U.S. equity markets tumbled nearly 2 percent Wednesday as the political turmoil finally caught up with investors. It was just the second time the S&P 500 has fallen by more than 1 percent since the election of Donald Trump, finishing down 1.8 percent, its lowest level in four weeks. The first sign of weakness since the election of President Trump has investors wondering if this is the beginning of a deeper correction or a short-term knee-jerk reaction. (See also: Opinion: Donald Trump Is a Clear and Present Danger.)
In a recent note to clients titled “She said, he said,” Bank of America Merrill Lynch lays out the cases for and against a bear market. Despite leaning on the side of a short-term decline, they believe there are cases for a deeper correction. “While there are plenty of potential catalysts for a 5-10 percent pullback (remember, 5 percent pullbacks occur about 3x per year!) we see few signs of an imminent bear market or economic recession,” Bank of America said.
The Bear Case
Those with one hand on the panic button will point to rising valuations, central bank policy and the impact of wage inflation to make the case for a stock market correction.
After a bumper first-quarter earnings season, which pushed major indices back to all-time highs, Bank of America notes that by most of its metrics stocks are overvalued. According to FactSet data, the 12-month forward P/E ratio hit 17.5, which is above the 5-year average of 15.2 and the 10-year average of 14.0. Despite this, valuation can be a poor short-term indicator.
The current bull market begun late 2009 when the Federal Reserve embarked on its unprecedented bond buying program (QE) and investors shifted into equities as interest rates became suppressed. However, as the Fed begins tightening, albeit slowly, the bond market is becoming more attractive as yields rise. The pace of the tightening has some questioning whether or not rising rates are here to stay. “Central banks shifting to a tightening bias is new and scary, but the starting point and pace of this tightening cycle is benign vs. history,” Bank of America said.
One reason behind the central bank’s tightening cycle is the steady, yet slow rise in inflation. The latest employment report showed wages increased at a year-on-year pace of 2.5 percent, a cycle high and up from 2 percent 12-months prior. While large-cap firms can deal with rising wage inflation, small-cap firms struggle as tighter margins. “We estimate that a 100 bp acceleration in labor cost inflation would pose a 2% headwind to Russell 2000 EPS, roughly double the 1% impact we estimate for the S&P 500.” Goldman Sachs said in a recent note. (See also: The Downside of Low Unemployment)
The Bull Case
On the flip side, bulls will argue the pace of the Fed’s tightening policy and balance sheet reduction is so slow that they remain accommodative, supporting the economy. Moreover, U.S. equities will still be boosted from global stimulus with the ECB, Bank of Japan and Peoples Bank of China all engaging in bond-buying programs. (See also: How Will the Fed Reduce its Balance Sheet?)
Surprise! A month ago the bulls would have had a strong case on the data front, with the Bloomberg Surprise Index at five-year highs. The acceleration was driven by a mix of manufacturing and confidence data. In February, the U.S. PMI index traded at 57.8, the highest level since 2014 and in early 2017 the U.S. consumer sentiment index made a 10-year high. However, this argument has begun to weaken as data is slowing, showing signs of rolling over.
The Bottom Line
As stocks take their worst hit in 2017 so far, some are wondering if the White House controversies are going to dent the eight-year bull run. However, with just one session of weakness, it will take a continued sell-off to have long-term investors worried. “So while summer months typically bring out the bears calling for volatility and pullbacks, our 2450 year-end S&P 500 target still implies a modestly higher market by year end,” Bank of America said.