In October and the first half of November we have seen volatility return to the equity markets. Consider this, in 2017 the equity markets did not have a move of 2% or more in a single day. In October 2018 alone we saw 10 trading days that had a move of 2% or more and a result was the equity markets recorded their worst month since 2011. We cover this in much greater detail below, but what the equity markets are telling us is that while the U.S. economy is still in excellent shape investors need to take caution due to some strong headwinds that are picking up.
On the positive side:
Jobs: Companies added jobs for the 97th-straight month, and the economy has now grown for 112 months in a row. The U.S. is on track to match the longest economic expansion in history. The previous streak was 120 months, which ended in 2008. For the second-straight month, U.S. unemployment is at 3.7%, the lowest in 49 years and wages are up 3.1% year-to-year, this is the highest rate since 2009.
U.S GDP: The U.S. economy grew at a strong 3.5% annual growth rate in the third quarter. Growth dipped from the second quarter’s 4.2% rate, but the economy still posted its best back-to-back quarters in four years. This is partially due to free spending by consumers and the federal government. On an annual basis, this growth rate would meet or exceed the Trump administration’s 3% annual growth target.
On the side of concern:
The economy is cooling: Next year, GDP growth is projected to steadily shrink as the effect of the tax cut wears off. Meanwhile, the Commerce Department said the U.S. is exporting less for the fourth-straight month and the trade deficit with China rose again to a record $40.2 billion.
Strong U.S dollar: The greenback is up nearly 4.5% so far in 2018 against other major global currencies, including the euro, yen, and pound. A strong dollar is a sign of a strong economy. But, it also comes with potential consequences.The stronger dollar is a problem for many large American companies because it reduces the value of their international sales and profits.
In light of a great economy that has some very forward-looking concerns the forecasts for year end and 2019 are all over the map. This can be stated without a doubt, the record bull market will come to an end at some point mainly on the back of weak global growth, rising U.S interest rates and a slowing U.S economy.
That said, with interest rates higher the “once left for dead” bond market now offers investors downside protection while producing a steady return for those seeking shelter and predictable interest income.
Investor Guidelines for the Current Equity Markets
During the summer of 2018, global equity markets were on a steady and seemingly never-ending rise. As stock prices rose in September, many analysts warned that U.S. stocks could experience violent swings through the fall of 2018. We mentioned in our August newsletter that we expected volatility to return in September and October. As it turns out, in September the equity markets were firm and saw price increases in the majority of sectors. October has a different story and the market spent much of the month lurching wildly. The S&P 500 rose or fell in excess of 1% in 10 days in a 16-day stretch. This was quite a change after a 74-day run with no moves of this magnitude. The drivers were generally seen as rising interest rates, the prospect of slower global economic growth, global trade talks and tariffs, along with uncertainty about the November midterm elections.
The S&P 500 ended October down 6.9%, which was the worst month in over seven years. Following a month like October the obvious question is, now what? Some market participants worry that the slump isn’t over but in speaking with institutional investors and traders we have found that the majority believe stock will bounce back through the end of the year. We tend to agree, and we have stuck to the strategy we mentioned in the August newsletter that volatility can create opportunity to buy quality sectors “on-sale.” We are firm believers that the October pullback created opportunities for long-term investors to invest in quality positions at lower prices. We are focused primarily on U.S. companies and U.S sectors that have an innovation advantage, year-over-year strong revenue growth, and manageable debt loads.
As we proceed through the end of the fourth quarter, we intend to stick to the four very important guiding principles below.
- Volatility is always inherent: Volatility will come and go. That is a given, and long-term investors should not let daily swings drive them crazy.
- Timing the market doesn’t work: If you attempt to sell when you think the market is overheated and buy back in when you think it is at a low, you will statistically get it wrong more than get it right.
- Add cash to the market over intervals of time: Every Copper River client has heard us talk about dollar-cost averaging, building positions slowly over time. This approach smooths out you purchase price of positions and has the effect of reducing timing risk.
- Be well diversified to reduce overall risk. Diversification means you have a mix of stocks, bonds, and cash equivalents to reduce general market risk. In the equity markets, we use sector rotation to keep portfolios diversified and protect against large movements in individual sectors or geographic regions.
Fed, Rising Rates and Bonds
It is impossible to watch or read the financial news without hearing the constant talk about rising rates. The Fed has been pushing the funds rate up by 25 basis points every quarter for nearly two years now, and the FOMC, firm in it’s belief that the U.S. economy is strong and resilient, said it wants to keep that “normalization” schedule essentially unchanged throughout 2019. That would put the funds rate in the neighborhood of 3%-3.25% in the next 12 months.
The market is pricing in three 25 basis point increases by the Fed in 2019 but the odds of three increases have dropped significantly in the last couple of days. Recent comments by Federal Reserve Chair, Jerome Powell, have indicated that the Fed is now paying more attention to the equity markets and the recent volatility. With this new “fed speak” we feel confident in our previous view that the Fed will pause sooner rather than later. Only time will tell, as the Fed can be very hard to predict.
Given the yield curve in relation to our fixed income holdings we will continue to keep portfolio duration relatively short and credit quality at investment grade.We do not see this approach changing in 2019. We will continue to focus on building individual bond ladders that offer investors an attractive annual yield with a short-term duration strategy in high quality issuers.
Year End Portfolio Planning
As we come into year end it is an important step for us to utilize tax loss harvesting and to work closely with our investors and their tax accountants and CPA’s. Tax loss harvesting is the practice of selling a security that has experienced a loss. By realizing, or “harvesting” a loss investors are able to offset taxes on both gains and income. The sold security is replaced by a similar one, maintaining an optimal asset allocation and expected returns.
In addition to portfolio management “tax loss harvesting” it is also important for us to work with our clients at year end to prepare for 2019 asset allocation adjustments. We are in the final steps of setting our models, their weightings and individual positions for next year. These are not dramatic changes, but their are changes as what worked in 2018 will change in 2019. We look forward to working with our clients on these final two steps as we come into year end.
We wish everyone a happy and healthy Thanksgiving holiday!
-Team Copper River