Corrections and PerspectiveFeb 7, 2018

Global stocks have experienced an abrupt correction, with major equity market indexes like the S&P 500 down nearly 9% from their highs at their worst point. Although this correction has only happened over a few days of trading, we suspect the culprit is a combination of investor complacency and a spike in volatility. To put this in perspective, on Monday, the Chicago Board Options Exchange Volatility Index (VIX) spiked 117%.

In the days before algorithmic trading, risk parity funds and momentum models, corrections that used to take weeks or even months, can now take hours. This was bad news for those invested in short volatility strategies that can experience dramatic drops, such as the one shown in the graph below.

Source: Bloomberg, Franklin Templeton Investments

On the other hand, the sharp back up in global bond yields is also raising concern among investors. US 10-year Treasury yields have risen 70 basis points since the beginning of September 2017, but roughly half of that move has occurred over the past 30 days, resulting in surprising losses for many bond investors.

Putting stocks in perspective

In times like these, it’s important to remember that stock returns are generally driven by two main factors: shareholder returns—in the form of dividends, buybacks, and earnings—and valuation multiples on those expected cash flows. Dividends and buybacks have been strong, with investors focused on yield. We’re currently in the midst of a record breaking earnings season as the synchronized global recovery (and tax cuts) have taken corporate profits higher globally.

Valuations typically support stocks when the economy is strong and inflation and volatility are low. This is precisely what we’ve had in recent years, but this environment may be in the process of changing—at least in terms of volatility. The so-called “Misery Index” (a way of viewing economic fundamentals by measuring the unemployment rate plus inflation) continues to be favourable. In the chart below, we have inverted this index to help in comparing it to the US stock market; as the index rises, the level of “misery” is actually falling. 

Source: Bloomberg, Franklin Templeton Investments

Though the correlation is far from perfect, you can see that over time there is a positive relationship between equity valuations (as measured by the S&P 500 price-to-earnings ratios) and improving economic conditions (as shown on the falling Misery Index, rising on the inverted chart).

What’s interesting is that the S&P 500 Index is now at its long-term average valuation (calculated from 1990 to 2017), while the Misery Index is well below normal, suggesting an exceptionally healthy economy and corporate environment conducive to higher profits. So while volatility may weigh on valuations in the short term, the corporate earnings environment looks very strong over the next 12 months, lending support to equity markets. Although returns may be more muted relative to previous years, we still expect them to be positive going forward making corrections like we saw this week buying opportunities, in our view.