Much to everyone’s surprise, the stock market, as measured by the S&P 500 has reached a new all-time high in 9 out of the first 11 trading days of 2018. The current level of market volatility, as measured by the CBOE Market Volatility Index called the VIX, has recently bounced off historic lows. It closed today at 11.53 after falling to just 8.92 on January 4th. Volatility has been increasing along with the market so far this year. For reference, the VIX at the beginning of 2007 was 10.02, which was at the time a new low.
Equity strategist Barry Bannister at Stifel recently said, “We believe yields are the main event for stocks in 2018, not tax-fueled earnings per share.” The Federal Reserve Open Market Committee (FOMC) is most likely going to raise the fed funds target rate at least twice during 2018, which would take it to 2% from the current level of 1.5%. Because central banks around the world are not yet ready to increase their short term rates due to a lack of inflation, it is more likely that the yield on the 10-year US Treasury bond will remain relatively stable around its current level of 2.57%.
The spread, or difference, between the fed funds target rate and the 10-year Treasury yield has proven to be a good indicator of future economic conditions. In fact, of the ten components of the index of Leading Economic Indicators, the narrowing of the fed funds/10-year spread is the “leading” leading indicator. When the yield curve inverts, meaning that short term rates are higher than long term rates, the economy has gone into a recession within 12 months 7 out of the last 7 times. Currently, the spread is about 1% between fed funds and the 10-year Treasury. Even if the FOMC raises rates two times in the first half of 2018, that would only narrow the spread to 0.5% or 50 basis points assuming the 10-year stays relatively constant.
Yes, the stock market is at all-time highs. However, other indicators like the yield curve, unemployment, wage growth, industrial production, personal spending, inflation and corporate earnings are not exactly at “excessive” levels. Therefore, we think any correction in stock prices will be short-lived at this point. It is likely though that 2018 will be a transition year for the economy. Hang on!
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