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The good times can’t last forever. After the stock market was on a tear in 2017, it now appears that “volatility” lies ahead. USA TODAY

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The stock market’s stomach-churning drop Friday and Monday was rooted in some topsy-turvy reasoning: What’s good for the economy is bad for stocks.

That belief became all too palpable when a strong January jobs report highlighted a substantial increase in annual wage growth to 2.9% from 2.5%. It stirred fears that bigger pay increases will trigger higher inflation, leading the Federal Reserve, and bond markets, to lift interest rates more rapidly than anticipated. Higher rates, in turn, will make bonds and other fixed-income assets relatively more attractive compared with stocks, which are riskier, spelling the end of the 9-year-old bull market. Or so the thinking went.

But wait. Americans have sought bigger pay hikes since the Great Recession ended in 2009. And the favorable economy those fatter raises reflect should be good for corporate earnings and stocks, no?

The answer lies in the gap between short-term investor reactions and longer-term economic fundamentals.

“Over the short term, it’s all psychology,” says Jason Ware, chief investment officer and chief economist for Albion Financial Group.

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In fact, the big market rebound Tuesday was at least partly borne of investors’ realization that there’s no reason to flock to the exits when the economy is this sound.

“This 'good news is bad news' phenomenon is a great example of why individual investors need to block out the daily noise of markets, think long term and focus on the big picture,” says Greg McBride, chief financial analyst of Bankrate.com.

The fear that an improving economy will spur higher interest rates and lower stock prices has been a staple of the recovery, Ware says. It was exemplified by market downturns each time the Fed signaled a retreat from its bond-buying stimulus in recent years, a move that was likely to nudge long-term rates higher.

Until recently, however, investors were enjoying a seemingly optimal combination of faster U.S. economic growth, an improving global economy and low inflation. Sure, the Fed has forecast steady rate increases over the next few years, but it vowed they would be gradual, calming investors.

The recent jump in wage growth, however, raised the specter of faster inflation that could force the Fed to boost rates more sharply. Adding fuel to the fire is the Republican tax cut package, which could spark even faster growth for an economy that’s already nearing capacity, with the 4.1% unemployment rate making it hard for employers to find qualified workers. That could stoke even sharper wage gains and inflation. 

But analysts say the market is being far too jittery. Several times over the past couple of years, annual wage growth has approached 3% only to retreat to its prior 2.5% pace.

“We’re not convinced you’re going to see continued 2.9%” pay increases, says John Lynch, chief investment strategist of LPL Financial.

Ware notes that growth in productivity, or worker output, has been meager in recent years. Only if productivity growth ratchets higher, Ware says, will businesses feel justified in increasing pay by at least 3% on a sustained basis. And while the tax cuts may spur stronger business investment in labor-saving technology, Ware doesn’t believe a significant increase in productivity growth is imminent.

Even if wage gains do accelerate, there are other forces, such as low-cost online shopping and the more global marketplace, that have helped temper inflation.

There are other constraints on rising rates. The yield on the 10-year Treasury note — a chief alternative to stocks for many investors — has risen from about 2.4% to about 2.8% so far this year. But Lynch notes that’s still low by historical standards. And if the rate creeps above 3%, he expects global investors to buy the bonds in large numbers, pushing the yield back down.

But let’s say wages and inflation do accelerate a bit more than economists expect. Does that justify a flight from stocks? Bigger paychecks mean Americans have more money to spend and businesses must invest more to meet that demand. All of those outlays are good for corporate earnings. Lynch expects earnings to increase about 15% this year and 10% in 2019.

And that should lift stocks, making them a far better investment even if bond yields do drift above 3% over the next year or two. Stocks, after all, have shot up an average of about 12.5% annually the past five years, according to Albion's Ware.

“Corporate profits have the closest correlation to equity prices over the long run,” Ware says. The problem is that markets react in real time, often based on a single piece of data, while earnings increase over time.

But no one said markets are logical. Without a 5% decline since the June 2016 Brexit vote, investors were looking for an excuse to sell and relieve some pressure, Lynch says.

"The market just needs to have a periodic shakedown,” he says.

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The stock market recovered after an early plunge Tuesday and was little changed in morning trading, raising hopes of a halt to a global sell-off in stock markets. The swings came one day after the steepest drop in six and a half years. (Feb. 6) AP

 

 

 

 

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