Seaborn Hall, 11/21/18, updated 11/23/18, updated 12/16/18, updated 12/29/18, updated 1/05/19
The S&P 500 is down 5.69% for the last year and 5.20% for 2018. However, it is still up over 28% over the last three years. In order of importance the top five reasons for the current market correction – the S&P 500 is down about 9% since the Mid-Term elections – are:
- Trade fears due to the United State’s adversarial position towards China. Tariffs are a tax on business and the current tariffs act as a drag on revenues of the big businesses of the Dow and S&P 500, causing investors to fear that future earnings will be adversely affected. Still, the current tariffs are a mere shadow of the negative effect of Smoot-Hawley in the early 1930’s. The positive side: Smoot Hawley covered almost all imports (over 20,000 items) into the United States, some thousands of products. The current tariffs affect only hundreds of products, primarily from China. Investors should bear this in mind, in addition to the fact that any breakthrough in negotiations with China will likely cause a huge boost to stock markets, as was the case, albeit briefly, in mid-November. At present it appears there may be continued uncertainty – and market volatility – until the 90 day negotiation period with China ends, around March 2, 2019. As an addendum to this point, the continued correction on Friday, December 14th stemmed from reports that the Chinese economy is slowing and fears that this may have a negative affect on global growth that will spread first to Europe and then eventually hit the U.S. Though these concerns are not unwarranted, see bold italicized comments above.
- The U.S. Federal Reserve Bank’s penchant for continued rises in the federal funds rate. With another rate hike that occurred at the end of December this year and two or three more rate hikes expected in 2019, investors are concerned about continued exits from equities into bonds as 2019 plays out – and as has happened in the past, that a loco Fed will derail the economic recovery. The problem here is that the US economy has never had this level of debt ($22 trillion and counting) prior to this and the Fed is not only raising rates, it is also unwinding over $4 trillion in liabilities
amassed during the recent QE. This later action also has the potential of causing rates to rise. The positive side: The 10 Year yield is so far staying around 3% or, as it is currently, under 3%, and the Fed can always reverse course if it sees the economy slowing. This may be about to happen, especially with continued stock market volatility. Plus, according to JP Morgan, as long as the 10 year Treasury yield stays under 5% (see chart, right), the stock market rises about 90% of the time. The 10 year recently dipped below 3% again recently.
- Fear of increased government regulations on the big tech companies like Apple, Facebook, and Amazon. This is a big part of the reason that the technology sector has experienced major pullbacks and a large part of what has caused the overall market pullback. The positive side: According to some experts, regulations should have little long term effect on advertising revenue bottom line for companies like Facebook, Apple, Amazon, and Google. With virtually no viable competitors currently, expect the Tech firms to lead again once the market rebounds.
- The results of the mid-term elections. This means it is very unlikely that we will see further tax breaks, lessened regulations, or a political environment that is conducive to long term stability and market optimism. The Democrats may also still be intent on impeaching Trump – not likely to happen, but action that could cause political instability and rock the markets. The positive side: The markets were anticipating a Democratic victory in the House of Representatives so this point may be a minor one in its current overall effect on the markets. Political gridlock may not be a negative thing for stock markets. In addition to a possible breakthrough in China trade, there may be compromises that will pass an infrastructure spending bill and a tax reform for the middle class, both of which could boost stock markets.
- Overall concerns that the market is overvalued. This includes fears that tax reform and increased earnings are already ‘baked in’ to previous stock levels and that equity markets have nowhere to go but down. This includes fear of an impending recession. The positive side: In the past, for example in the late 1990’s, markets continued to rise long after they were considered overvalued. In addition to this, most forecasters do not predict a recession until late 2019 or sometime during 2020, at the earliest. The yield curve is flattening, part of the reason for this week’s correction, but even if the yield curve inverts (a sign of impending recession) it is generally 18 months to 2 years before a recession actually occurs.
As a plus one and two to the reasons above, one, the last week of the year’s severe ongoing correction on the Dow was caused primarily by continued fears of a global slowdown in the midst of overhanded Fed policies, but was also exacerbated by a pending government shutdown. Another reason the drops may have been so severe is that software trading programs and algorithms automatically sell portions of their equities once the market has passed down through a certain level. For example, many RIA’s sell out 5% or 10%, or even more, from both U.S. and Foreign equities once the market has broken the 200 Day Moving Average level, as it did on Christmas Eve Day.
This last week’s volatility was caused by fears that Apple will not be as profitable in the future due to the China slowdown – and due to the overall fears, again, of how the Chinese economic slowdown may affect the global economy. But, volatility is not really far outside of normal bounds (see chart). The sustained rise towards the end of the week was caused by positive interpretation of comments the Fed chair Powell made in a meeting in Atlanta.
The stock markets have regained some of their losses primarily due to re-set valuations that are presently attractive and optimism that the Fed is beginning to understand its affect on the markets and that it will re-adjust its policies accordingly in 2019.
The battle between the bulls and the bears rages on. Some pundits believe we are already in a recession; others still believe this is just a normal correction and the markets will eventually continue up before a recession around 2020 or after. We are more in the later camp, but this does not mean that a Perfect Storm could not continue to pull down markets and prove us wrong. All things considered, for long term investors, CS recommends re-balancing and cost-averaging into the markets anywhere close to – or below – Dow 24,000, maintaining global diversification, and adding to allocations of corrected tech stocks like Facebook, Amazon, Apple, and Nvidia.
We also advocate rebalancing towards international over U.S., value over growth, and large cap over small cap. Cost averaging into short to medium term bonds and out of some equities is a good strategy as we move through 2019. Medium sized, higher quality gold mining stocks may be a contrarian play, but primarily in the later part of 2019 or later once gold has moved down below $1200/ounce. Also take a look at mid-stream MLP’s.
Maintaining a global diversified portfolio with healthy levels of REITS and other alternative strategies can be a defense against prolonged market falls. Unfortunately, even these type of portfolios do not work well during continuously up and down, volatile markets like we have experienced in 2018. However, staying invested for the long term in globally diversified portfolios (see charts. left and right) – rather than moving in and out of the markets and attempting to time them – has proved wise most of the history of the markets.