The Great Melt Up in Stocks Continued, Until it Didn’t
After a January peak driven by economic optimism for US tax reform, a swift 10% decline ensued triggered by several factors: an early year rise in interest rates; the tweeter-in-chief’s tough tariff talk drew an immediate market response that a trade war was imminent; and the latest 2.5% selloff was based on comments from the new federal reserve chief who suggested he would raise rates gradually if the economic data showed continued strength; the same line the fed has repeated for the past couple years.
Markets are called “discounting” mechanisms because they interpret available information and make their best guess about what that means for the future. Prices adjust accordingly. Markets get it right over long-time periods; over short time periods they can be myopic, spasmodic, and even idiotic indicators of the future. Yet declining account values can create very real emotional distress if not kept in perspective. Keep the following in mind when markets panic:
- Markets have predicted 7 of the last 4 recessions!
- You don’t need to compete with the market. Your interests are best served by owning an asset mix that is aligned with your financial need for return and your mental need for safety of principal.
- “Don’t just do something, stand there.” Simple, good advice to avoid panic selling from John Bogle at Vanguard. Simple, yet often easier said than done, AND it assumes #2 is in place.
Asset Class Review
For Q1, only emerging stock markets held onto gains for the new year. Europe continues to show economic improvement, yet trade concerns, UK political uncertainty, and fear of rising US rates caused its stock market decline even though they have signaled they will keep their monetary stimulus in place. The Pacific region of trade dependent Asia was hurt by the trade war scare. US stock valuations remain highly valued in comparison to historical metrics and on a relative basis next to other countries.
Large US technology firms have consistently outperformed the broad market for the past 10 years and now make up 22% of the S&P 500. Some argue that these companies (FAANG – Facebook, Amazon, Apple, Netflix, and Google) have built unassailable market positions, with sustainable profit margins that justify their higher valuations. Perhaps. The historical evidence is that profit margins exhibit a strong “mean reversion” tendency. That is, above average profits (both margins and growth) attract competition, which drives profits down toward an average. If competition doesn’t do it, there are always governments!
Consider the Trump rants against Amazon, the Facebook congressional hearings, and the Google fine from the European Commission (EU) as reminders that regulatory scrutiny is omnipresent. Additional examples: The EU recently unveiled several ideas to tax large digital firms. According to The Economist, EU regulators claim these digital firms pay only 9.5% tax rates compared to 23.5% for brick-and-mortar firms. The EU is also in the process of rolling out new standards for data protection (GDRP) which are so complex it isn’t clear yet how they will impact business models. Cybersecurity fears are here to stay. Security isn’t convenient, for companies or for consumers.
Commodities led for the first time in a very long time, albeit with a wide divergence within this index: oil & agriculture had strong gains; industrial metals were down; copper, usually a good barometer for future economy activity, was down 10%. US Home sales saw the biggest drop in three years.
Income generating assets diverged:
- REITs declined despite 5%-6% yields and a historical high spread to the 10-yr treasury bond at 2.7%. Unless the 10-year is rising to 5% or more, it’s an example of the trader’s myopic view. Even if rates rise more, the inflationary cause would increase REIT rents and help the value of real estate assets.
- US bonds were under water as markets expected a sustained rise in rates that stalled.
- International bonds benefited from a declining dollar
Fear of inflation accelerating subsided near quarter end as rates declined from their peak and trended sideways.
Bitcoin isn’t in our asset class mix. Funny, I haven’t head the upbeat conversations in the café since the price dove about 65%. The bubble looks like it has burst. The underlying blockchain technology will find use, however as an investable theme it looks like a lot of educated guesswork is needed.
Myth: The Economy and the Market
As the data below shows, markets can decline when the economy is good. It’s true that stock prices are driven by corporate profits which are a function of good economic conditions. But they aren’t always in sync. The best way to deal with the short-term noise that can occur in the market is to have an effective long-term strategy that is aligned with your goals.
Market Declines Without Recession
Sources: Morningstar, The Economist, Stocks for the Long Run, Wealth of Common Sense
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