by Brad M. Weafer, CFA Chief Investment Officer
Recent Market Volatility Has Been Concerning, But That Should Not Be A Reason To Panic
KEY POINTS:
- Equity markets have struggled for the last month, particularly the year’s best performing stocks
- Rising interest rates and growing threats to China’s economy are the likely cause
- These risks are troubling, but don’t suggest an imminent end to the bull markets in stocks
For the first time in months, volatility has returned to U.S. equity markets. Major domestic equity indices have fallen from recent highs notched in mid-September. Selling has accelerated in early October, historically the most volatile month of the year for stocks. As of this writing the S&P 500 is down 5% from the high-water mark reached on September 21, 2018 and the Russell Mid-Cap Index is down 7%. Looking at the details suggest an even more challenging backdrop. Bespoke Investment Group notes the average stock is down a much greater percentage than the index leads one to believe. The average large cap stock is down 13% from 52-week highs and the average mid cap stock is down 17%. There has been a significant rotation away from stocks that have done well all year into stocks whose shares have underperformed. Strategas Research Partners points out that the year’s best performing stocks are down 4.8% in the first six trading days of October, while the broader market is down just 1%, (see Figure 1 below). This has been particularly jarring for investors who enjoyed outsized gains through the first nine months of 2018. Nowhere has this trend been more evident than in the technology sector. Technology was the best performing sector through September 30, 2018 (up over 20%) but has been the worst performing sector this month (down over 7%). It should surprise no one that clients’ anxiety has increased in recent weeks.
When markets fall, pundits are quick to identify a cause, though the answer is rarely simple. In this instance, we see several factors contributing to the increased volatility. Interest rates hit seven-year highs, with the ten-year U.S. Treasury yield dropping 3.2% last week. While the increase in rates is largely driven by news of good economic growth, higher rates raise borrowing costs for both corporations and consumers. This could weigh on earnings’ growth in coming quarters, the key driver of the market’s advance. There is also concern that continued economic growth will only hasten the Federal Reserve to raise rates faster, amplifying the upward pressure on rates. Higher rates generally correlate with lower valuation multiplies, putting pressure on what investors are willing to pay for stocks. If that wasn’t enough, there has been an increasingly hostile rhetoric from political leaders aimed at China. Data suggest the tariff threats are having an impact on Chinese economic activity. Many multinational companies do business there, creating another threat for some (not all) company earnings.
When client anxiety is heightened, we can assist. So, what should you do?
First, we should not panic. While month-long equity corrections and sector rotations such as this can be painful and emotional, it’s important to remember this is too short a time on which to base investment decisions. Even after recent declines, the S&P 500 has returned 5.8% year to date and 11.3% over the last 12 months, both respectable returns relative to history. Remember, focus on the long-term.
Second, take some solace that we invest in individual companies. At a portfolio level, this allows us to avoid some known risks (such as companies with too much debt, high exposure to China, or extreme valuations). We always focus on companies with strong and stable profitability, low financial leverage, with defensible business models and strong management teams that have a similar stake in the long run as common shareholders. Furthermore, we only invest when the stocks of these companies are trading at attractive valuation levels. We have highlighted a few risks facing the market today, but there are also risks in the future we can’t identify. We trust our companies’ executives and employees to drive shareholder value regardless of the macros environment. Focus on investing in great companies.
Third, if these messages fail to calm your nerves and the volatility is keeping you up at night, it may be time to speak with your manager to discuss your allocation between stocks and bonds. We don’t equate volatility to risk, but if fear causes you to panic and sell at the wrong time, your long-term balanced returns will suffer. Finding the right balance of higher risk assets (like stocks) and lower risk assets (like bonds) is paramount to achieving personal long-term financial goals and objectives. It is important for you to focus on your specific asset allocation.
Forecasting markets is difficult but we try to prepare for any outcome and manage the potential risk from adverse scenarios. Nevertheless, we do believe the prospects for U.S. economic and earnings’ growth remain bright. We concede there are risks to both monitor and actively manage, but that alone does not portend an imminent end to the nine-year bull market. We will never be able to predict each twist and turn in the market, but caution against using this instance as a time for rash action. We have suffered many of these corrections since the bottom in March 2009. Ultimately, U.S. economic growth and the earnings power of our companies has persevered through the cycle. We expect that trend to continue.
Market Commentary Disclaimer: This publication is for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. The information contained herein is the opinion of Boston Financial Management and is subject to change at any time based upon unforeseen events or market conditions.