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Partners in Building Wealth

News & Notes – October 2018

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October is the month we expect a spooky stock market and scary economic headlines. October is often a volatile month for stocks. Friday, October 19thwas the 31stanniversary of the 1987 Black Monday Crash that few on Wall Street remember.  Then and now the market always recovers from its darkest days and investors are fine if discipline, rather than emotion, drives investment decisions. This bull market is one of the longest in history, fueled by near zero interest rates and strong corporate profits.  It would be unreasonable to think that a correction is not in the cards. Goblins, politicians, ghosts of crashes past and fearful pundits should not cause panic or emotional selling.

Reports of weak economic data seem to be overshadowing strong corporate earnings on days when the stock market declines.  Softer new and existing home sales in the face of higher mortgage rates, fears of slowing global growth and higher interest rates have played havoc on the stock and bond markets in recent weeks.  This does not mean recession.  US GDP growth is forecast to be almost 3.5% this quarter which is still strong.  Note the shaded area in the chart below which was the last recession.  GDP growth typically declines in recessions, taking stock prices with it.  We do not expect a recession in the near future and it would be rare to have a severe market decline without a recession.

Volatility in stock prices has increased with some recent discussion of recession.  JP Morgan believes we have a 50/50 chance of a US recession in the next two years. The New York Federal Reserve puts the odds of a recession next year at 14%.  It is highly likely revenue and earnings growth will slow next year and it is hard to imagine double digit stock market returns when corporate profits slow and interest rates move higher.  Is a stock market correction possible? Yes.  Does this mean recession? No, not unless economic reports get much worse or interest rates rise suddenly and sharply.

The surge in US Treasury yields reflects the Federal Reserve’s confidence in strong economic growth.  The ten year US Treasury yield is the highest since 2011.  US manufacturing is strong, consumer confidence and investment sentiment are high.  The labor market is strong, with the lowest unemployment rate since the 1960’s. After 10 years of a strong stock market and near zero interest rates it is not surprising that stocks are more sensitive to headlines and higher interest rates.

Investors were complacent at the end of this year’s strong second quarter- lulled into thinking the stock market will remain “on hold” until the midterm elections are behind us. After many years of rising stock prices it is easy to believe the past and present will be the future.  Stock markets rolled into this new quarter, only to be spooked by the realization that interest rates could move much higher while the economy begins to slow. This October stock market decline, while sharp and quick, is not surprising. This is the twentieth time there’s been a plunge of 3% or more in stock prices since the bull market began in 2009. While startling and concerning, this does not mean we are headed toward a 2008 like market drop.

No one can accurately forecast the stock market in the short term.  There are too many variables.  It is best not to try.  The stock market is made up of many companies and the performance of stocks within the market has varied.  There are numerous examples of overpriced stocks.  Best to trim them, take profits when available and avoid beauty queens – those companies that blind investors with their story, their promises of outsized growth only to disappoint over time. Any company that is trading at a price that is 50 times earnings is priced to perfection and poised for a fall if their earnings don’t exceed expectations.

On the other hand, over fifty large companies are down more than 30% from their highs.  It is possible to find value, even in the ninth year of a bull market.  Best to look at stocks on a case by case basis and forget trying to predict what the market will do in the near future. If the focus is on the daily moves in the market then emotions are likely to take over.  Inexperienced investors tend to sell when afraid and buy when they fear missing out – the opposite formula for wealth creation.

Disciplined asset allocation is critical in protecting assets from a market decline.  It is tempting to maintain high equity exposure when the market is advancing and it is hard to sell or trim stocks that continue to move higher.  The discipline to sell richly valued stocks into a strong stock market is critical. Reducing stocks before the market turns down is like repairing your roof before it rains.  It is too late to take action when rain pours into the house – or adjust asset allocation when stocks have declined.

It was easy to paint a rosy picture for stocks two years ago when interest rates were low and promises of tax reform and less regulatory legislation boosted confidence in corporate earnings.  This played out and US economic growth and corporate profits surpassed even the most optimistic expectations.  The US stock market stands out this year as the only positive market around the globe.  How long will this last? It’s hard to know. Are foreign stocks more attractive?  This could likely be the case.  As the chart below from FactSet shows, our stock market is the only major world market in the green this year.

The economy should slow as interest rates move higher so it doesn’t hurt to take profits now.  This may not be the market top but it is hard to imagine significant upside in stock prices as interest rates rise and bonds become more competitive. Investors will gravitate toward companies that have strong cash flow, low debt levels and consistent earnings and dividend growth.  Large, well established companies should do well at this stage of the economic cycle.

The best approach now is to become more conservative and trim richly priced stocks that have appreciated and make certain that the allocation to stocks is appropriate given the account objectives and circumstances. Young investors have plenty of time to make up losses.  Older, retired investors may not. If stock prices grow 7% a year after a 20% correction it could take 3.5 years to recover the lost market value.  A weaker stock market recovery, say 3% per year, would take 8 years!  Age and time horizon play a key role in deciding the amount to invest and hold in stocks.

Investors who own mutual funds need to know what they own. All mutual funds are not alike. Some have higher risk than others so it is important to know what the fund invests in and how the fund performs in down markets.  Is the risk level suited to individual circumstances and objectives? Morningstar and other subscription services provide research and mutual fund background.  Now is the time to look more closely into what is owned – while the stock market is reasonably strong.

Index funds are not without risk.  It is estimated that 37% of the US fund market is invested in mutual funds and exchange traded funds that replicate indexes.  This does not mean that index funds are “safer” than other funds.  They move with the market and will decline as stocks move lower.

The recent market volatility and stock price declines are worrisome.  However, these corrections reduce excessive valuations and help stocks trade at reasonable prices. These declines, if moderate and short lived, set the stage for market stability and further advances down the road.  Investor expectations move from exuberant to realistic as the market pauses. If the economy begins to falter and recession looks likely then concern is justified. In the meantime, focus on individual, high quality companies and avoid the latest fad.  This is the time to adjust asset allocation, reduce risk and focus on healthy, proven companies and not panic and overreact.