Market Commentary: “Markets Can Overreact in the Short Term”

Wall Street indexes have predicted nine of the past five recessions.
Paul Samuelson, 1966

The quote from Paul Samuelson may have been written over 50 years ago, but remains just as relevant today. The world-renowned economist and Nobel Prize winner reminds us that markets can overreact in the short term and, just as importantly, he proves that economists can indeed maintain a sense of humor. The last few months appear to have been one such period of overreaction, even though it never feels funny when in the middle of it. The S&P 500 dropped alarmingly in December, seemingly portending an ugly recession, only to shrug off its earlier concerns and rise sharply in January.

Equity Markets

The S&P 500 bounced almost 8% for the month, though the bounce didn’t fully retrace the market’s decline in December. The smaller-cap issues that make up the Russell 2000 had an even more dramatic move, climbing 11% in January after a 12% decline the previous month. Non-US stocks had similar swings in January, with the MSCI EAFE rising 7% and MSCI EM rising 9%. On a trailing 12-month basis, US stocks were the clear winners, appreciating around ten percentage points more than their international counterparts.

A number of issues conspired to create December’s carnage, only to reverse in January: Fed tightening, on-going trade wars, the impending government shutdown. After absorbing nine Federal Funds Rate hikes over two years, the market became increasingly concerned that monetary policy was becoming too tight.

The trailing P/E multiple of the S&P 500 contracted by almost 20% in 2018, one of the largest declines in the last 100 years. This is the 15^th time with a contraction that large since 1950, and in only two of those previous instances was the market down the following year.

As much as these types of market moves are difficult to watch, it is important to remember that the market often experiences this kind of volatility. Historically the stock market has corrected – or fallen 10% from its peak value – on average, roughly twice every three years. Since 1928, the average market correction has resulted in a decline of about 16% over a period of 64 days. By this measure, the volatility in 2018 was fairly typical.

US Sector Scorecard

The Industrials sector benefited from several tailwinds during the month. Just as a resolution to trade wars seemed nearer, economic data was released suggesting stronger economic production. The Institute for Supply Management’s monthly survey of manufacturing companies rose sharply from December’s reading of 54.3 to 56.6, indicating strong overall economic growth. Industrial companies’ earnings were also quite strong with 86% of those firms reporting earnings stronger than expected.

By contrast, some more defensive areas such as Utilities and Health Care lagged during the month. As the market became less concerned about overall growth, investors eschewed the relative safety of dividend plays such as utility companies, and those with less cyclical earnings such as health care companies. Despite the waning investor sentiment, both Utilities and Health Care are some of the few sectors to end January in positive territory on a 12-month basis, and are also expected to have the strongest earnings growth in the near term.

The risk-on environment we witnessed among stocks in January was reflected in the bond markets as well, as those bonds with higher credit and duration risk outperformed. The broad-based Bloomberg Barclays US Fixed Income Aggregate index bounced over 1% after a weak end to the year. Longer duration issues outpaced their shorter duration peers. In particular, Treasury bonds that mature in 10 to 20 years rose 0.8% for the month compared the one- to three-year Treasury bonds with returns of just 0.3%. High yield bonds, which carry higher credit risk than corporate or Treasury bonds, also outperformed, returning 4.5% in January.

January’s strength came on the heels of a particularly disappointing 2018 in which bonds had negative total returns for the calendar year. With the latest run, all the major bond indexes have firmly positive returns on a 12-month basis – a good reminder that returns can easily swing from positive to negative and back again in the short term.

The Economy and the Fed

Though economic indicators are decelerating, suggesting slower growth this year, they are still in positive territory. In December, faced with the trifecta of trade wars, a tightening Fed and the government shutdown, consumer sentiment took an abrupt downturn, dinging retail sales – though the data wasn’t reported until February because of the government shutdown. This happened despite the fact that jobs remained plentiful and wages continued to grow modestly.

In that curious balancing act between the market and the Federal Reserve, the Fed’s concern about a slowing economy ended up driving stocks and bonds higher. By January, the Federal Reserve signaled an important shift from a tightening stance – in which they continually ratcheted up interest rates – to a holding pattern – in which rates are expected to remain steady through 2019. This more dovish outlook on the part of the Fed encouraged investors to come back to the market.

Conclusion

Although we’ve said this before, it is worth repeating: the recent market volatility is a great reminder that markets may not always go up in the short term. As the economy slows, the market will continue to grapple with various cross currents like the Fed, corporate earnings and trade wars, and we will likely continue to experience volatility. Despite that volatility, markets provide great potential for building wealth over the long term.

Looking further into 2019, it is safe to say that we are closer to the latter stages of this economic expansion than we are to its beginning. Not even Paul Samuelson could predict with any reliability the next recession. But I believe he would have agreed that a well-crafted, long-term financial plan that incorporates thousands of different market cycle simulations – bulls and bears, expansions and contractions – can help our clients meet their goals no matter the near-term gyrations in the market.

Live richly and invest well,

Kara Murphy, CFA

Chief Investment Officer

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Definitions
S&P 500 Index: A broad based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. It is a capitalization-weighted, unmanaged index that is calculated on a total return basis with dividends reinvested. The S&P 500 represents about 75% of the NYSE market capitalization.
Russell 2000 Index: This index measures the performance approximately 2,000 small-cap companies in the Russell 3000 Index, which is made up of 3,000 of the biggest U.S. stocks. The Russell 2000 serves as a benchmark for small-cap stocks in the United States. 
MSCI Europe, Australasia, and Far East (EAFE) Index: This index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada.
MSCI Emerging Markets Index: This index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. As of June 2009 the MSCI Emerging Markets Index consisted of the following 22 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey. 
Bloomberg Barclays U.S. Aggregate Bond Index: A market capitalization weighted bond index of investment grade U.S. dollar-denominated fixed- income securities. 
Bloomberg Barclays Municipal Bond Index: The Bloomberg Barclays U.S. Municipal Index covers the USD-denominated long-term tax exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds and pre-refunded bonds. Gold (spot): Gold price per ounce in US Dollars.
S&P 500 GICS Sectors Level-1: In 1999, MSCI and S&P Global developed the Global Industry Classification Standard (GICS), seeking to offer an efficient investment tool to capture the breadth, depth and evolution of industry sectors. GICS is a four-tiered, hierarchical industry classification system. It consists of 11 sectors, 24 industry groups, 68 industries and 157 sub-industries. Companies are classified quantitatively and qualitatively. Each company is assigned a single GICS classification at the sub-industry level according to its principal business activity. MSCI and S&P Global use revenues as a key factor in determining a firm’s principal business activity. Earnings and market perception, however, are also recognized as important and relevant information for classification purposes, and are taken into account during the annual review process.