly (anything above the FOMC’s 2% inflation target would be considered “too quickly”). This is a problem because the higher yields go, the more expensive debt-financing becomes for corporate America, and the more expensive debt-financing becomes, the slower corporate growth is likely to be in the future.
The level that traders seem to be paying the most attention to at the moment is 3% on the 10-year Treasury yield (TNX) chart. As you can see in Fig. 2, the TNX hasn’t climbed to 3% since late 2013, in the aftermath of the FOMC’s announcement that it was going to be tapering its quantitative-easing (QE) program.
Fig. 2 — CBOE 10-Year Treasury Yield (TNX)
Many traders believe that if the TNX climbs above 3%, the rising cost of financing corporate debt will start to inhibit earnings growth.
Declines in Earnings Growth Rates
Earnings in corporate America have been growing by leaps and bounds during the past year, and this quarter has been no exception. According to FactSet, with 68% of the components of the S&P 500 having already reported their fourth-quarter earnings, the S&P has a blended earnings growth rate of 14% year-over-year (see Fig. 3).
Fig. 3 — S&P 500 Q4 2017 Earnings Growth (Source: FactSet)
Earnings growth is expected to continue accelerating until the fourth quarter of 2018. According to FactSet, analysts are anticipating the following earnings growth rates:
- Q1 2018 — 16.9%
- Q2 2018 — 18.7%
- Q3 2018 — 20.3%
- Q4 2018 — 17.3%
These are stellar numbers, but if anything happens to cause these numbers to slow down before the fourth quarter, traders will have to update their expectations and will likely feel more pressure to start taking profits off of the table.
Slowdowns in Share Buybacks
One of the key drivers of the earnings growth the market has been enjoying for the past few years has been strong share buyback activity (see Fig. 4). Whenever a company buys back shares, there are fewer shares on the market that can lay a claim on the earnings a company generates, which typically drives the amount of earnings per share (EPS) higher. Since traders are usually willing to pay more for a stock with high EPS, stock prices have been rising as share buybacks have been increasing.
Fig. 4 — S&P 500 Share Buybacks (source Yardeni Research)
Many companies have said that they plan to use a large portion of the savings they will see from tax-reform to buy back additional shares of stock, which should keep this trend going for a while.
However, when companies eventually do start scaling back their buyback programs, earnings-per-share growth is likely to slow down, and traders are likely going to be less willing to pay such high price multiples for those stocks.
The Bottom Line
Everyone on Wall Street is still a little raw from the volatility they experienced last week, but they are still focused on the longer-term fundamentals that have been driving the market for the past few years. The market may have gotten overheated, but that doesn’t mean that the bullishness is now extinguished.
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InvestorPlace advisers John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next SlingShot Trader trade and get 1 free month today by clicking here.