Correction or Crisis?
Stocks have been on a bit of a wild ride to date, as you may have noticed. We certainly have, and we welcome this development. If you have been around us long you know that we play a somewhat tiresome tune; we repeatedly remind our clients that markets go up and down. Often, in a long period of rising prices the continuation of the bull market takes on a certain inevitability. This is true in a micro sense – there is always a hot stock, or a handful of them - and in a macro sense, wherein broad swaths of risk assets, be they houses, commercial buildings, stocks, commodities, are rising. This can feel like hitting soft-tossed whiffle balls with a stiff tailwind. Only a piker would miss this bull market, these stocks. The looking glasses, such as we imagine them to be, become tinged with rosy clarity.
Of course, inevitability works both ways, and it is precisely the unpredictability of markets, prices, economics and political interplay that repeatedly play havoc with these rosy-tinged assessments. The prices of all things are comprised of the agglomerated expectations of all market participants. For example, even if we don’t flip houses for a living, most of us nonetheless purchase a home in hopes that the price will eventually rise, because that is nice. When we know prices are likely to fall, we define our purchase as “consumption”. We consume our daily commuter car; we invest in a vintage Ford Mustang, or a rare artifact. The only difference? Our price expectations, or more precisely, our expectation of what others’ future price expectations may be relative to our own. This is a long-winded way of saying we like to invest in things when we think that others will also believe the future price will be higher than it is now.
If you’re about to click over to something more entertaining, less obvious, please hang with me.
Why does this matter?
It matters because since September 20th stocks and risk assets of almost all types have experienced volatility and falling prices. Given the state of domestic politics, I should point out that a modest correction in stocks at the end of the longest bull market in recorded history might be the best news we have had in a while. That’s not political commentary; it’s meant to serve as a lament on the state of fraying American civility as well as a reminder that stocks go down some of the time, and that is a good thing. Therefore, it is important to put the current correction into context.
From September 20th through Monday October 29th, the S&P 500 declined 9.8% on a total return basis (dividends soften the blow a bit); the global stock index also fell the same amount. The Dow fell a bit less, 8.2%, and bonds declined by just 0.15%. The basket of high flying FAANG stocks declined, on average, by 15%, buoyed by Apple, which was down only 3.5%. Of course, all these assets had risen by 130-200% since the March 2009 bottom, but even that is not the interesting part.
Do you know the return of stocks from January 26, 2018 to February 8th, 2018? S&P -10.1%, Global stock index, -9%, bonds, -1%.How about the return from May 21st, 2015 to February 12, 2016? S&P -12.8%, Global stock index -19%, bonds +2.2%.
Now that we have closed October, it turns out to have been the worst month for stocks since 2011, but fell a few percent short of the worst months of the financial crisis, which lands it squarely into healthy correction territory.
However, global stocks were down more in those two periods, but perhaps because they were off calendar year end, or shorter, only the recent correction permeated our collective news flow. The Lyft driver I rode with last week mentioned it, newspapers picked it up, even the well-respected academician and market wonk, Aswath Damodaran, who wrote this week in his “Musings on Markets” called this a “crisis”. C’mon, this guy literally wrote the books on valuation. Nonetheless, we joined the collective breath holding as the market continued to defy gravity. I even processed this with some alarm before I dug in and realized we’ve seen this and worse in recent months. In fact, as I write this we have notched a few solid up days, and Facebook put in a near years’ worth of gains just bouncing up on Tuesday.
Bonds are headed for their third worst year in the last 65 or so. To date the aggregate US bond market has returned -1.7%. This, friends, is the near apocalypse in bonds. Bond prices fall when interest rates rise. The greater the rise in interest rates, generally speaking, the worse the fall in prices. This holds true for most bonds. The interest rate on two-year US treasury bonds, perhaps one of the safest investments the world has ever known, has risen 46% year to date. The rate on ten-year bonds has risen 25% year to date. That is a lot, and yet we have bonds down less than 2%. Notching big gains is exciting; so too is protecting capital in an asset class that barely declines in its apocalyptic years.
Samadhi and I attended a great presentation in Denver last week put on by one of our asset management partners, First Trust. One of the slides reminded us that looking back to 1926, US stocks have had positive annual returns 74% of the time. Bonds do so even more often.
If you’re reading this, you are most likely a client, or we hope you will become one soon. We believe powerfully in a few things: taking the long view, being patient and understanding that protecting against losses is at least as important as chasing returns. We never take our eye off the risk-return contract. In the correction from mid-2015 to early 2016 we were able to demonstrate our commitment to protecting against drawdowns. We have done a bit better than the market during this correction, and we are pleased when we look at the year to date return. We had lagged the steadily rising market, somewhat by design. And now we see that YTD returns are generally better than the indexes. Yes, indexes are down for the year; as we look across accounts, you should find you are down less than a relevant benchmark year to date.
Many factors weigh on our comfort with the markets as we look forward: the political climate, a very uncertain global economic playing field, the prospect of ongoing trade wars and domestic unrest in the US, contemplation of cold-war style tensions with Russia, China, even Saudia Arabia. We have no way of knowing if this is a prolonged correction, the beginning of a bear market, or simply a profit taking correction. We do know that corporate profits and expectations thereof drive stock returns, and corporate profits continue to be very strong. A lower corporate tax rate supports that. The Federal Reserve is steadily hiking interest rates to prevent the economy from overheating. This is a countervailing factor, but their telegraphed intentions to raise rates should not surprise any market participants.
Despite our “relax and stay the course” tone here, we nonetheless have a disciplined investment process driven both by valuation and momentum. Where valuation focuses on the relative prices of things, momentum assesses the current direction of the markets and adjusts accordingly. Our momentum strategy really underpins our process, and over the last three months has steadily moved more and more to a “risk-off” position. First we sold emerging markets, then developed international in favor of high yield US bonds. Then just today, as your inbox will show, we sold the broad US market. Interestingly, this trade would typically lead us into long-term US treasury bonds, the ‘flight to safety’ instrument. But due to rising rates and the rather orderly nature of the recent market selloff, even those investments are in a declining market. So we currently have a large allocation to very short term government bonds in our Global Growth portfolio.
While we encourage perspective and looking through short term corrections and market movements, we also know that when our investment process signals caution, we are well served to listen. There are behavioral aspects to this. First, that we are actively managing risk within portfolios obviates the need to worry about changing one’s allocation to stocks and bonds in real time; even 100% growth accounts are now 40% cash, 60% in diversified value managers. Second, the market rewards patience and punishes short-term anxiety driven action. While we believe this to be a healthy correction, we are nonetheless respectful of the information that has been transmitted broadly across global stock and bond markets. Following our investment process in a disciplined manner also minimizes our own risk of error, just as we also hope to protect our clients from impulsive reactions.
We continue to apply our process to portfolio management, seek new investment ideas, keep costs low and do our best to serve you in all the other ways we believe are valuable. These include updating and reviewing financial plans, checking in to make sure our allocations are in line with your goals and expectations, and also making ourselves available to answer questions, research ideas, take meetings or just catch up and talk you through the markets.
Next steps as we move into year-end are to evaluate and make loss-harvesting trades, which we do in late November to early December. We also encourage you to consider any year end contributions you could make to a 529, your employer 401k/403b/457 plan or even your Simple, SEP, Roth or Traditional IRA account. If you would like to contemplate those contributions, please do give us a call to discuss.
As always, we are so grateful for your trust in our firm and our process. Thank you for choosing us to be a partner in your financial life.
Kreighton, Will, Dawn & Samadhi