With all of the volatility that has crept back into the risk markets since the end of September, it is natural to question the viability of the longest bull market in the history of markets. The S&P 500 is down over 9% since September 20th, which is a short-term move that hasn’t been seen for some time. It’s during times like these that one should step back and look at where we stand from a longer term perspective. For example, if I had asked anyone in the beginning of the year if we made it to the end of October and the S&P 500 was up about 1%, would anyone really have been surprised? Would anyone feel as scared as they do right now if they only knew the level today versus the level of the S&P at the beginning of the year?
We are currently in the midst of a correction in most risk-based assets as we enter the late stages of the business cycle. Most risk-based assets are highly correlated right now. The indiscriminate selling is profit-taking as stocks are hitting the wall of worry due to economic slowdowns in China and Europe, rich valuations, the reality that U.S. corporate earnings may have peaked, fears that the Fed may raise interest rates too much, trade tensions between the two largest economies in the world (U.S. and China), fast approaching mid-term elections with last minute political positioning that may result in a gridlocked government, and October happens to historically be one of the worst months for stocks.
Everyone is aware of and talking about many of the negative factors referenced above and this intense speculation is what may be causing the latest correction. However, recessions are not typically caused by the factors everyone is aware of and talking about, they are caused by the breakdown of foundational economic factors that are often overlooked or not a focal point for the majority of people.
Bull market corrections are healthy and needed in order for stocks to consolidate and then move higher, especially at this late stage of the U.S. business and economic cycle. Fundamentally, the U.S. economy is strong. Everyone that wants a job can find one. When people have jobs they make money. When they are making money, they are spending money which leads to economic growth. Monetary policy is easy outside the U.S. and gradually becoming slightly more restrictive in the U.S. Right now fed funds futures (the market of investors) are pricing in three more rate increases between today and the end of 2019 taking the effective O/N fed funds rate to 2.875%. The Fed is projecting four more rate increases between today and the end of 2019 taking the effective O/N fed funds rate to 3.125%. If the market is wrong and the Fed raises rates four more times instead of three more times, it’s highly doubtful that the extra 0.25% is really going to be enough to derail economic growth.
Inflation is relatively low and stable, inflation expectations reflected in the TIPs market have been falling, financial conditions are supportive, bank balance sheets are strong, and there are no major imbalances aside from government deficits and underfunded public pensions. President Trump, in an interview with the Wall Street Journal on Tuesday, stated that he is using the “threat of tariffs” as negotiating leverage with China. He talked about how it worked with NAFTA and how he is hopeful that it will work with China. Stocks don’t go down and stay down without an economic recession and an economic recession appears to be more than a year away.
Having a balanced portfolio with bonds, gold, and cash (3.5-5.5% across all asset allocation models) to offset risk-based asset exposure in periods of volatility when risk-based assets are highly correlated is the key to protecting and preserving wealth on the downside. Please note that we are never complacent and continue to closely monitor economic fundamentals and key technical levels across the markets and will adjust accordingly if conditions warrant. There are always big picture economic issues with the potential to cause a larger downturn. The largest one in our view is the overwhelming amount of debt that has been amassed in the U.S. and developed international markets. In our view this will not be a larger market issue until rates increase precipitously, which we are not concerned about at this time. This time table is not certain so we are constantly monitoring conditions that would alter this. For now we continue to feel we are in a correction and the elements are in place for the cyclical bull market to continue through year end.
Jonathan D. Smith, CFA – Chief Investment Officer
Andrew C. Zimmerman - Chief Investment Strategist, DT Investment Partners
Note: DT Investment Partners’ commentary discusses general developments, financial events in the news and broad investment principles. It is provided for information purposes only. The material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Investments in various asset classes entail different investment risks. For example, small cap equities tend to be more volatile than large or mid-cap equities. International equities and emerging markets have exposure to currency fluctuations, foreign taxes, political instability and the possibility for illiquid markets. Fixed income investments involve interest rate and credit risks among others. Real estate investing includes risks such as declines in value of real estate, changing economic conditions, tax laws or property taxes. Commodities’ investing is highly volatile and subject to changing economic conditions and the vagaries of speculators among other risks. Further, diversification and strategic or tactical allocation do not assure profit or protect against loss in declining markets. Index performance returns do not reflect any management fees, transaction costs or expenses. One cannot invest directly in an index. Past performance does not guarantee future results.