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Since my last intra-month market update (4 days ago) we have continued to see volatility in the markets. And like last time, instead of writing a review on January, I have decided to write another review about what is going on in these markets, as they are continuing to show us new information each day. I like to use metaphors when explaining why the market does what it does, however sometimes it’s hard to find the right one. My attempt today will be centered around the medical industry, and thus will be wrought with inaccuracies to real medicine. But given the take from a guy who has had zero training in medicine, but has seen quite a few movies and TV shows, I plan to reach the general population and not my medical clientele.
For purposes of terminology, let me explain what the industry describes as a pullback, correction, and a bear market. If any market/sector drops more than 5% the industry calls it a pullback. If any market/sector drops more than 10% we are saying that market/sector is in a correction. Finally, any market/sector that drops more than 20% we say is in a bear market.
Rewind to beginning of this year. Volatility was effectively close to dead (I realize I just humanized a quantitative measure). We had seen the least amount of volatility in the markets since 1966. With a fading heartbeat, that makes the EKG sound off an alarm, and volatility looks to be no more. Then nurses and doctors will run over and use a defibrillator to “shock” volatility back into existence (think House, Greys Anatomy, Scrubs, or my current favorite, The Good Doctor). Great, everything is back to normal. That would seemingly be a good metaphor for what is going on these last 9 days. Volatility is supposed to happen. In fact, looking back to 1980, volatility has had a 10% correction once every 2 years. Its average correction in that timeframe was over 15%1. Oddly enough, our last one ended February of 2016. The main difference between 2 years ago and today is back then it took 57 days to get the correction. It only took 9 days for us to find a correction this year2. I would go so far as to say that volatility like this is actually breathing REAL life back into existence, and not this existential euphoria we have gotten used to these last 18 months.
Where do we expect this correction to stop? That’s extremely hard to predict. If the average market correction is 15%, it would not surprise me to see the market drop another 5%. Will that cause CNBC and other news outlets to fixate on the markets? Yes. Will they remember to focus on what actually is driving our markets and economy forward? Maybe CNBC, but most others will not. The main question people are probably struggling with is, “Could this be worse than a correction? Could this be a bear market?” Let me say, it is extremely rare to have a bear market not attached to a recession; and in the times that has happened the recovery has been faster than are most recent government shutdown (slight exaggeration). So when markets return to a normal volatility, we as investment managers begin looking at the fundamentals of the economy. If the economy is looking weak, or the economic indicators are sounding alarms, we take a risk-off approach. If everything looks great or even just okay, we look for opportunities to rebalance; just not to rebalance away from risk.
Well then let’s look at the economy. Economies are cyclical. We’ve talked about this over the last 3-4 years in our communication that the economy goes through four main stages in a cycle: Recession, Recovery, Middle (Mature), and Late (Aging), followed again by a Recession. How can we understand what stage we are in? There are leading indicators that consistently help us with this. There are five indicators that we follow:
10 days ago, out of all of these indicators, valuations were the only thing showing yellow signs (not red). However with the pullback these last 9 days, valuations have come down considerably and therefore puts this indicator back on the shelf….with literally every other indicator. The LEI needs to show negative year-over-year to become a concern. We are nowhere close to a negative indicator; in fact this index is showing rapid growth in December5. Manufacturing PMI was also incredibly strong (mentioned in the last intra-month market update), and if you look inside the components of the PMI index, the most “leading” indicator, New Orders, is at 65.4% - well above the overall strong PMI index reading of 59.1%6. The yield curve is flattening but nowhere close to being inverted. LPL Research today mentioned it would take roughly 5 Fed rate hikes to just get to negative and the movement has been in the opposite direction as of late. The advance/decline line does not show any signs of major deterioration.
Another thing we look for is excess in the markets. Are there bubbles that are building up that would cause bursts and rock the market in a greater way than the markets could handle? Think financial bubble burst, real estate valuation burst, internet valuation bubble burst. Nothing today shows signs of extreme excess.
Why is the market correcting? The greatest fear I see is the fear of rising interest rates and inflation. The latest reading for the most followed inflation number, CPI was December’s reading of a year-over-year increase of 2.1%. While this reading has been increasing over the last year, it may or may not be the right measurement to measure US inflation. For instance, the Federal Reserve does not use CPI, but Core PCE (Personal Consumption Expenditures) as their measure to track for voting on interest rate hikes. That reading only came in at 1.5% year-over-year. So inflation may not be as strong as some indicators may say7. Rising interest rates mean the cost of business goes up. Makes the real estate market look less appealing and since the real estate markets are a large portion of consumer spending (which is a large portion of economic growth) it can create signs of spending decreases and a slowing economy. Current pressure on interest rates rising also has the potential to be a modest correction of a range that used to include the Federal Reserve as an active buyer. With the Fed lowering their balance sheet, it has taken a consistent buyer out of the markets and therefore could have changed the trading range of treasuries to a new normal. History shows that rising rates are positively correlate to rising markets when the 10 year treasury is under 5%8. Currently we are under 3%. While the sharp increase over the last 10 days has caused some to be concerned, we don’t necessarily look at the rising rates as a reason to sound alarms.
The point here is volatility in the market is good, when not accompanied with a weakening economy. We have gotten used to no volatility, and that may have created some unrealistic expectations of what it even means to be in the market. We would encourage all of our clients and those investing to maintain their risk profiles and look for opportunities in the market. That is our current goal for the rest of this month.
As always, please let us know if you have any questions. We would be happy to discuss.
LPL Financial Advisor
Vice President, AGH Wealth Management
1 JP Morgan Guide to the Markets 1 QTR 2018, page 12 – looking at just years markets ended positive or only down 2%
2 Morningstar Direct™
3 “Purchasing Manager’s Index” is an indicator of the economic health of the manufacturing sector.
4 “Institute of Supply Management” Manufacturing Index monitors employment, production, inventories, new orders and supplier deliveries.
7 https://fred.stlouisfed.org/data/CPIAUCSL.txt and https://fred.stlouisfed.org/data/PCEPILFE.txt
8 JP Morgan Guide to the Markets 1 QTR 2018, page 15
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs and does not assure a profit or protect against a loss.