The Week Ahead – A Double-Edged Sword

Welcome to “The Week Ahead” where we take a moment to provide our thoughts on what we can expect in markets and the economy during the upcoming week.

Last Sunday I visited a local park with my four-year-old son who asked me to push him on the swing set. It’s something that he never seems to get enough of. The swinging motion reminded me of the stock market. Not the fact that the market goes up and down; although it clearly does. I was thinking more about the physics of the swinging motion being somewhat analogous to financial markets. The act of pushing the swing creates an inertial force, which moves it forward and up until at some point gravity overwhelms this vector, pulling it back down to Earth. As the swing changes direction, it creates enough momentum for it to move in the opposite direction with nearly equal force.

Interestingly we can make a similar assessment when it comes to momentum in equity markets. Up until last week, the stocks that had done well seemed to have achieved escape velocity as they soared to ever greater heights. Over the last 12 months, growth stocks (companies that tend to have superior growth rates, but are more expensive) have trounced their less expensive, slower growing cousins by a multiple of 3x (22.3% vs 7.2%). There are certainly some fundamental reasons for this outperformance. Faster growing companies certainly deserve higher valuations relative to companies that are growing more slowly – but as we’ve seen in past markets, investor optimism can drive valuations to extremes. Trade tensions, slowing global growth rates and rising bond yields are among the reasons as to why stocks have sold off; true to form, those stocks driven up by momentum are seeing the biggest swings in the opposite direction. While most economic indicators continue to augur for a benign environment for stocks, we will be keeping an eye on the Leading Economic Indicators (LEI) print for further indications of economic strength.

It should be noted that market volatility is to be expected, especially as the Federal Reserve raises interest rates. Last year was an anomaly in that we did not see a single market drawdown greater than 3%. Going forward we expect a return to normalcy, which means market corrections should occur with some degree of regularity. Indeed, on average the S&P 500 experiences a pullback of 10% or more every 357 days. While momentum can drive markets in the short-run, the gravity of valuation and fundamentals is ultimately inescapable.

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
― Benjamin Graham

Data deck for October 15 – October 19: