I wanted to take a minute to address the most recent bout of volatility in the market. Before addressing the causes for the recent downturn and providing our thoughts, it’s important to remind investors of the benefits of having a diversified portfolio. Different areas of the market will outperform at different times and it can be tempting to wonder, why bother holding asset classes that are not performing as well as others at any given time? The reason is that changes in the market happen quickly, much more quickly than changes in the economy and much more often. In fact, since 1980 the average annual intra-year drop for the S&P 500 is 13.8%, yet the Index has rebounded to finish the year positive in 29 of the 38 years analyzed and averaged an annual gain of 8.8%.
Well-diversified long-term portfolios should contain varying degrees of exposure (based on individuals’ age and risk tolerance) to bond markets to provide downside protection when the stock market falls. While the bond portion of a portfolio may hold back gains when markets are rising and the stock portion may contribute more to losses when markets fall, both play an essential role in an inherently unpredictable market. Moves to get overly defensive when market volatility emerges will inevitably cause investors to miss out when markets rebound, just as moves to get unsuitably aggressive when markets are rising will backfire in a downturn. Therefore, it is essential to have a diversified portfolio and a long-term plan in place.
Turning to the recent market volatility, rising interest rates initially weighed on the market. Higher interest rates render the cost of purchasing a home, car, or anything else that may involve debt more expensive, which can decrease demand for these goods. Businesses also reassess which projects or investments they will pursue to ensure they are still profitable at current interest rate levels. Recall that interest rates in the United States were near zero for many years and that some rise in rates was inevitable as economic conditions trended toward normal. This is both to prevent the economy from eventually overheating (thus causing a recession) and to provide the Federal Reserve with ammunition to fight the next recession. There is a risk that the Fed hikes rates beyond where is necessary and slows the economy too much, but the United States is in a much better position that the rest of the world’s developed economies that have yet to begin the process of returning interest rates to normal levels. We discussed this in depth in a previous blog post.
Compounding rate concerns is the drama over tariffs and trade wars. While there was a time that these disputes pervaded global trade, trade concerns are now much more contained to China. An agreement with the European Union to scrap threats of auto tariffs represented a significant de-escalation and the recently signed NAFTA replacement resolved issues closer to home. While the trade dispute with China appears to be more severe and potentially prolonged, it also involves the theft of intellectual property and other issues that, at some point, has to be settled. We remain optimistic that some agreement will eventually take place as the potential gains from free and fair trade for both countries remains enormous.
The most recent factor weighing on the stock market has been corporate earnings. To be clear, most companies have beaten estimates, but several higher-profile companies have issued underwhelming earnings reports. For the most part, poor results overseas from industrial giants and chip companies have diminished investors’ expectations for foreign earnings growth. This is not a complete surprise as growth overseas has been weakening and this is one of the reasons that Condor Capital has maintained an underweight toward international stocks in clients’ accounts. In addition, a few companies have reported rising input and materials costs, which is to be expected at this stage of the economic recovery and has been heightened by the previously discussed tariff issues. However, it is important to note that earnings for the S&P 500 Index are still expected to grow by over 20% for 2018 before returning to a more normal growth rate in the high single digits in 2019. Thanks to a tax cut and robust global growth heading into this year, 2018 was always expected to be a peak year for earnings growth. Peaking earnings growth is not the end of earnings growth. A return to normal earnings growth does not equal recession.
While the news focuses much attention on the potential headwinds facing the market, there are also some significant positive factors at play. Unemployment is below 4% for the first time since 2000 and still falling, while metrics surrounding the health of the manufacturing and services sectors of the economy are healthy. Meanwhile, inflation is tame and domestic economic growth has been strong. Today, third quarter GDP was reported at an annualized rate of 3.5%. This comes on the heels of a 4.2% reading for GDP growth in the second quarter. These mark the strongest back-to-back quarters of economic growth since 2014 – hardly an indicator of immediate recession. Finally, thanks to robust earnings, stock valuations are more attractive than they have been in several years.
None of this means that there won’t be continued market weakness in the near-term or a recession at some point. In fact, we know with virtually 100% certainty that a recession will eventually occur. Economic recessions are a normal part of the economic cycle just like market downturns are a normal part of the market cycle. The best way to handle these occurrences is to be prepared heading into them. By maintaining a properly diversified portfolio and sticking to the long-term investment plan, portfolios are designed to weather storms in the market and economy. Attempting to time the market is a guaranteed way to underperform over the long-term. At Condor, we remain cautiously optimistic based on the fundamentals and, as always, urge investors to maintain an appropriately diversified portfolio that suits their larger needs regardless of short-term moves in the stock market.