Trademark Market Perspective for 2/13/18
The continuation of the negative response of bonds to the strengthening economy and more importantly, to the normalization of interest rates, began to spill over into the stock market on January 29th. Over the next two weeks, a historically normal level of volatility reasserted itself in the stock and bond markets. I’d like to discuss what happened and how we are positioning now.
What Happened
In our view, the market surge from the passage of the corporate tax cut in late December through Friday January 26th was a “melt-up”. Investors were euphoric, believing the stellar returns of 2017 would be repeated in 2018. The S&P 500 was up about 7.5% for the year at the close that Friday.[1] As is often the case, however, investor enthusiasm got out of hand. Speculation in products designed to magnify returns on the upside led to steep losses as the market ran into a wholly predictable speed bump[2].
Stocks declined modestly on the 29th and 30th as investors began to realize that 2018 might in fact see three or four interest rate hikes.[3] When the Labor Department reported a robust employment number on February 2nd, interest rates surged well above their December 2016 highs. The stock decline gained momentum. See Figure 1 below.
Source: YCharts.com
It should be noted at this point that about a decade or so ago financial wizards created an investment product called VIX, which enabled one to hedge stock risk by owning exposure to volatility. If your stock portfolio declined for example, volatility (VIX) would theoretically rise, which would offset some or all of your losses. Some years ago, however, those wizards introduced a product that did the exact opposite of VIX – in other words the security they created increased in value if volatility (VIX) declined. Rather than a hedge, that security (VelocityShares Daily Inverse VIX, Ticker: XIV) is essentially a pure speculative bet that the stock market will continue to rise. It is hard to imagine a better environment for this product than 2017; the stock market rose every single month last year and never declined as much as three percent at any point. XIV gained 182% in 2017![4] At some point, however, things were bound to change.
Beginning last week, as interest rates rose, and stocks began to sell off, volatility soared. Investors in various products that bet against volatility saw losses pile up and they flooded the market with sell orders to try to limit their losses. The stock market buckled under the weight of forced selling Monday, Tuesday morning, Wednesday afternoon, and again on Thursday. XIV, which closed at $136.73 on January 26th (up from just over $50 on New Year’s Day 2017), fell to $5.40 as of the close on 2/6 – a loss of over 96%![5]
The past two weeks have wrung a lot of the speculative excess out of the stock market. The economy and corporate revenue growth are strong, and it would be exceedingly rare for an economy hitting on all eight cylinders (so to speak) to suddenly blow out six of them. There are almost always several months from the point of maximum market participation to the point where the whole market rolls over[6].
Putting Volatility in Perspective
Volatility is a normal part of investing, and the markets certainly reminded us of that fact last week. It’s important to keep a long-term perspective and recognize that to be successful investors we need to accept volatility as a necessary part of our journey. Below is a look at the calendar year returns, intra-year gain and intra-year decline of the Russell 3000 since 1979. As you can see, large swings higher and lower are a regular part of investing.
Source: Dimensional Fund Advisers
In taking a longer-term perspective we inherently accept the fact that capitalism works. If that’s our fundamental belief, it’s easier to ride out periods of volatility. Below is the distribution of US market returns since 1926. The red blocks red represent years of negative total market return and blue blocks represent years of positive total returns. As you can see there are more blue than red blocks; since 1926 75% of the time the market has produced positive annual returns. Of course, past performance is not a guarantee of future results, but as investors we can use history as a foundation to inform our beliefs.
Source: Dimensional Fund Advisers
How We Are Positioning Now
We believe that for the time being interest rates will stabilize around current high levels. These levels are not high enough to hurt the economy broadly speaking, but they will continue to cause problems for the companies and industries most sensitive to interest rates. Utilities, real estate, and consumer staples stand out in this regard. Here’s the real trick: these industries are typically the worst to own in a rapidly expanding economy but the best to own once the economy rolls over. The recent sell-off has really improved the valuation characteristics of utilities and REITs relative to the overall market, yet they are still performing relatively poorly. High dividend and low volatility strategies tend to emphasize those themes and most of those funds are under performing. I don’t think that is going to change in the short run. Investors may want to look at strategies that emphasize quality instead. Quality probably won’t be a market leader, but it may give me some degree of downside protection without being too vulnerable if rates continue to rise
We believe the time has come to underweight bond duration relative to the Barclay’s Aggregate Bond Index. Additionally, we are cautions with regard to below investment grade credits. Over the last two weeks floating rate bonds held up well, while high yield gave up more than a percent-and-a-half.[7] While we believe high yield may have a relief rally in the short term, this is not an area you want to overweight if you expect interest rates to rise.
The bottom line for stocks is this: if interest rates remain reasonably stable in the new higher range they have established in 2018, we believe stocks may once again resume their rally. If not, and weakness spreads beyond utilities and real estate to the industrial and transportation sectors, we’ll have the first evidence the longer-term bull market may be ending. Because stocks performed so well over the previous three months, short and long term moving averages are still confirming that the primary trend is upward – even with the recent decline. For that reason, we believe that a modestly bullish bias continues to be warranted.
Disclosure
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[1] Source: YCharts.com
[2] Some background: With the economy performing well, the Federal Reserve no longer needs to take extraordinary measures to support it. They can continue to raise interest rates toward their natural level, which is a little above the rate of inflation (currently around 2.1%). We are always told the stock market can handle rising interest rates. There is always a point, however, when that is no longer true.
[3] The Fed has been telling us it expected to increase rates three or four times this year, but investors have become conditioned to the Fed losing its nerve and only hiking once or twice in a year.
[4] Per Morningstar
[5] Source: YCharts.com
[6] The broad market peaked about a year and a half before the overall market peak in 2000. The interval was shorter in 2007.
[7] Source: YCharts.com HYG, BKLN 1/28/18-2/9/18