October Correction

Global markets have been under pressure so far in October. In fact, there really hasn’t been any safe-haven around the world except cash. Let’s look at the returns of the last 4 weeks and year-to-date (YTD) as of 10/26/2018 in various markets around the world*:

Those type of returns around the globe are alarming. Especially when things seem to be doing well in the US economy and corporate America. Isn’t US GDP growth quite strong, unemployment at record lows and corporate earnings growth strong? They are, so what is causing investors so much anxiety these days? I’ve explored several reasons why investors might be selling below:

The Federal Reserve has been raising interest rates. So far in 2018 there have been 3 rate hikes with the Fed telegraphing one more in December. Concerns abound that the Fed will raise rates too fast and spur on an economic recession. The benchmark 10-year treasury is now over 3%, a level it hasn’t seen since December of 2013. See chart below**:

In reaction to higher rates, homebuilding and auto industries are showing some slowdowns. These are important industries in the US. Will this continue? See charts below:

Inflation also has investors concerned. Full employment can lead to wages growing and a strong economy can lead to higher costs both for consumers and corporations. Inflation is now above the 2% level which is the Fed’s longer-term target. See chart below**:

The tariff wars the US is having with other countries is also causing investor angst. So far, the tariffs that have been imposed have not slowed down the economy. But if the trade war continues there is the potential for it to negatively impact the economy. The below chart reflects the possible negative impact a tariff war could produce on our economy’s GDP growth:

Finally, there seems to be some concern that the US economy and corporate earnings growth has peaked and will incrementally look less robust in 2019. There is some merit to this as earnings growth in 2019 is forecast around 10% yr/yr (versus roughly 20.5% in 2018)*** and it will be hard for the US economy to continuously produce 3-4% GDP growth every year.

In summary, investors are concerned about rising interest rates, inflation, tariffs and a peaking US economy. In addition, we are now in 3rd quarter corporate earnings reporting season and many CEOs are mentioning that inflation and tariffs have the potential to hurt their profits going forward. All of this has led to the market pulling back despite what seems to be a constructive environment for stocks.

Is this just another correction in the stock market that happens all the time? Or is this the end of the long bull market and the start of a bear market? We don’t have a crystal ball, but we feel this is an overdue correction and not a crash. We don’t see the economy slipping into a recession anytime soon. Remember corrections (periods of 10-20% declines) are much more frequent than bear markets. In fact, since 1974 of the 22 corrections that have taken place only 4 have turned into bear markets. See the chart below****:

Stock markets look forward, and right now the concern is about future growth being negatively affected by interest rates, tariffs, inflation, etc. In times like these it helps to keep an eye on the longer-term and ask yourself if you are correctly allocated between stocks and bonds. Also, look back and see if your financial goals and objectives are on track. If they are, stay the course. Don’t let the emotional halo of a correction drive you into decisions you may regret.

*Morningstar, Inc Index Performance: Return (%)

**Economic Research, Federal Reserve Bank of St. Louis

***FactSet, Earnings Insight, October 26th, 2018

****Schwab Center for Financial Research with data provided by Morningstar, Inc. The market is represented by the S&P 500 index.

To expand on these Market Reflections or to discuss any of our investment portfolios, please do not hesitate to reach out to us at 775-674-2222.

Posted on October 30, 2018 Read More

Third Quarter Market Review

The third quarter is history and markets are standing tall despite warnings of seasonal weakness and further trade concerns.  U.S. stocks, led by the red hot growth sector, set two records this quarter.  This is now the longest running bull market ever and major indices achieved all-time record levels in September.  Growth has been an important factor as U.S. GDP growth hit 4.2% in the second quarter.  Supportive fiscal policy, confident consumers, strong corporate earnings and low interest rates may likely keep momentum positive through year end.

The Federal Reserve is sticking to their well-telegraphed game plan of gradually raising short-term interest rates 25 basis points per quarter. The September move marks the fourth consecutive quarterly rate hike bringing the targeted Fed funds rate to 2.00-2.25%.  The journey to a normalized monetary policy is underway as the Fed simultaneously tries to shrink their balance sheet while raising short-term interest rates.  The Fed needs to get all their tools back in the tool box before the next economic downturn hits.  So far so good, but they will need years to completely finish the job as the balance sheet reduction project is in its infancy.

Trade and trade agreements are still a hot potato for the markets.  Despite all the facts, tweets, and opinions, the market is taking much of this uncertainty in stride.  President Trump announced a preliminary agreement with Mexico to modernize NAFTA and the market applauded.  Even Canada joined at the very last minute.  China and the U.S. continue to up the tariff ante. While the end game is unknown, it appears ramping up the rhetoric and action is becoming less of a market negative.  A final trading agreement between the two economic powerhouses may well prove to be a future bullish catalyst for stocks.

The strong U.S. dollar, along with trade tariffs, have taken their toll on the foreign markets.  To date, the U.S. stocks have fared much better than both international and emerging markets.  The Dow Jones Industrial Average was the lead dog in the third quarter gaining 9.63% while setting an all-time high.  The S&P 500 and the NASDAQ composite also had a strong quarter gaining 7.71% and 7.41% respectively.  The two major international indices (MSCI Emerging Markets and MSCI EAFE) were mixed for the quarter at -1.09% and +1.35% respectively.  Growth stocks are still outperforming value stocks around the globe.

The bond market is dealing with multiple cross currents, but the tide is taking interest rates marginally higher, causing prices to decline.  The benchmark 10-Year U.S. Treasury spent most of the quarter yielding just below three percent but ended the period yielding 3.05%, up 20 basis points in the quarter. The yield curve continued to flatten, as the 2-Year Treasury rose by 29 basis points to end the quarter yielding 2.81%, and the 30-Year Treasury rose 21 basis points to yield 3.19%.  Someday bonds will once again offer value.  Until then, own short duration bonds for liquidity and portfolio risk control.

Portfolio diversification is the most important tool to achieve your long-term financial goals.  We diversify to manage risk and protect against unwanted volatility.  Short-term market moves can entice investors to abandon a well-diversified approach at exactly the worst time.  The record rally into quarter end raises questions better left unasked.  Questions like, “why do I own bonds?”, “why do I have a cash position?”, “why do I own international stocks?”, and “why don’t I have all my money in Amazon and Apple?”  The correct answer is diversification.  Protecting your nest egg through diversification does not need an apology.  U.S. growth stocks are currently the best place to be, but leadership rotates over time.  The right asset allocation allows your portfolio to weather all storms and will keep you invested for the long haul.

MARKETS BY THE NUMBERS:

To expand on these Market Commentaries or to discuss any of our investment portfolios, please do not hesitate to reach out to us at 775-674-2222

Posted on October 1, 2018 Read More

Value stocks as a driver of performance

We consistently discuss the benefits of “buying low and selling high”.  We are not alone in this regard as many successful investors, including Warren Buffett, tout the advantages of “value” investing.  While value is primarily defined as an investment trading below intrinsic value, there is significant debate about the proper way to measure value for a stock.  In addition, recent research suggests that valuation has little to do with short term future returns, but is very important for long term returns.

In regard to determining value, the price to book value metric has been a widely used valuation measurement.  Book value measures the amount of tangible assets on the balance sheet, and includes things like inventory, cash, and real estate.  Historically, a lower price relative to the book value per share indicates a value stock. Recently, there has been debate on how accurate book value represents stocks in an economy that is heavily reliant on services rather than tangible goods (such as the U.S. economy).  According to Barron’s, service oriented stocks have large percentages of their values in intangible assets like brand name, intellectual property, or customer loyalty.  These assets don’t show up on the balance sheet and would not be included in price to book value calculations.  Therefore, are we excluding investments as “value” stocks simply because the usual measurement system does not properly calculate their value?

With regard to valuation and the influence on future returns, analysis has shown that valuations don’t have a significant impact on returns in the short term, but have been shown to have a large impact on longer term returns.  The JPMorgan Guide to the Markets reflected this in the below charts.  On the left, you see that 1 year returns are relatively random across the valuation spectrum, but over 5 years (the chart on the right) returns are heavily influenced by how much you pay for the investment.

What this means for investors is that assessment of value is not a one-metric analysis.  Factors like price to earnings, cash flow, and the future outlook of the business are all worthwhile metrics to assess a stock’s value.  Second, in the short term, many different drivers can supersede valuations when it comes to returns.  However, as the time period expands, paying attention to company value and “buying low” and “selling high” tends to reward investors over time.

Sources:

  • The Reformed Broker
  • Pension Partners
  • Barron’s
  • JPM Guide to the Markets

To expand on these Market Reflections or to discuss any of our investment portfolios, please do not hesitate to reach out to us at 775-674-2222.

Posted on August 28, 2018 Read More
 
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