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December 21, 2018 Blog 7 min read

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

Benjamin Graham

  • Market volatility has continued in recent days, with equities under pressure amidst a flight to quality.
  • The most recent catalyst was disappointment in the Fed’s forecast for its benchmark funds rate for the coming year. While they pared back the number of projected rate increases for 2019, the markets were hoping for an even more dovish stance.
  • Market sentiment has soured a bit in recent months, but we believe that both equity market valuations and economic conditions remain constructive.
  • While the economy is slowing, we believe the near-term risk of recession remains quite low. As such, current equity market volatility is more likely to resemble a market correction against the backdrop of a continuing expansion, which tends to be much less severe than the bear markets that accompany a recession.
  • Reconfirming one’s risk tolerance, maintaining adequate cash reserves, engaging in appropriate tax-motivated transactions, and rebalancing back to targets are constructive steps to consider during periods of market volatility. We advise investors to consider such actions as appropriate, while avoiding the urge to make material changes to their investment strategy in response to periodic changes in the market environment.

The market has been voting recently, and a majority of those casting ballots apparently don’t like what they see. Investor sentiment has slipped, as fears about the Fed potentially overtightening and slower growth outside the United States have weighed on the collective investor mood and triggered an uptick in volatility across both fixed income and equity markets. The most recent catalyst was a negative reaction to the Fed’s quarter-point rate hike announcement on Wednesday, which took the central bank’s benchmark short-term interest rate to a range of 2.25 – 2.5%. While the 0.25% increase was widely expected, the Fed dialed back their baseline expectation for rate hikes next year (from three quarter-point increases to two), which was less than investors would have preferred, eliciting a negative reaction in equity markets.

In a certain sense, the Fed was caught between a rock and a hard place. Had policymakers made no adjustments, they would have been accused of being tone deaf and oblivious to the slowdown that is occurring. Had they moved more aggressively to dial back expectations, investors may have viewed it as a sign that the central bank believed that risks have increased dramatically, requiring a more abrupt reversal in policy. Clearly, policymakers didn’t believe that’s the case, determining that a moderate adjustment was appropriate and sufficient given their interpretation of current conditions.

Equities opened today on a moderately positive note, but have moved into the red as the day has progressed. The S&P 500 is down about 16% from its mid-September high and the Russell 2000 index is down about 25% from its peak in late August. With U.S. equity markets well into correction territory, the core question is where the markets are likely to go from here. As longtime clients know, we do not believe that it’s possible to accurately predict the short-term directionality of markets and will not attempt to do so. What we can do, however, is evaluate current conditions in a historical context and against a backdrop of objective data. In short, we will focus on the “known” rather than the “unknown” to help guide our actions and decisions. To that end, we will focus on a few key factors that merit consideration: market valuations, economic conditions, potential risks, and investor sentiment.

The outlook for equities: factors to consider

  1. Market valuations – For the past several years, we’ve largely characterized U.S. equity market valuations as being elevated, but not grossly overvalued relative to the low-inflation, low-interest-rate environment. In the past year, a surge in corporate earnings and declining prices have both contributed to equity valuations declining meaningfully. Consequently, stocks are much cheaper today than they were a year ago, and long-term return expectations have also improved as a result.
  2. Economic conditions – The economy is slowing and is projected to grow at a moderating pace in the coming year. Still, as we have conveyed in our recently released Road Ahead 2019, we believe there’s a meaningful difference between “slower growth” and “no growth.” While the slowdown is real, most economic data still points to continued growth and little risk of an imminent recession.
    • Labor market conditions remain solid, with respectable job creation and a low, stable unemployment rate. Job creation has slowed in recent months, but layoffs remain exceptionally low. A sharp, sustained increase in layoffs would be a negative sign, but there is no indication of that as of now.
    • Activity in the cyclically sensitive manufacturing sector remains quite robust. The ISM Manufacturing Index remains well into expansionary territory, and new orders (perhaps the most noteworthy leading indicator within the index) are growing at a very strong pace, even accelerating last month.
    • Leading economic indicators continue to point toward widespread strength. While there are indications that growth is slowing, and is likely to moderate further in 2019, the index still points to above-trend growth well into 2019.
    • The yield curve has flattened, but has not inverted, an event that generally occurs 12-18 months before a recession. In fact, it was a full two years before the onset of the recession in the latest cycle.
  3. Potential risks – As always, various sources of uncertainty could weigh on the economy and risk assets. Among the more noteworthy risks are the potential for a policy error by the Fed (most likely in the form of overtightening), the flowthrough effects of a slowdown outside the U.S., an escalation of ongoing trade tensions (particularly with China), a range of geopolitical uncertainties, and a lack of clarity on policy matters in Washington. Still, we believe that the economy, for now, appears sufficiently robust to remain in expansion despite those potential sources of risk.
  4. Investor sentiment – Unlike valuations (which have improved) and economic conditions (which are slowing, but still appear to be solidly expansionary), investor sentiment has turned negative in recent months. Concerns about the potential negative “what ifs” related to the economy and policy in particular have been among the primary drivers for that pessimism. Unlike valuations and economic fundamentals, which tend to be more durable, sentiment can – and often does – shift quickly. However, negative sentiment is often cited as a contrarian indicator, and troughs in sentiment have tended to be a bullish signal.

Add it all up

As noted, most believe that the pace of growth is decelerating, a trend that is likely to continue in the coming months. The economy could slow more than economists anticipate, but for now we believe that the U.S. is in the midst of a growth slowdown, and that recession risks remain low. That is important, because stock market corrections in the absence of a recession tend to be less severe and more short-lived than those accompanying a recession. Since 1945, the S&P has experienced 28 corrections during expansionary periods, with the average drawdown being about 15%. Contrast that with drawdowns that accompanied recessions, which tended to be more severe, and were much more likely to extend into a bear market (decline of 20% or more).

The bottom line is that the decline that has occurred in U.S. equities is in line with a typical peak to trough decline that occurred against the backdrop of a growing economy. Ebbing economic growth is one risk that catches investors’ attention, and can contribute to a downdraft in equities. Certainly, it’s possible that market volatility could continue, but if the current bout resembles prior corrections under similar non-recessionary conditions, the recent retrenchment in equities is likely to be closer to the bottom than not.

That could, in fact, present an opportunity for investors to rebalance their portfolios or put idle cash to work at prices that are more attractive than they’ve been in some time.

 What does it mean for investors?

As always, we strongly urge investors to avoid the temptation to make material changes to their investment strategy during periods of volatility. It may be tempting to reduce one’s exposure to equities and other risk assets, but doing so after a drawdown has occurred is not advisable, and increases the risk of locking in those losses.

Instead, we recommend that investors look through periods of volatility and remain focused on their true investment time horizon – usually measured in many years or even decades, not weeks or months. We would advise investors to reconfirm their overall tolerance for risk and asset allocation, evaluate the adequacy of their cash reserves, take advantage of any tax-planning opportunities (through the recognition of losses and avoiding taxable capital gain distributions from mutual funds where appropriate), and rebalance their portfolios back to strategic asset allocation targets.

As long term investors, we strongly recommend that you make investment decisions based on weighing the market’s valuations and fundamentals, not voting on its potential – and unpredictable – short-term direction.

Disclosures

Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain.

Data sources for peer group comparisons, returns, and standard statistical data are provided by the sources referenced and are based on data obtained from recognized statistical services or other sources believed to be reliable. However, some or all of the information has not been verified prior to the analysis, and we do not make any representations as to its accuracy or completeness. Any analysis nonfactual in nature constitutes only current opinions, which are subject to change. Benchmarks or indices are included for information purposes only to reflect the current market environment; no index is a directly tradable investment. There may be instances when consultant opinions regarding any fundamental or quantitative analysis may not agree.

Plante Moran Financial Advisors (PMFA) publishes this update to convey general information about market conditions and not for the purpose of providing investment advice. Investment in any of the companies or sectors mentioned herein may not be appropriate for you. You should consult a representative from PMFA for investment advice regarding your own situation.