Wow! January was ugly! The S&P 500 was down almost 3% as volatility increased significantly. Stocks are struggling, oil is slumping, and deflation fears are capturing headlines.
While stocks were declining through January, bond yields were dropping, adjusting to the conventional wisdom that inflation is dead. In fact, the Fed’s measure of 5-year inflation expectations dropped from 2.5% to just 1.8%.
Most of the volatility in the stock market during January can be blamed on currency issues. With the U.S. dollar strong, multi-national companies are experiencing less profit from international operations. Of the 500 largest companies in the U.S., approximately 40% of revenues come from operations outside the U.S. A strong dollar has weakened international profits for U.S. companies.
Perhaps the biggest news in January was the European Central Bank’s launch of a $1.1 trillion euro quantitative easing plan. And while deflation fears are justified in Europe and Japan, I do not believe they are justified here in the U.S. Yes, oil prices are down, but healthcare, education, and food costs are not. In fact, the core CPI, which excludes food and energy, is still rising at 1.6%. Deflation occurs when there is a drop in the general price level—not just oil—and I do not see that happening here in the U.S.
My sense is that we are in for a correction sometime later this year. It may even be a whopper. U.S. stocks are trading in the top quartile of valuations, as measured back to 1870. Earnings expectations are high, yet real sales, real income, and industrial production are all moderating. The data sets do not suggest a recession by any means, neither do they support nosebleed valuations in U.S. stocks.
So what happens after the correction? I believe stocks will regain their footing, led by U.S. small cap stocks and European equities. For Europe, the quantitative easing should provide a boost to stocks. A lower Euro will also boost corporate profits for European companies. U.S. small cap stocks could do better than large cap stocks due to the fact that most of their revenues are derived domestically. A stronger dollar has much less effect on small companies than large and the dollar is likely to continue strengthening against the euro and yen.
January is often referenced as a predictor for the full year. Although this is somewhat Wall Street lore, the lesson of this January might well prove true. This year is likely to be tough on large cap US stocks. I write this, not because of the January barometer myth, but because of macroeconomic and monetary policy fundamentals suggest this will be a difficult year.
