A “healthy correction’’?

Date: February 12, 2018

When stocks plunge as they did last week, we often hear experts describe the falls as “a healthy correction” so as to suggest that normal upward service would resume shortly and that there’s nothing to worry about.

The logical riposte would then be to ask if these experts had, at any point in the prior months leading to the selloff, ever described the run-up in stock prices as “unhealthy”. In the majority of cases, the answer is “no” which, when you think about it, kind of devalues the original “healthy” claim.

The truth is “this is a healthy correction” is one of the worst clichés to have found its way into the stock market’s lexicon but unfortunately, its use is commonplace. Just as bad are “bargain hunting” to describe bounces and “profit-taking” to describe falls, both terms conveying absolutely no useful information to readers and listeners. After all, if people sold because they wanted to “take profit”, then what about the buyers who presumably would only have bought because they wanted to make a profit? Why not then describe selling as “profit-making?”

Stock prices rise and fall because of changes in expectations about interest rates, earnings, the economy and risk. They had risen almost non-stop on Wall Street since 2008 because the market knew that the US Federal Reserve would keep interest rates low whilst pumping money into the system via its “quantitative easing” or QE measures.

The market had also come to believe that the Fed would open the taps at the first sign of trouble, as it did when the US’s crooked banks threatened to crash the financial system following the collapse of Lehman Brothers ten years ago.

The plunges of the past fortnight are because somehow, the market has now come to accept that the era of easy money is over, that US stocks trading at valuations that were at the start of the month almost twice their historical median values could maybe have moved into bubble territory and that this time round, even if the Fed does embark on a large-scale monetary rescue, those efforts may not work.

Howeve, during last week’s volatile trading, “a healthy correction”, “bargain hunting” and “profit taking” were widely employed in the popular press, illustrating an important lesson for investors, which is not to believe everything they read and to think carefully before making investment decisions.

For example, as noted in last week’s article that warned of the return of risk and volatility, investors should question whether that other awful cliché, namely that “the fundamentals are still intact”, really holds true.

The starting point has to be to ask if the US economy is really as robust as it’s made out to be, or whether growth that came from large-scale monetary injections by the central bank, can prove sustainable without an accompanying improvement in output and productivity.

In this connection, note that although US president Donald Trump has frequently boasted of the success of the economy since he assumed office, MIT professor Simon Johnson in his “Trumponomics is failing on growth” (published in Business Times on 2 Feb 2018) pointed out that US growth in 4Q 2017 was below-par at 2.6 per cent and that initial estimates for full-year 2017 growth are around 2.3 per cent – lower thanthe economy under President Barack Obama.

Furthermore, Mr Trump’s tax cuts that Wall Street welcomed which much gusto are not expected to have much effect on economic growth as they are mainly about redistribution from middle-income households to the rich, whilst there were no incentives in Trump’s tax plan to encourage badly-needed capital investment. Meanwhile, other experts have also noted that the unfunded tax cuts have come at exactly the wrong time – with the economy at close to full employment and wages rising, the last thing it needed was a fiscal stimulus that could fan inflation worries.

Speaking of which, last week’s volatility on Wall St was widely attributed to the return of inflation and interest rate expectations, concerns which sent the 10-year US Treasury yield surging to 2.85 per cent and stocks plunging. (There is a school of thought that if the yield crosses 3 per cent, the game could really be over for stocks).

Apparently, thousands of experts failed to recognize the threat posed by rising oil prices, wage increases and the inflationary impact of tax cuts in the months before February but suddenly realization dawned on all of them at the same time. Once again, investors are encouraged to think about this and make up their own minds when it comes to putting money in or taking it out of stocks.

Over the course of the five days, the Straits Times Index fell about 153 points or 4.3 per cent to 3,377.24, wiping out all its 2018 gains. If not for support for DBS after it announced a hefty dividend, this reading would surely have been a lot worse. Turnover averaged S$2.2 billion, much better than recent averages, but then with volatility spiking up as it has, this is to be expected. It remains to be seen whether the improvement in turnover can be sustained.

When volatility will settle is anybody’s guess; however, investors should note the following:

1) During each trading session, the STI tends to track the Hang Seng Index and Dow futures, though not necessarily in that order. Unless there is a large unexpected movement overnight on Wall Street, movements in the STI are usually in anticipation of how the US market will trade later that day – on Friday for instance, the STI fell by more than 50 points but ended with a 39 points loss because the Dow futures bounced off its intraday low. As it turned out, Wall Street managed to end Friday in the black;

2) If you have to be invested, then it’s probably better to stick to index stocks as these enjoy the bulk of liquidity (usually about two-thirds of daily dollar volume).