On behalf of the Altium Investment Committee;
After more than a year of steady market appreciation, volatility has emerged from historically low levels. Following a strong equity market rally in January, the S&P 500 “corrected” in February (meaning a price decline of more than 10% from its most recent high). Mounting concerns over inflation and rising interest rates seemed to spook investors. Other factors cited for the pullback and corresponding volatility during the first quarter include heavy computer trading and short covering from investors who had taken the opposite bet on volatility.
Volatility has continued thus far into the second quarter as the market tries to digest an abundance of geopolitical news and domestic economic data. While the economy shows few signs of slowing down, risks to growth are rising with concerns over a trade war with China and the pace at which the U.S. Federal Reserve continues its tightening of monetary policy.
It is important to remember that market volatility is a normal part of investing and it is nearly impossible to predict how deep and sustained any market correction will be. Corrections will occur within the normal course of a market cycle (such as in the first quarter). For long-term investors, reacting emotionally to volatile markets may be more detrimental to portfolio performance than the correction itself. Altium advocates that investors remain committed to an asset allocation plan, designed in coordination with a long-term financial strategy. Furthermore, Altium utilizes a number of portfolio optimization and management strategies to prepare for and manage through periods of increased volatility.
Key Headlines During Q1 2018
Stocks “corrected”, yet were only down modestly; Bond yields increased
In the first quarter, large cap U.S. stocks and international developed market stocks were down 1.2% and 1.7%, respectively*. During the quarter, the S&P 500 “corrected”, when it was down just over 10% from its peak on January 26th to its low on Feb 8th.
The Barclays Aggregate Bond Index was down 1.5% in the quarter as yields on the 10-year U.S. Treasury bond shifted higher (increasing from 2.46% to 2.74%).
Yield Curve remains positively sloped; a favorable sign for the economy
The U.S. Federal Reserve raised the fed funds rate by 0.25% to 1.75% in March, following three quarter point increases in 2017. The Fed has signaled it will raise rates 2 more times in 2018. Supporting the decision to raise rates, Fed Chairman Jerome Powell stated, “the economic outlook has strengthened in recent months” and “the economy is healthier than it’s been before the (2008) financial crisis”**
Short and long-term U.S. Treasury bond yields increased in tandem with the Fed rate hike during the quarter. Yields on the 2-year Treasury bond increased from 1.92% to 2.27%, while yields on the 30-year Treasury bond increased from 2.81% to 2.97%.
The spread between the 2-year and 10-year U.S. Treasury, while continuing to trend lower, ended the quarter positive by roughly 0.50% (An inverted yield curve would occur when this spread becomes negative; Later we discuss what this potentially means for the economy).***
Volatility has returned to the market
After a period of relative calm in the market, investors have been swiftly reacquainted with volatility. While volatility can cause anxiety, we reiterate that market volatility is a normal and expected characteristic of investing, especially towards the later stages of an economic cycle. To offer some perspective on the degree of volatility that we are experiencing, we studied daily market volatility over the past decade. Using the S&P 500 as a reference, we looked at the number of days in which the daily intra-day price of the index fluctuated +/- 2% or more. In calendar year 2017, there were zero occurrences at this level of volatility. So far, in 2018, we have had 11 days, on track to reach a level of volatility last experienced more than 6 years ago.
Signs of an economic contraction
We continue to keep an eye on indicators that would signal to the markets that an economic recession is on the horizon. The economy has avoided a recession since 2008, which is the second longest period between recessions in history. A recession technically occurs when the gross domestic product (GDP) suffers two consecutive quarters of negative growth.
A slowdown is the first stage of economic contraction. This stage, which can last a few months to a year or longer, is typically characterized by declining confidence, rising inflation, a peak in short term interest rates and an inverted yield curve (where long-term yields fall below short-term yields). Historically, volatility has increased and stock prices have started to decline in advance of a recession (the last business cycle stage).
An inverted yield curve is a popular indicator used by economists when studying recessions. Despite a rate increase by the Fed in March, the spread between 2-year and 10-year Treasury bond yields remains positive by roughly 0.50%. In other words, the yield on a 10-year bond is 0.50% greater than the yield on a 2-year bond. A positively sloped curve has historically signaled inflationary growth, therefore, leading us to believe that we are not yet facing an economic recession.
The chart below depicts how an inverted yield curve (in 2000 & 2006-2007) preceded the last two recessions (in 2001 & 2008). This occurs when the yield on the 10-year bond is lower than the yield on the 2-year bond. We included performance of the S&P 500 (represented by the black line) to offer perspective on how the U.S. equity market performed during this period. Based only on the yield curve analysis we can argue that the economy is not at risk of entering a recession in the near-term.
Source: Bloomberg: 10-year & 2-year Treasury Spread; S&P 500 Index daily prices
Bull market and bear market corrections
Similar to volatility, market corrections are also to be expected (there have been 37 since 1946). A normal correction within a bull market is defined as a market index price decline greater than 10%, but below 20%. However, a bear market occurs when a market index declines 20% or more.
In the table below, we provide some more detail on what to expect from various market corrections (utilizing the S&P 500 index in this study). When the price decline is under 20%, the bull market is considered uninterrupted. On average, corrections within a bull market have historically resulted in a price decline of 13% over a 3-month period, while taking 3.5 months for the index to recover (and reach its previous high). Bear market corrections (price declines 20% or more), on average, have historically resulted in a market index price decline of 30% over a 13-month period, while taking nearly 21 months to recover.
Since the 2008 economic recession, the S&P 500 has experienced five market corrections (before February of this year, it had been nearly 2 years). The S&P 500 would have to close at a price below 2,298 (down 20% from the most recent peak) to enter a bear market. In the graph below we focus on the past five corrections, specifically how the market has reacted and recovered from each. We reiterate that corrections are normal and historically investors are rewarded for staying invested.
Source: Bloomberg; S&P 500 Index daily prices
We understand that heightened market volatility can be unsettling and may at times lead you to question if portfolio changes are necessary. We believe the most prudent action is to remain invested in an appropriate allocation that adheres to your well thought out investment plan. We opine that trying to time the market in order to avoid the potential losses associated with periods of increased volatility will ultimately hurt long-term performance.
Altium utilizes a number of portfolio optimization and risk mitigation strategies to prepare for periods of uncertainty. While it is impossible to eliminate systematic risk (or market volatility), portfolios are designed for each client based on his or her specific level of risk aversion. Examples of risk mitigation strategies include allocating to fixed income assets and having lower exposure to higher risk asset classes (i.e. high yield bonds & small capitalization stocks). Additionally, proper asset class diversification can reduce the unsystematic risk exposure (i.e. specific company or industry risk) within a portfolio. Examples of managing unsystematic risk would be reducing concentrated positions of an individual stock and implementing individual bond ladder strategies designed specifically for a rising interest rate environment.
Additionally, Altium utilizes active portfolio management techniques and is prepared to take advantage of market volatility. Examples include active tax loss harvesting and dynamic portfolio rebalancing. It is also important to have an efficient distribution strategy in place when making withdrawals from a portfolio. For example, when equity assets have declined, it may make sense to source distributions from fixed income assets or cash equivalent assets to allow equity allocations time to recover.
Gregory Slater, CFA, CFP®
Chief Investment Officer
Chart A) 1Q 2018 Total Return of Major Asset Class Indexes
Source: Bloomberg; 1Q 2018 total return, International, emerging market, S&P 500, Barclays Agg indexes
* LC US stocks = S&P 500 Total Return Index; Emerging Markets Stock Index = MSCI Emerging Markets Net Total Return Index; International Markets Stock Index = MSCI EAFE Total Return Index
** Source: Jerome Powell, Federal Reserve Chair
*** Yield curve; spread between the rate on 2yr. Treasuries
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