First Quarter 2018 Key Takeaways
Volatility returned to the financial markets in the first quarter for the first time in a while. Stocks surged out of the gates in January, then corrected sharply before rebounding into mid-March, clawing back much of their losses. They then dipped again into quarter-end, buffeted by a potential trade war and a Facebook data scandal. When the dust settled, large blue chips were down around 1% for the quarter.
Regarding client calmness: “I (Ron) have been very impressed with the limited number of calls our office has received during recent stock market volatility. We have worked hard to educate you on how the markets will have their moments (this is normal), and how this is all part of the cost of being invested to be able to earn more than risk-free investments provide. However, please know we are always available.”
Developed international stocks also got off to a strong start to the year, before suffering similar losses to U.S. stocks during the sharp correction in early February. They made up ground relative to U.S. stocks in March and ended the quarter down 1%.
European stocks (unhedged) lost a bit more than 1%. This could be due to a variety of reasons from European politics to a lower exposure to technology.
Emerging-market stocks held true to their higher-volatility reputation. They shot up 11% to start the year, fell 12% during the mid-quarter correction, and then once again outgained U.S. and international stocks to finish the quarter with a 2.5% return. Our portfolios have an overweight exposure to emerging-market stocks which enhanced our returns in 2017 versus the overall risk (beta) of portfolios. We anticipate this will continue to work in our favor during 2018.
Core bonds didn’t play their typical “safe haven” role in the first quarter. They posted losses during the sharp stock market correction in February and delivered a 1.5% loss for the quarter overall, as Treasury yields rose across the maturity curve.
At the end of last year (2017), by some measures U.S. stock market volatility was the lowest it had ever been in 90 years of market history. While the 10% market correction this year was short-lived, it provided a reality check for equity investors. However, the global economy still looks solid in the near term.
We did have one inquiry I would like to share with you as a point of education. During one particularly strong market down week, someone asked me if there was a plan in place to adjust if things continued to get worse. Liz Ann Sonders, Charles Schwab’s Chief Investment Officer, said it best: “Panic is not a strategy. It’s gambling if you adjust during rough times.” I told my client that we make our adjustments well in advance of market turmoil. That’s what diversification is for. The skill is to set your overall portfolio risk at a level you can live with during the toughest of times, all while attempting to maximize your long-term required returns. As we continue to share not only your portfolio returns with you, we have also been highlighting your portfolio risk (beta) so you can be aware of your risk level and participate in the discussion.
First Quarter 2018 Investment Commentary
Market and Portfolio Recap
Needless to say, it was a bumpy start to the year for financial markets—something we’d suggest getting used to in the months and years ahead. After years of record-low volatility, the 10% market correction this quarter was a reality check for investors: Stocks can go down as well as up.
Equity investors should understand that stock market declines of 10% or more are normal. They’ve happened in over half of all calendar years since 1950. In exchange for their higher long-term expected returns, you must be willing and able to ride through these inevitable periods of decline.
If you watch the news, it could be easy to conclude that this was a difficult quarter. However, we are pleased with our portfolio performances across all risk strategies. Most of our strategies came very close to breaking even. We always desire to make a profit, but we will take a break-even quarter (after expenses) when stocks (S&P 500) experienced a 1% decline along with bonds also losing more than 1%.
Market and Portfolio Outlook
We have two primary observations about the quarter’s rocky ride. First, the declines witnessed serve as a good reminder that markets do not exclusively go up. Until the recent drop, the S&P 500 had rallied for more than 400 days without registering even a 3% decline from its high. That was the longest streak in 90 years of market history. Thus, from that perspective, the return of market volatility is a return to “normal” market form. We believe investors should be prepared for continued volatility rather than expect that things will revert back to the unnaturally smooth markets we experienced in 2017.
Our second observation is that despite the dramatic news headlines and market volatility that might suggest otherwise, the global macroeconomic and corporate earnings growth outlook has not materially changed or deteriorated from what it was at the start of the year. In fact, the economic news that triggered the recent selloff was not a report of economic weakness but one that suggested the economy might be getting a bit too strong, with a tight labor market finally translating into higher wage growth and broader inflationary pressures. Fundamentally, even after the correction, the U.S. and global economies still look solid. Global growth may no longer be accelerating, but it remains at above-trend levels and the likelihood of a recession over the next year or so still appears low (absent a macro geopolitical shock).
The U.S. economy is getting later, if not late, in its cycle. We are experiencing the unwinding of an unprecedented period of global monetary policy influence, and geopolitical tensions fill the headlines—the latest being the potential for a trade war between the United States and China.
It is not in our nature to speculate on whether any of these factors will trigger more market volatility, and what their impact will be if and when markets react. However, it is in our nature to ensure we’ve properly assessed and managed risk in our client portfolios across a wide range of shorter-term outcomes, while positioning them to capture longer-term returns.
Bonds are typically utilized as a portfolio protection strategy to offset the higher risk of stocks. However, we find little comfort in bonds providing this protection in today’s rising interest rate environment. Investors are advised to look to other strategies, such as private real estate if they want traditional portfolio protection. Another approach is to accept this inherent risk and strive for the higher returns offered by stocks and high yielding fixed income investments (preferred securities, business loans, and infrastructure investments). The higher risk strategy recognizes that short-term volatility is a given and will cause nervousness, but over time investors are always paid well for assuming the heartburn.
We have adopted a higher than normal allocation to foreign markets, as the potential foreign returns appear favorable to U.S. stock funds. Our clients experienced a higher return for each unit of risk assumed (beta) than the U.S. markets provided in 2017. We anticipate this trend to continue.
There is a positive economic outlook for the U.S. economy going forward, but much of the potential gains have already been achieved in stock market returns. Therefore, any upsetting or unsettling news causes such a violent reaction in daily market valuations. The positive outlook also explains why the floor doesn’t fall out from under market prices, and with every drop stock prices have tended to recover in short order.
The Best Defense
As we reflect on the volatility levels we have witnessed so far this year, it’s worth reiterating why we emphasize a five-year or longer time horizon as the basis for your financial planning. It is over those longer-term periods that a true picture is developed. Over the shorter term, markets are driven by innumerable and often random factors (i.e., noise) that are impossible to consistently predict (although that doesn’t stop lots of people from trying).
There are a lot of paths financial markets and the economy can take. Headline risk changes every day. Simply put, markets and economies are unpredictable. But when it comes to the investment world, we are often our own worst enemy. We fall prey to performance-chasing and our natural inclination to “do something.” The best defense is a sound, fundamentally grounded investment process like ours that you can have the confidence in to be able to stick with for the long term.
Recently one of our clients said it best: “I don’t worry about the daily news. I mostly shut it off. We pay you to do the worrying for us and to keep us informed.” This is spot on. We desire a retirement for our clients that’s based on contentment, leaving the worries to us.
Thank you for your continued confidence and trust.
Ron Dickinson, CPA, CFP®, MPA-Tax
[Financial Planning and Investment Management Services offered through Dickinson Investment Advisors, Registered Investment Advisor. Statistics and market information provided by Litman Gregory Advisor Intelligence.]