February 6, 2018

As we entered 2018, the equity markets staged an impressive rally that sent the S&P 500 up more than 7 percent in the first four weeks of the year. However, last Friday volatility returned to the market with stocks selling off, only to rebound strongly today. What happened and how do we proceed from here?

Volatility rises as the economic cycle matures

• As expansions age and the economy expands, central banks attempt to control inflation by changing the level of interest rates. If they raise rates too much, the economy begins to slow and a recession often follows.
• Friday’s employment report indicated that wage inflation increased although it remains far from alarming levels. This has sparked fears that the Federal Reserve will respond by raising rates too aggressively. We are closely monitoring developments on this front, but we feel it is premature to sell stocks on inflationary concerns.

Electronic trading and quantitative equity strategies appear to have been a major factor

• When stocks were selling off, high yield bonds declined just a fraction. This is a strong piece of evidence that suggests technical factors, such as computer-based trading, were primary drivers of the declines rather than a perceived deterioration in earnings or the economic outlook.
• Computer-based trading and quantitative equity strategies, which are often automated and trend following, played a significant role. These strategies tend to exacerbate market movements by trading huge quantities of stock based on the direction of the market and other factors that do not incorporate long-term fundamentals.

Market fundamentals remain strong

• Expectations for earnings growth in 2018 have been rising steadily in recent weeks and earnings are now estimated to grow almost 14 percent this year.
• Economic growth continues to accelerate, and the International Monetary Fund recently made yet another round of upward revisions to its economic growth forecasts for 2018.
• Valuation is the only fundamental indicator that has given us pause. Prior to the correction, stocks were trading at valuations that were a little high, but the recent sell-off has removed much of the excess. Currently, the price-to-earnings ratio stands just below 18, which is a modest premium to the average over the last 25 years.

Corrections are normal in bull markets and stocks have increased meaningfully

• At its recent peak, the S&P 500 had increased 57 percent since the lows of the last correction, which occurred in February of 2016.
• Volatility has been exceptionally low during this phase of the bull market. In fact, the recent sell-off was the first decline of more than 5 percent since June of 2016.
• Given the length and magnitude of the current bull market, a correction is healthy at this stage.

How do we handle volatility?

We have been rebalancing portfolios throughout this bull market. That means we sell stocks as they rise and add to the assets in the portfolio that have not performed as well. This approach allows us to buy low and sell high on a systemic basis. In addition, we remain focused on fundamentals, such as earnings growth, rather than trying to time the market or predict swings in market sentiment. Ultimately, the stock market follows the path of earnings and they remain strong at this juncture.

At this stage we see no need for a change in strategy, but this is a fluid situation and we are watching developments closely. Of course, we are also looking for opportunities to buy quality companies at attractive valuations.

Most important, our portfolios are designed with a long-term asset allocation based on your goals and risk tolerance. After a long period of calm markets, events like this may clarify how much risk investors are willing to accept. If you would like to discuss your portfolio or financial plan, please do not hesitate to contact us.