Volatility rises given concerns about the outlook

Volatility has increased

In 2017, markets around the world rallied strongly with broad participation across both the U.S. and foreign markets. However, 2018 has been a year of decoupling. In the first nine months of the year, the U.S. equity markets diverged from those of foreign countries generating solid performance while international equities declined. In the last three months, we experienced another divergence as the U.S. stock market has fallen despite current fundamentals that are strong. For example, volatility has increased, yet this quarter, companies reported annual earnings growth of more than 25 percent and unemployment reached its lowest level since the late 1960s.

What’s driving the volatility?

While many indicators continue to demonstrate the strength of the U.S. economy, the stock market is forward looking. Accordingly, the volatility has been driven by concerns about a significant reduction in the economic growth rate, or perhaps even a recession, as we progress through 2019. Just as important, the trade dispute between the U.S. and China, as well as a potential policy mistake by the Federal Reserve, serve as catalysts. Specifically, our relationship with China and the trajectory of the Federal Reserve’s tightening policy have the ability to propel the economy, and the stock market, in one direction or the other over the coming months.

A review of the fundamentals

The fundamentals have been quite good this year. The economy has been growing well above its longer-term trend and earnings growth for the full year is projected to be more than 20 percent. The question the market is grappling with relates to the outlook. For 2019, earnings growth is expected to slow given a moderation in the economy and the fading impact of this year’s tax reform. Currently, a consensus of approximately 5 percent earnings growth seems to be forming and at that level, the S&P 500 Index is trading at less than 15x 2019 earnings. In other words, given current expectations, the market is reasonably valued as it is trading below its long-term average.

Action items

During volatile times, it is natural to wonder if action should be taken and what changes, if any, should be made. It’s important to realize that we have been active in managing portfolios and have already taken steps to prepare for an environment of heightened volatility. While more adjustments will likely be necessary as we progress through coming months, here is a summary of actions we’ve already taken to help weather the storm.

1. Rebalancing: Rebalancing each quarter forces a discipline in which we trim the assets that have increased in value and lock in profits. In other words, we regularly and systematically buy low and sell high. We have engaged in this process throughout this expansion which means we have been systematically trimming winning positions over the last nine years.
2. An emphasis on quality, liquidity and transparency: Our equity portfolios have a strong bias to high quality companies with more than 80 percent of all individual equities earning a quality score that ranks in the two highest quintiles from Standard & Poor’s. For many companies in our portfolios, a recession provides an opportunity to take market share from weaker players in their industries.
3. Modest international equity allocations: We have maintained a modest weighting in international equities for many years as they have not enjoyed the same positive fundamentals as their U.S. counterparts. Today, we continue to have a relatively low allocation to this segment of the market.
4. More defensive positioning: For those clients invested in our Multi Strategy Portfolio, we have systematically reduced the equity allocation as we progressed through the year, and in recent months, we have increased the allocation to U.S. Treasuries while reducing floating rate and corporate debt.
5. Focus on high quality bonds: Our fixed income portfolios invest in high quality bonds. For some firms, the fixed income market provides a new and different way to take high levels of risk. Junk bonds, leveraged loans and debt denominated in foreign currencies have been popular investments in recent years. We take a different approach by focusing on high quality bonds that are designed to provide a ballast to the risk in the equity segment of the portfolio.

In the coming weeks and months, we will be parsing the incoming data and will continue to actively manage portfolios, adjusting them as necessary. Thank you to our current clients for your trust and confidence, and of course do not hesitate to connect if you would like to discuss this in greater detail.