February 2018 Newsletter

A Long-Awaited Correction

February 13, 2018


Well, we waited 18 months for a correction in the S&P 500 and finally got one.  Fortunately, we generally raised our cash position in portfolios to roughly 30% prior to the larger spike down, which mitigated downside risk and gave us capital to employ at lower valuations.  Now however, the challenge is to reset our asset allocation with the market’s valuation fears reduced.  Is fear overdone allowing us to move back in, or is more downside risk ahead?

Credit Suisse analysts think this is a good time to put money to work. Here are their reasons.

While unemployment in the United States still stands at 4.6% it may need to drop to 3.5% before wage-rate inflation (full employment) kicks in, causing inflation.  Two major disinflationary factors are therefore still in play, technology and the labor participation rate. According to analysts, the labor participation rate in the US is still two percentage points below its previous peak (adjusting for demographics).  The critical level of wage growth is estimated to be between 3.25% and 3.5% annually as compared to the current 2.4% growth in average hourly earnings.  This data compares nonsupervisory workers and private worker patterns over time which currently ranges between 2.4% and 2.9% percent.

Moreover, while wage-rate inflation and core Consumer Price Index data is set to pick up fairly sharply in the coming months, Credit Suisse analysts think crunch time for wage-rate inflation occurs when wage growth rises to between 3.25% and 3.5%, not 3%. The reason is that the Federal Reserve Board has consistently suggested they favor a mild inflation overshoot. Their preferred inflation measure, Core Personal Consumption Expenditures (CPE) is currently just 1.5%.

Meanwhile, the breadth of global earnings revisions and economic growth momentum remain very supportive of the equities markets.

The equity risk premium seems high at this stage in the economic cycle, an estimated 5.3% versus a warranted equity risk premium of 3.5%. This may mean the economic cycle will be extended much longer.

While talk of tightening monetary policy is at hand, monetary and financial conditions remain loose, with credit and some non-US equity markets selling off only mildly in this latest correction.

On a (short-term) technical basis, the premiums paid for puts are now extreme.

Inflation Risk

So, market risk, both for the stock market and the bond market, can be, at present, expressed in the two major components of inflation, as a function of the cost of labor (wage-rate inflation) and the cost of capital (high interest rates charged by banks for the use of leverage).

It should be noted that while inflation is expected to be rising in the coming months, the average inflation rate is expected to remain in the mid-two-percentage-point range for the next five years.  So, despite the first meaningful monetary policy tightening steps in the current cycle having been taken, monetary and financial conditions remain incredibly loose, whether one observes the monetary/financial condition indices or simply real fed funds rates.

Perhaps one of the most bullish conditions for equities is that there is little sign of a bond-for-equity switch. In fact, there has been little bond-for-equity rotation. Despite the far superior risk-adjusted return of equities relative to bonds, the past three months have witnessed almost identical inflows into both asset classes. Ordinarily, as the first chart below illustrates, outperformance by one asset class leads to inflows:

Most of the normal preconditions for a market peak have not been seen. Below you’ll find a Credit Suisse score card for signals indicating a market peak. A score of 3 or higher represents the greatest danger.


In my next report I will discuss market risk and the critical indicators on which to focus to assess the potential for impending recession.

Thank you for your continued trust and support.


Vaughn Woods CFP, MBA

Investors should be aware that there are risks inherent in all investments, such as fluctuations in investment principal.  Past performance is not a guarantee of future results.  Asset allocation cannot assure a profit nor protect against loss.  Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed.  Views expressed in this newsletter may not reflect the views of Bolton Global Capital or Bolton Global Asset Management. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. VW1/VWA0226

Sources: Credit Suisse, Global Equity Strategy, February 6, 2018, 2018 Outlook: Equities, Regions and Macro, 11/28/2017.