After months and months of experiencing an extraordinary period of muted volatility, we finally encountered stock market fluctuations that have grabbed investors’ attention. Below is a weekly bar chart of the S&P 500 Index:
Each bar represents the high and low for one week, starting with the first week of January 2017 and ending with the last week of March 2018. In case you have been glued to the Winter Olympics and March Madness and have not surfaced long enough to appreciate what has happened, this chart shows the incredible differences between the first 13 and the last 2 months of that period. Not only was the difference between the weekly highs and lows dramatically tamer during the first 13 months, but the direction of the bars was primarily up or sideways, with no meaningful down periods.
During February and March 2018 those trends changed. There were meaningful differences between the highs and lows, and the direction of the weekly bars stopped the long multi-month upward trend and resulted in the first significant market correction in well over a year.
Why did this happen? First, remember that the extremely low volatility seen in 2017 was an anomaly, which was discussed in this newsletter more than once. Also, market corrections are almost always swifter than market advances. You have probably heard the analogy that bull markets go up like an escalator, while bear markets go down like an elevator. Talking heads pointed to a few reasons that this change in market direction occurred, including:
1. Traders finally deciding to take profits.
2. Investors realizing that interest rates were going up (This has been known for nearly 2 years.)
3. President Trump announcing tariffs for certain trading partners, leading to fear of the beginning of trade wars.
4. The sharp correction of several FAANG (Facebook, Apple, Amazon, Netflix and Google) stocks, led by an unauthorized Facebook data transfer from 50 million members to at least one third party, and President Trump’s confrontational statements toward Amazon.
You may have heard other reasons. The bottom line is that the market was ripe for some type of pullback. Any of the above reasons, individually or collectively, would have been sufficient for the market to take a breather.
When rates go up, what do stocks do?
A popular question asked by clients is the following: Do stocks go down when interest rates go up? Many investors assume that is the case. Logically, as interest rates move higher, bonds become more attractive to investors, thereby providing more competition to stock market returns. Should one expect more money shifting to fixed income from stocks when rates rise? One of the more interesting financial studies regarding this topic can be seen below. It helps answer this question.
In the above scatter plot, each dot represents one month from August 1954 to December 2016. Each dot’s position represents both the monthly changes in the Federal Funds Rate and the corresponding change in US Stock Market. All dots on the top half of the chart represent times when the Federal Funds Rate was rising. If stocks would generally decrease when rates rise, you would expect to see the majority of dots in the upper left hand quadrant. But that is not what happened. In fact, it appears as though the dots are evenly distributed in both positive and negative stock market returns when rates are rising. Interestingly, the exact opposite is the case as well. When the federal funds rate is decreasing, both positive and negative stock market returns occur.
What’s the lesson? The fact that interest rates are rising does not mean the stock market will go down. In fact, it appears that over the last 60 plus years, monthly stock returns are fairly uncorrelated to the moves in the Federal Funds Rates. This should point out that investors shouldn’t try and time the market based on this relationship. We are constantly advising against attempting to time the purchase or sale of equities. This is just one further piece of evidence that empirically shows that most formulas for market timing, including ones that may make logical sense, do not work.
What does work? Having defined risk/reward parameters on your portfolio, and keeping them consistent by selling equities when their percentage become larger than planned, and buying them with income funds when the percentages of equities become smaller than planned. That’s called rebalancing. Rebalancing is, by definition, buying low and selling high. It has nothing to do with trying to time the market. Rather, we are bringing the portfolio’s equity and income percentages back to their desired amounts. Simple, yet highly effective.
Tax Reform: The Aftermath
Now that Tax Reform is law, many still have questions about certain provisions that may affect them. Please feel free to use Dixon Hughes Goodman’s tax expertise to answer your questions. Simply log onto their homepage – www.dhgllp.com – click on the link entitled “Tax Reform Developments” and peruse the vast amount of information about this historic change. It’s free, and it’s a great source of information.
First Quarter 2018 Asset Class Returns
After a continuation of 2017’s strong global equity markets in the first few weeks of January 2018, the market finally showed downward volatility for the first time in well over a year. By the end of the first quarter, all domestic and most International equity asset class gains had eroded, and were replaced by modest, single digit losses. Growth outperformed Value, while Large and Small Caps had very similar returns. Domestic and International returns were also similar. Domestic Real Estate was the big loser, seeming to have the worst of all worlds, combining the losses of both stock and bonds. Fixed Income experienced losses across the board, with longer term bonds losing more value than intermediate or short term, which is usually the case in a rising interest rate environment.
Of course, the big question is whether this is the start of a longer term bear market (defined as at least a 20% correction from highs), or simply a consolidation of very favorable, and somewhat extended, global equity markets. Domestically, the economy is chugging along. Unemployment is at a 17 year low, and corporate earnings are healthy. The Federal Reserve is continuing their methodical raising of the discount rate, announcing plans for three raises in 2018. This is primarily an exercise in getting short term rates back to a normal level after nearly a decade of artificially lowered rates to assist in climbing out of the great recession of 2008-09 (QE1, QE2). Interestingly, only .25% separates the 10 and 30 year US Treasury yield (2.78% vs. 3.02% at time of writing), so it is fairly clear that intermediate and long term markets are not too concerned with dramatically higher inflation over the next several quarters.
There is no reason why this long term bull market cannot continue. However, looking much further out, we would not be surprised with deeper pullbacks along the way, given the age of this upward trending market. While current earnings and economic growth remains strong, economic factors such as tariffs and trade wars can obviously disrupt these positive trends. But for long term investors these types of drawdowns are part of the journey. Try not to get too excited by the increased market fluctuation. Remember, the current market ups and downs are actually closer to the norm than the tepid volatility we have become used to over the past few years.
Meanwhile, get outside and enjoy the springtime and all the beauty that goes along with it.
Frederick F. Kramer IV, JD
Co-Chief Investment Officer