One week ago, FactSet revealed that 250 of the stocks in the S&P 500 had dropped more than 20% from all-time peaks. The index itself, however, had only declined a modest 5% from its record top.
Today, there are more indications of market distress. The Russell 2000, a popular small cap barometer, has dropped 13% from its high. The Dow Jones Transportation Average has fallen 13% as well. And the Financial Select Sector SPDR (XLF) is sitting at a 52-week low.
Theoretically, shares of financial institutions should perform well when the economy is firing on all cylinders. However, the investment community is expressing concern about higher interest rates and the credit risks associated with outstanding loans.
Is another financial crisis lurking? That depends on one’s perspective on developments abroad.
For example, Italy’s battle with the European Union has revived fears about bank exposure to Italian sovereign debt. The iShares European Financials ETF (EUFN) is down 26.5% from its 52-week high water mark.
In contrast, price depreciation for U.S. assets has largely coincided with a “hawkish” Federal Reserve. Chairman Powell and committee member colleagues appear resolute in hiking the overnight lending rate four more times by the end of 2019.
On the surface, pushing the Fed Funds Rate (FFR) from the 2% level to the 3% level across a 12-month span may not seem like a big deal. On the flip side, the shift from zero percent rate policy to where we currently stand (2%) has adversely impacted mortgage rates and home affordability. The latter is at a 10-year low.
Another concern may be profit margins. When one couples higher borrowing costs with higher labor costs, U.S. dollar strength and tariffs, it is not too difficult to forecast deceleration in U.S. corporate profit growth.
It follows that some of the volatility and rapid-fire selling of stock assets relate to investors rethinking valuations. For instance, year-over-year earnings growth comparisons lose the tax-cut benefit in the first quarter of 2019. Higher overall costs are likely to hinder profitability. And previous claims regarding a low-rate justification for exceedingly high stock valuations falls by the wayside.
