It has been a tough few weeks for equity investors with stock prices pushing lower across the board. The large-cap equity indexes such as the S&P 500 have formally hit correction mode (loss greater than 10%) while more volatile indexes like emerging markets and small-caps are in bear territory (loss greater than 20%). While clearly painful for investors, this latest bout of selling isn’t unprecedented. As the table below illustrates, we have seen five corrections in the S&P 500 greater than -10% since 2009, and two that came close (-9.8% and -9.9%).
Another way to look at it is shown below. The top panel shows the S&P 500 since 2008 while the bottom panel shows the drawdowns from the market highs. This latest decline isn’t that unusual but certainly stressful.
If anything, this latest bout of selling may be getting long in the tooth. A measure some traders follow is the VIX ratio. It is a measure of implied volatility in the market and has tended to be a decent contrarian signal, especially when it spikes to a high level. As you can see below, we are getting to the point where the VIX has been during major selloffs in the past and has typically predicted a turning point. Of course, it could go higher still if panic selling sets in, but long-term investors should take this as a sign to swim against the current rather than go with the flow.
For investors in diversified portfolios it isn’t all bad news. Bonds have started to play their normal diversifying role again. Since early November bond yields have fallen and traditional government bonds have appreciated. For example, intermediate-term Treasury bonds are up +3.4% since yields peaked on November 8th and have gained +1.3% so far in December.
Why are Markets Going Down?
In our December 7th letter we highlighted three factors that are driving the selling of the last few weeks:
1) Worries about global growth and what a flattening yield curve might be telling us about the odds of a recession in 2019.
2) Uncertainty about Fed policy.
3) Uncertainty about trade.
The immediate catalyst for this week’s decline is tied to the Fed. They met this week, and on Wednesday they raised rates another 0.25%. And while they said they would raise rates only twice next year, not the three times they thought a few months ago, investors in general were disappointed that the Fed didn’t take a more aggressive stance. Granted, the Fed did indirectly signal they could pause their tightening campaign if incoming data warrants it, but there has been a growing consensus that the Fed would either not hike this month or at least promise not to hike next year.
The reaction to the Fed meeting then ties back to the first point noted above. There is a growing worry that growth next year will not only soften around the world (this is broadly expected), but that recession risks are becoming real. This is leading to a self-reinforcing cycle whereby selling begets more selling even though very little has changed on the fundamental side.
How Real are the Recession Risks?
While there have been instances of bear markets without accompanying recessions (1987 immediately comes to mind), they are rare. Usually recessions and bear markets go hand-in-hand. On this score, there is some reason for optimism. The risk of a recession in the next year still looks relatively low despite what the markets may be signaling. Certainly, the growth rate in the U.S. is coming off the boil as the tailwind from the fiscal stimulus dissipates, but the hard data is giving you very few hints of a pending recession. Take the following:
1) Growth expectations for the fourth quarter are solid. Consensus is at +2.5% while the Atlanta Fed is just under 3%. Growth expectations for 2019 as a whole are still running in the mid-2% range. While it may fall short of this, no analyst we follow sees a contraction in the next twelve months.
2) Industrial production is unusually strong in the U.S. It is weaker in the Eurozone, but not contracting.
3) Weekly unemployment claims are still pushing lower. Typically before a recession you’ll see this increase as companies begin to cut staffing levels. This then starts the nasty negative feedback loop of layoffs leading to slower growth which feeds into more layoffs. This isn’t the case today.
4) The housing market has weakened noticeably the last few months as higher rates have led to lower transactional volumes. However, we are seeing hints of stabilization. For example, mortgage applications for purchase have rebounded swiftly after a notable drop earlier in the year. This is a sign that the bottom isn’t going to drop out of the market any time soon. If anything, applications should pick up further given the recent dip in long-term interest rates.
5) Critically for the markets and the path for Fed policy, inflation has moderated. Core inflation (red dotted line below) has fallen modestly in the recent months, and the dramatic decline in oil prices should ultimately pull core inflation even lower.
This is important because it means the Fed isn’t battling an inflation problem this cycle. They have the flexibility to stop their rate hike cycle early in 2019 as both growth and inflation soften.
Where There’s a Will There’s a Way
Ultimately investors need to make a judgement call about growth in 2019. If they feel we are likely to see a recession, then taking defensive steps today would still be warranted. However, if they feel the economy will settle into a lower but sustainable rate of growth, then making dramatic allocation shifts now would be unwise. We are certainly in the latter camp. We are not arguing that growth won’t slow in the year ahead. It almost certainly will as the tailwind from the fiscal stimulus wears off. However, it appears to be too much of a leap to say the economy will contract. A slower growth environment would also mean less inflationary pressures and a Fed that likely goes on permanent hold sometime next year. This isn’t a bad environment for stocks. As a matter of fact, it is exactly the environment we lived with over much of the post crisis period – slow growth, low inflation, and an accommodative central bank.
Where could we be wrong? The Fed may focus too much on the hard economic data and their fear of inflation and not enough on the stress in the financial markets in 2019. This would mean they tighten too much and create a recession in late 2019 or 2020. We can’t rule this out. Another obvious risk is trade policy. A significant deterioration here could be problematic for the markets and the global economy. And while it is easy to spin a pessimistic scenario here, it is just as easy to see a more benign outcome as market pressures force the key players to take a more accommodating stance. In our mind these risks argue for investing in a balanced portfolio of stocks and bonds, not moving 100% to cash.
Unfortunately, market gyrations are a natural part of investing and it seems like we have had our fair share ever since the tech bubble burst in 2000. And while few people want to hear it during times of stress, the best advice is typically to stay the course, turn the T.V. off, and don’t read the financial press. At moments like this our emotions can betray us. Our fight or flight instinct might have been great on the African savanna when a lion came our way, but it doesn’t do us much good when it comes to investing. Long-term investment plans shouldn’t be blown off course by market gyrations. That being said, it is always important to hold sufficient cash reserves, carry adequate insurance, keep debt levels low, etc. so you can weather market storms. Finally, make sure you actively work with your financial advisor to ensure you are in the portfolio allocation that best suits your needs.
-Gemmer Asset Management LLC
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