Whether you thought January was a good month for the markets probably depends on your perspective. If you are a “glass half full” type of person, you are probably optimistic and grateful that the S&P 500 only lost 0.04% despite the headlines. After all, in the span of just one month we saw the tensest geopolitical moment since Russia invaded Crimea in the U.S. assassination of Iran’s top general, the most paranoia-inducing pandemic threat since the Ebola outbreak of 2014 in the rapid spread of Coronavirus, and to top it off U.S. GDP grew at only 2.1% in the fourth quarter, the slowest pace since 2016. Markets, though positive overall, did experience volatility as a result of these developments. The S&P 500 had some of its worse trading sessions since August, back when mediocre economic data had investors more concerned about a slowdown. This included a drop of more than 600 points in the Dow on the last day of the month. The VIX, also known as the “fear index,” spiked from a tranquil level around 12 to over 19 over a short period of time in late January. Still, one cannot help but feel that the takeaway from January is less about the bad news that occurred and more about the markets’ resilience to it. Are market fundamentals so stable that this other news doesn’t matter, or are the investors and the pundits that they follow wrapped in a false sense of security?

Let’s look first at valuations. FactSet reported that, as of January 17^th, the forward 12-month Price-to-Earnings (P/E) ratio of the S&P 500 was 18.7. This is the highest it has been since May 2002, though still below the peak of 24.4 in March 2000, before the dot-com bubble burst. In other words, stocks are expensive relative to historical trends, but not prohibitively so. It’s also important to note that valuation metrics like the P/E ratio don’t do a great job of predicting what will happen in the near-term—the inverse correlation between a high P/E and a low or negative stock return only takes shape when observed over a time span of several years. The concern, however, is that a high P/E can amplify the effect of other bad news, especially if market sentiment is already negative. And if analysts lower their forecasts for earnings—the “E”—without a proportional decrease in stock prices, then by default the valuation just became more expensive. Valuation metrics must also be considered in the context of interest rates. The yield on the 10-year Treasury bill came down significantly during January, finishing the month at 1.52%. Lower interest rates support a higher P/E, but even a mild uptick could upset this balance.

Now consider the economic landscape. We’ve already mentioned the lackluster GDP growth, announced on January 30^th to be 2.1%, but what news did we get earlier in the month? The ISM Manufacturing PMI disappointed at 47.2 versus an expected 49, nonfarm payrolls only increased by 145 thousand versus an expected 164 thousand, and year-over-year wage growth also missed estimates, coming in at 2.9% instead of 3.1%. By no means are these data terrible, but we question whether the markets’ apparent sentiment accurately reflects these numbers.

Like any other month, the news was not all one-sided. The Fed signaled on January 29^th that it had no intention of raising interest rates any time soon after cutting its benchmark rate three times in 2019. It is the current consensus, according to the CME FedWatch Tool, that the Fed will stay pat during the first half of 2020, but that there is a good probability of an additional rate cut, probably in September or December. Of course, such things become more difficult to predict the further out the forecast.

Another contributor to positive sentiment is the general mood around the upcoming presidential election. Admittedly not an empirical data point, it is our observation that market pundits and many other industry professionals are expecting a Trump victory. Whatever your personal politics may be, a Trump reelection would likely provide additional fuel to this market because of his pro-business stance and continued hints at additional tax cuts. It seems the markets, at present, are counting on this. There appears to be an overconfidence bias, derived from President Trump’s immunity to investigations, his grip on the Republican Party and Democratic infighting during the primary season that market watchers assume will translate into an election-day victory for Trump. Whether this holds true or not remains to be seen, but if election uncertainty rises in the coming months then volatility will follow.

By this point you may think we see the glass as half empty, but it’s not our intent to make our readers bearish and paranoid about the markets. Rather, we just think the mood needs to be calibrated somewhat to reflect the challenges markets will face in 2020. Volatility, even correction-level volatility, though never fun for investors, can be a healthy release valve to reset expectations. After a relatively smooth ride and a great outcome in 2019, investors may have forgotten what real volatility feels like. Better to recall it now than when it strikes unexpectedly and induces rash decision-making.

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