April 5, 2019
A recent report from Yellowstone National Park stated that grizzly bears start hibernating in late November and emerge from their dens in late March. We started thinking about the benefits of behaving like a grizzly bear when it comes to investing during periods of elevated market volatility. We would feel far more rested now and unfazed by the recent bout of volatility.
Over the past two quarters, as the grizzlies slept, the S&P 500 index experienced its largest quarterly decline in almost 8 years. Then came the index’s biggest quarterly gain in almost 10 years. While we stated in our recent fourth quarter commentary that historical market data supports our belief in keeping calm during volatile periods, we could not have predicted the sharp recovery during the first quarter of 2019 1.
As always, we recommend that our clients stay the course and avoid market timing. However, we also continue to emphasize maintaining an asset allocation suited to your individualized strategy. While we expect volatility to persist in the near-term, we believe investors will be rewarded for staying focused on the long-term. If you experienced discomfort during the most recent wild market swings, your tolerance for risk may have changed. We must always maintain a balance between your ability to handle risk, as determined by your financial plan, and your willingness to stomach market volatility.
December 2018 Market Sell - Off
In December, the S&P 500 index rapidly fell nearly 16%. The Fed asserted its plan to raise rates
throughout 2019, while the President ridiculed Chairman Jerome Powell’s actions. The perceived instability surrounding the world’s most influential central bank, coupled with economic data that sparked increasing global growth concerns, were more than the market could handle 1.
What Changed in the New Year?
In January, Chairman Powell and several former chairpersons spoke about the Fed adopting a more patient stance toward raising interest rates. They signaled the Fed was going to listen to the markets, putting investors at ease and willing to take on market risk once again. Economic news flow was also fairly encouraging. Fourth-quarter corporate earnings mostly met and exceeded expectations while headlines suggested progress in Chinese trade negotiations.
While the Fed’s decision to keep rates constant in the near-term will make a big difference on economic growth projections, not much else has changed. The U.S. equity market is back near all-time highs, but many investors do not seem convinced that the powerful winter rally will continue.
A Healthy U.S. Economy with Low Probability of a Recession in 2019
Key indicators suggest the U.S. economy is healthy. Gross Domestic Product (GDP) in the U.S. is now likely to grow at an annual rate of 2.1% in 2019, down from the Fed’s previous 2.3% estimate. While lower than historical standards (GDP growth in the U.S. averaged 3.2% from 1947 until 2018), the current level of GDP is consistent with the growth experienced during the post (2008) crisis economic cycle 2.
Consumption is the largest component of U.S. GDP and consumers keep spending, which is helping sustain current levels of GDP growth. The positive read on the consumer includes data such as retail sales, disposable income, confidence and low unemployment.
The Federal Reserve Bank of NY yield-curve model now predicts a 24% probability of a U.S. recession beginning in the next 12 months. For comparison, this probability reached 40% in November 20072. The U.S. economy is strong, but it is only one, very large piece of the global puzzle.
Global Anxiety Persists
Apart from Fed policy, today’s risks are little changed from a few months ago. While any one event may not single-handedly cause a significant disruption to the markets, a few missteps together may have a larger effect. This effect might not be a swift correction similar to the fourth quarter of 2018, but it would likely create an environment of sharp day-to-day moves in both directions.
Q1 and Full Year 2019 Earnings – Has the bar been lowered enough? Reduced year-over-year earnings growth is likely priced into the market, but any further significant reduction to current estimates may spook investors.
The Fed – Economists now generally think the Fed will lower rates before raising them again. Most see rate cuts starting in 2020, although some have suggested they could happen as early as this summer. We expect the market to remain extremely volatile during the Fed’s eventual transition period from tightening to easing.
The Economy – Predicting a recession will be a hot topic throughout the year. Investors will keep a close eye on global growth indicators (such as Global Composite PMI, which measures the overall strength of global manufacturing and services sectors) and react to any unexpected changes in the numbers. As it relates to the consumer, will we see a meaningful impact to spending due to the recent tax law changes that individuals are experiencing first hand this tax season?
Yield Curve Inversion – We continue to focus here, as many economists believe that the odds of a recession significantly increase when the yield curve inverts. In late March, for the first time in 12 years, the spread between the 10-year and 3-month Treasury rates turned negative, if only for a few days. Since monetary policy has a powerful influence on the yield curve, it will be interesting to see how the prospect of lower short-term rates (determined by the Fed) affects the usefulness of this indicator at predicting a recession this time around.
China – Trade negotiations and economic growth will control the headlines. As we write this, Chinese delegates are in Washington reportedly making headway on a deal. What a deal might look like is largely unknown. Tariffs and intellectual-property security are the key issues. Most headlines in recent months about the Chinese economy have involved slowing growth, although the most recent news was more upbeat. Either way, we anticipate heightened market volatility as news surrounding China unfolds.
Brexit –Brexit has not been in process for our entire lives, although it sure feels this way. The most recent update has the UK leaving the European Union on April 12 without a deal. Unless, of course, there is an extension. Even if a second referendum cancels Brexit, the damage to the UK economy will largely persist. We think a bad precedent will be set if there is no deal before the eventual exit. Uncertainty surrounding the agreed-upon terms of the exit is, in our opinion, the biggest Brexit- related risk.
Market Timing is a Losing Proposition
In our recent commentary (Full Version), we provided a few studies supporting our belief that the most important action to take during volatile periods is to remain invested and committed to your long- term strategic asset allocation plan. We looked at how longer holding periods minimize the variability of returns over time.
In the table below, we provide an analysis of the S&P 500 index over the past year. While 12 months is a short period, it reminded us of the most recent DALBAR study, which reported that the average U.S. investor lost twice as much as the S&P 500 index in 2018. In other words, emotional behavior caused investors to make decisions that significantly influenced their returns 3.
Source: Mornigstar Direct: S&P 500 daily price
The analysis above is simple by design, in order to make a case for staying invested. If an investor purchased the S&P 500 index and held the asset for the entire 12-month holding period, the index returned a positive 9.78%. However, if the investor sold the index at its low and purchased it again only 2 weeks later, returns for the 12-month holding period would be 1.23%. The impact of trying to time the market in this scenario resulted in a significant under performance relative to the index holding period return. Determining the appropriate re-entry point is arguably the most important factor, certainly in this case, and history has shown us that missing the first few days of a recovery significantly impacts returns.
Benefit of Portfolio Diversification
We also looked at how portfolio diversification can minimize the variability of returns. For many of you, with moderate portfolio allocations, conservative assets (including fixed income, cash and cash equivalents) play an important role within your specific plan. In the study below, we again look at equity market returns over the past 12 months.
Source: Mornigstar Direct: S&P 500 daily price & Bloomberg Barclays Aggregate Bond Index
The diversified portfolio in this study exhibited significantly lower volatility as compared to being 100% invested in stocks (S&P 500 Index), capturing 84% of the upside yet only 56% of the drawdown that occurred between September and January. The diversified portfolio in this case represents a 60% weighting to stocks (S&P 500 index) and a 40% weighting to fixed income (Bloomberg Barclays Bond index).
While this study is not to be used as a predictor of future results, portfolio diversification remains a core concept within our overall investment philosophy. This applies to the inclusion of multiple equity and fixed income asset classes. Despite continued low absolute yields, we believe fixed income is still an important asset class depending on your overall plan and risk tolerance.
It’s often said that, “markets climb a wall of worry”. It’s true. People like to talk about how uncertainty hurts markets, but the reality is that uncertainty, while greater at some times than others, is a fact of life. There is always an abundance of things to be concerned about, but that is no reason to get away from your long-term plan.
Indeed, staying invested is critical to achieving your long-term goals. We understand that emotions and logic are sometimes disconnected, which is why understanding not only your ability, but also your willingness to take on portfolio risk is integral to our portfolio design process.
We are here to help you adhere to your goals, whether it be through our portfolio management or consulting strategies. We want you to have confidence in your plan and in your allocations, allowing you sleep comfortably through the harshest of winters.
Gregory Slater, CFA, CFP®, CIPM®
Chief Investment Officer
Chart A) 2019 Year to Date Total Return of Major Asset Class Indexes
Source: Bloomberg; 2019 year to date total return, International, emerging market, S&P 500, Barclays Agg indexes
1 - Source: Bloomberg: S&P 500 Index; Emerging Markets Stock Index = MSCI Emerging Markets Net Total Return Index; International Markets Stock Index = MSCI EAFE Total Return Index.
2 - https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20190320.pdf; https://www.newyorkfed.org/research/capital_markets/ycfaq.html; Board of Governors of the Federal Reserve System, Federal Reserve Bank of New York and NBER.
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