Here's What To Expect After The Market Selloff

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A sell-off happens for good reasons.

The equity market is adjusting to fundamental changes in liquidity.

• Previous conditions: Cheap money has been floating around everywhere with no inflation to show for it. There's also been share buybacks galore as CEOs used free money to boost share prices by reducing their company's outstanding shares.
• Current conditions: The era of low inflation and cheap money is ending. Inflation is picking up and interest rates are poised to rise another 0.75%. Share buybacks will discontinue.

The trigger was Friday’s strong payrolls and strong wage inflation. The markets read this to mean economic growth would drive inflation and higher interest rates. This would likely lead to more fed rate hikes.

Now, these are good things because they are deriving from economic growth, instead of the previous 10 years of financial shenanigans.

But stocks look pricey as a result.

Higher input costs like wages will pressure company margins. That means lower earnings, so the price-to-earnings ratios (P/E) are overstretched. Meanwhile, higher bond rates make stocks look less competitive. For example, when a stock was pumping out 2% in dividends but bonds paid <2%, then the stock looked valuable. But no longer. Ten year Treasury yields are around 2.8%. (The basic income investor question is: Would you rather own the safest asset - U.S. government bonds - yielding 2.8%? Or would you rather own "riskier" stocks yielding 2%?)

As subscribers to our sister site TheMoneyballTrader.com know, I expected a bit more of a blowoff because the market typically overshoots. We certainly got that. Now we are seeing some selective buying back in.

Stocks now look attractive for a few reasons.

One is mechanical: when stock prices surged 8% in January, this put institutional investors under pressure to sell equities. Most major funds have a bond/equity balance that they must maintain. Post-selloff, they can buy back into stocks.

What Will Trigger My Buy-In Target?

Here again, TheMoneyBallTrader subscribers know that last week I said anything below 2,650.

I said 2,650 for two reasons.

First is a back-of-the-envelope approach. The economy should be growing 3% per quarter. Maybe 4% with the tax cut. (My gut feel). Instead, it grew 7% in January. If we expect Q1 2018 to be another 3% rate, then it should be 2,700 by March end (~6 weeks away).

An alternative is a more rigorous, data-driven approach.

I have a proprietary labor-driven metric (the SouthBay Fair Value becnchmark). As you can see from the 20 year chart, this data reflects strong correlation between the Fair Value Index and the S&P 500. The 2nd chart is the same data on a shorter time-scale.

Based on this data, the market was overvalued 10% on a y/y basis. So a drop to 2,650 is more in-line with the underlying economic fundamentals. And that’s about where we are.