Key takeaways regarding recent market activity:

• The market’s old companion volatility is back and likely with us in 2018
• Rising rates and inflation concerns will continue to be a key concern for all stock markets
• Despite solid US and global economic fundamentals, potential for market gains are lower than in 2017
• Our approach is to stay diversified and rebalance as opportunities occur

What Happened: Welcome Back Volatility

A market correction can be unsettling but it’s important to remember it is normal. We haven’t seen one in a while as we have been in an unprecedented period of low volatility. The market sell-off of the past week was swift and appeared just days after a new market high. The S&P 500 stock index hit a new all-time high of 2873 on January 26. Thirteen days later on February 8, the S&P 500 was down -10.2% from that high, mostly from losses in the past five trading sessions. To put this into perspective, the S&P 500 is down -3.5% for 2018 due to the spike up in the first three weeks of the year.

The reason for the sell-off: rising interest rates on the 10-year Treasury bond along with a whiff of wage inflation from the Feb 2 jobs report got the attention of stock investors. Higher rates are generally negative for equities, especially after the prolonged period of historically low rates. The 10-year Treasury yield moved up from 2.4% at the end of 2017 to 2.8% in early February. And when coupled with a forward P/E ratio on S&P 500 stocks at the upper end of its historic range, investors got nervous. Add to this mix, the intention of the Fed to push up short-term rates at least 3 times this year, and the stage was set for a sell-off. The sell-off itself was likely amplified by short-term trading programs and hedging activity, which often dominate daily trading.

The irony of the situation is that S&P 500 earnings have been excellent this quarter and are projected to continue to be strong in the near term. And that is usually positive for stocks. We believe that the positive economic environment will likely limit the decline in equities. However, the bottom line is that rising rates will likely make it difficult for markets to move up in 2018 as the current US economic cycle, now almost nine years old, may finally be in its late stage.

Going Forward: Why Stay Invested?

So, what happens now? The economic backdrop continues to be positive, which will support markets. While growth is almost always a good occurrence, too much growth and earnings momentum can cause inflation to rise, which above a certain level is problematic. Some analysts believe the recent cut in corporate tax rates may push the economy toward an overheating phase. We are not in full agreement with this view, as the impact of tax reform on both consumers and corporations is still unclear. However, if inflation does rise, the Fed would address it by raising rates more quickly, which in turn would push up interest rates in general. And that scenario would likely be negative for stocks.

Under almost all scenarios, we do see rates and inflation rising. The concern for the markets is how much and how quickly. Right now, the bond market is expecting the Fed to tighten 2-3 times this year, up from lower assumptions only six months ago. That means that the bond market’s expectations are much closer to the Fed’s projected tightening path. Which, in turn, suggests that the 10-year yield may now be closer to “fair value” than it has been, and interest rates may settle in the current range and perhaps move slowly to the upside. As such, we will keep a close eye on both inflation and rates.

Even with rate and inflation concerns, the solid economy and earnings picture does provide a way forward that may result in gains for stocks this year. It just won’t be the smooth ride of 2017. Whether the market settles down from here or continues to exhibit high volatility is not knowable. Our view is that it will stay choppy for a while. The recent whipsaw is a reminder that volatility and pullbacks are the price we pay for the excellent returns that stocks can produce over the long run.

The chart below shows that sizeable sell-offs and pullbacks are normal even in years where the market is positive.

 

Finally, let’s put some context around the current market sell-off. The US stock market has had a strong run over the past 15 months without even a -10% market pullback. As a result, the S&P 500 was up over +30% in that period. Corrections of -10% are normal and happen about every 2-3 years, so it is no surprise that one would occur now. Over the past 50 years corrections, defined as a -10% to -20% price drop from the peak level of the market, have averaged about -14% and bottomed in about five months.

While we can’t predict what will eventually happen, this provides some context. At worst, a bear market, defined as a drop of -20%+ in the broad index, could develop from this correction. We put a low probability on that occurring given the US economy is on solid footing and not showing any signs of a recession, which usually accompanies a bear market. In summary, a correction is normal, and for long-term investors who stay the course, it’s often a healthy development that can help markets consolidate and eventually move higher.

Current Investment Strategy: Keeping Our Balance

As we have noted at volatile times in the past, we at Nauset are long-term investors, not traders, so our mantra is to stay balanced, diversified and disciplined. Our advantage is that we are long-term investors and we can handle short-term volatility as we manage positions for the long-term. 

We build clients’ portfolios for the long run and to fit clients’ financial plans. As part of that approach, we weather market corrections like the current sell-off, and as conditions evolve, we adjust to new market realities. While a market correction may be unsettling, we have a bias to action around the following three areas:

1. Rebalancing – we continuously monitor our clients’ portfolios and will take steps to rebalance to specific client asset allocation target ranges and risk profiles. 
2. Tax-loss harvesting – With the recent sell-off, recently purchased positions may be in a loss position. We may sell these positions from taxable accounts to create a capital loss and buy back the same security 31 days later, or buy a similar security, to replace it in the allocation. This will provide clients with a tax offset for a portion of earned income or gains we take in the future.
3. Opportunistic buying – Volatility and sell-offs often create price distortions and thus opportunities in individual securities, subsectors or sectors. We are monitoring the market for the opportunity to add to areas that we find attractive, such as cyclical and growth stocks in tech, financials and consumer discretionary sectors.