The U.S. equity market had a very strong year in 2017, with the S&P 500 returning 21.8%. And 2018 got off to a strong start, with the S&P returning 5.7% in January. In addition, volatility, as measured by the VIX, was at historically low levels, ending 2017 at about 10.
While volatility began to pick up a bit (we ended January with the VIX at about 13), it remained at historically low levels. Then, on Feb. 1, although the S&P 500 fell just two points, the VIX jumped to over 17. The following day, the S&P 500 fell 60 points (2.1%) and the VIX experienced its largest one-day increase, jumping all the way to 37.
It has remained at relatively high levels since (between about 28 and 33). What’s more, the S&P 500 gave up more than all of its year-to-date gains, closing Feb. 8, down 3.5% for the year. These kinds of major negative moves can cause even investors with well-thought-out, written and signed investment plans to lose discipline and engage in panicked selling.
Given the lack of any major negative economic news, investors and the financial media alike struggled to explain the market’s behavior. You have likely read all kinds of hypotheses, including some blaming risk-parity strategies, inverse leveraged VIX funds and managed volatility strategies, among others. Unfortunately, the research shows that often there is no good economic explanation.
The best example of this is the crash of October 1987, when the S&P 500 fell about 22% in one day. We have had several “flash crashes” as well. With that in mind, I thought it would be helpful to review the determinants of stock prices and provide some possible, if not likely, explanations for this most recent crash.
Earnings & Discount Rate
Stock prices are determined by two things: earnings and the discount rate (the rate on the riskless benchmark of one-month Treasuries plus the risk premium demanded by investors) applied to those earnings. Earnings are the numerator in the discounted cash flow calculation. The discount rate is the denominator.
Fortunately, the news on the economic front is just about as good as it gets. In fact, for the first time since before the financial crises, almost all developed and emerging market countries have improving economies, with growth, and estimates of future growth, increasing.
Additionally, news on the inflation front has been quite benign. Finally, with recent tax cuts and rising expectations for U.S. economic growth, corporate earnings reports have been strong, with most reports coming in higher than estimates. The latest estimate of operating earnings for the S&P 500 in 2018 is about $155, up from about $132 in 2017, an increase of 15%. Surprisingly, at least to most forecasters, the weaker dollar is increasing earnings of U.S. multinationals.
Thus, there doesn’t appear to be anything in the economic data to explain why the markets would crash as they have. We will turn to the discount rate and see if it is the culprit.
Many investors are concerned that the market is vulnerable because valuations are excessively high (the Shiller CAPE 10 was still above 30). That’s another way of saying the discount rate is too low. With the S&P 500 closing Friday at 2,620, earnings of $155 translates into a price-to-earnings (P/E) ratio of 16.9, not much above the historical average. (For those concerned about valuations being high, I recommend you read my recent article on the subject.)