A Wall Street Update: Back to Reality...

Ernest Hemingway once said about bankruptcy, it happens “gradually and then suddenly.” Well on Wall Street we got a rude awakening recently as we moved from little or no volatility last year to multi-day triple digit declines. We were lulled into complacency in 2018 with a gently rising market. Now it’s back to reality.

Over longer periods of time, say ten years or more, the stock market moves in lockstep with corporate earnings, which tend to go up 6% to 8% per year. But this is on average. In any given year both earnings and the stock market can make major gains but also suffer big losses. Wall Street is an emotional roller coaster.

The question now is where are we in this cycle of ups and downs? We have seen interest rates decline almost continuously since the early 1980’s. With short term rates well under 1% in 2018, it was not a matter of if interest rates would go up, but when. The Number One determinant of long term interest rates, we feel, is inflation expectations. Wage increases recently have taken a spike up and the fear is inflation will follow soon. This may put pressure on bond prices, interest rates might go up and stocks have to compete with more attractive bond returns. Voila, the market becomes more volatile and a correction becomes a real possibility.

That’s where we might be shortly. Scott Brayman, the managing director of Champlain Investment Partners, a successful small/mid cap institutional money manager in Burlington, Vermont pointed out in a recent speech that a correction is way overdue. He reminded us of Warren Buffett’s favorite indicator of common stock prices, the ratio of the market’s value to GDP. Right now (see chart below) that indicator is flashing yellow, if not red. A correction may indeed happen, but we do not see Bubble conditions today. No sector (excepting maybe Bitcoin earlier this year) is at stratospheric levels like High Tech in 2000 or Housing in 2007. So any decline today might be a ‘normal’ cyclical one not a life altering one (i.e. 2008). A worried market showing more volatility is usually not the most dangerous market. It’s the ebullient ones you have to worry about. We are staying invested.

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