Q1 Market Update: Sometimes risk assets go down…

Q1 Wrap Up


The 1st quarter saw a return of volatility,  ending a 9 quarter win streak. Most asset classes finished lower for the quarter, led by the aggregate bond index. Emerging markets and small caps finished positive.

Diversification works over time, that much we do know. However, that doesn’t mean it works every day, month, quarter, or year for that matter. Long term investors shouldn’t be dismayed, or surprised, when asset classes act in unison at times. Stay diversified, and don’t chase performance.


From a sector level, technology and consumer discretionary were the only two sectors to close with gains for the quarter. The weakest sectors were the rate sensitive consumer staples and utilities, along with energy and basic materials.

spx 2018 perf

Much has been made about the recent volatility in the markets. But it’s not nearly as bad as it’s been made out to be. For example, the Dow closing down 1,000 points in one day sounded awful. But in reality, when the Dow is near an all time high above 20,000, a 1,000 point daily move is only about 4%. 4% isn’t fun, but it’s certainly far from a doomsday scenario. The 1987 crash experienced a 22% decline in one day, even though the decline in points was less, it was far more impactful than anything we’ve seen.

To clarify this point, the above chart shows the 2018 year to date performance of the S&P 500. Even with the recent volatility, the market is only down 3.19% year to date. This is perfectly normal. Stocks are risk assets, sometimes they do go down. Before $1 is invested, understand that you’ll have to put up with these periods from time to time. That is why stock investors have been compensated well over time (assuming you don’t panic and sell), because you have to deal with this periodically. It comes with the territory.

spx 2016 perf

Is this a precursor to another crash? I understand how investors are still fearful of market crashes after the lost decade of 2000-2012. But the reality is that not every decline ends in a crash. Stocks can, and do, go down without it being a crisis. Why just a couple years ago, the market got off to it’s worst start ever. The above chart shows how 2016 got to negative 10.51% year to date performance level, more than twice as bad as our current situation in 2018. Yet the markets proceeded to do just fine.

Market Technicals – Trader’s Timeframe


The last time the market experienced a correction (decline of 10%+ from highs) was 2015-16. The above chart shows how the decline came in two selling “waves”. The first initial selloff came fast and sharp, producing a 12.55%. The market rebounded much of the decline, but eventually succumbed to a second round of selling that took the index down below the prior low, for a full decline of 15.21% before it was all said and done.


If we fast-forward to today, we can see a similar setup potentially playing out. The first initial selling shock wave came in February, pushing the index down 11.84% from it’s highs. We rebounded, gaining back much of the lost ground, but have once again come under selling pressure.

A similar 15% decline, matching what happened in 2015-16, would mean support on the S&P 500 would stand between 2435-2462. Should the February low fail to hold.

This seems reasonable and rather normal for stocks historically. Given the current fundamentals of strong earnings growth, reasonable valuations when compared to fixed income and inflation, and low risk of recession, this scenario would be the maximum downside I could really see us experiencing. And it’s quite possible the February low holds, and we never get that lower low at all. Even so, it’s worth having a plan in place beforehand.


Despite all the noise in the media, things are quite good economically. Scary headlines are not fundamental analysis. People will use this time to justify all their preconceived notions about everything from finance to politics. But the reality is that stocks are risk assets. They go down from time to time. And often there’s no rhyme or reason. Half of all years since 1950 have experienced a double digit correction in stocks. This is nothing new or out of the ordinary. Get used to it!

Eventually the dust settles and things calm down. And then there will be a whole new set of problems to worry about. If your waiting for the “all clear” sign before investing, your either going to be late to the party and/or paying an exorbitant price.

Remember, volatility is not the enemy because it causes these swift price fluctuations. It is the enemy because it drives bad decisions. Don’t let this volatility scare you out, or away, from your long term investments. You only lose if you give in.


The Good News…

After a sharp decline in the stock market last week, investors were once again awakened to the reality that stocks are called risk assets for a reason… sometimes they go down. The reason why stock investors have been well compensated over the years, is because they have to put up with these types of volatile events from time to time. Nonetheless, I know the financial media will be quick to dwell on all the negative aspects of last week’s action. However lets take a look at the good news.

  1. Dividend Yields have increased.


Dividend yields have an inverted relationship to price. As the price of a stock or index (S&P 500) rises, the amount of the dividend (in percentage terms) decreases. And vice versa.

The chart above is the dividend yield on the S&P 500 index. We hit a low of 1.73% as the market topped out in January. After the decline, the dividend yield has increased to 1.82, a 5% increase.

     2.  Valuations have gotten cheaper


Earnings Per Share (EPS) projections for the S&P 500 companies in 2018 and 2019 have risen sharply in the last two months. The 2018 estimates were for $146 per share in December and are now $157.02 per share. An increase of about 7.5%. The 2018 earnings growth estimates are nearing 20%.


So the increase in the earnings estimates coupled with the decline in the price of the index has culminated in a decrease in the valuation investors are paying for those earnings. Before the decline investors were paying almost 19x 2018 earnings. Now investors paying 16.3x for 2018 earnings, which is closer to the historical average. Especially given the low inflation, low interest rate environment we are in.

Investors are paying 16.3x forward earnings when earnings growth is projected to be close to 20% for the year. And interest rates are still below 3%, at least for now. That’s a pretty enticing offer.

    3. The correction has almost equaled the 2015-2016 decline.


In 2015, the stock market experienced a correction of about 12% and then proceeded to get off to the worst start to a year ever recorded in 2016. The total combined correction was about 12.31% on a closing basis, and 15.21% on an intra-day basis.

If we project that from the all time highs hit earlier this year, potential support should be in the area of 2519 and 2435 on the S&P 500. We got close to that level on Friday and have bounced back a bit since then. It’s possible that the market may be “scrapping bottom” in terms of the Friday low. Further downside appears limited even though this bottoming out process could likely take time. This correction will setup the next leg higher.

     4. Largest volume amounts have come on the up days


The chart above is the S&P 500 index ETF, the most liquid and popular fund used to track the S&P 500. As you can see, the days with the most amount of volume have come on the two days that the market has closed higher.

I take this as a positive because you often see the reverse during corrections. The down days are usually accompanied by higher volume totals. Not this time. At least not yet.

5. “Black Monday” 1987 was the buying opportunity of a lifetime!!!


No two situations are ever truly alike. But the pace of last week’s decline surely brought up comparisons to the 1987 stock market crash. The 1987 crash was the only technical bear market that wasn’t accompanied with an economic recession in the post WWII period. A bear market is highly unlikely without an economic recession, but there is always a slight chance. However if we really look at what happened, and it’s aftermath, my hope is that by facing our fears we can learn from them.

The above chart shows the daily price action in the S&P 500 index in 1987. The index had been rising sharply, showing a year to date gain of 39.5% by September! So the crash came sharp and fast, a 36% decline which came mostly during the last 3 days. But the year to date decline maxed out at 10.62%, which isn’t out of the ordinary. In other words, the market got way ahead of itself and had to readjust.

I can’t imagine what that must have felt like. There is no way to not let such a steep decline bother you. But we do have a choice of how we react to those emotions.

In this case the decline was short lived and presented the buying opportunity of a lifetime.


The chart above shows what happened after the 1987 crash. The crash is barely visible. It kicked off one of the biggest bull markets in history from 1987 to 2000. Resulting in a total return of about 816%.

The emotions were real. But as long as you didn’t panic, you made out well.

Summary: Corrections and volatility are a typical part of the market cycle. What happened in 2017 isn’t the norm. We experienced a rising market without anything more than a 3% correction for almost 2 years. And now we are making up for lost time.

The financial markets are adjusting to the new reality of a stronger global economy. Yes rates are starting to rise, but it’s for good reasons. Sooner or later the market will realize this. In the mean time, investors should try to remain as balanced as possible. Not getting too high when things are good, and too low when things turn down.

It’s very unlikely that a significant bear market will occur. But even it if does, as we saw in 1987, it would likely be short lived and setup a strong rally.

What Happened!?

Well its been awhile since investors felt what it’s like to experience a correction. As a result of todays close, the markets have now experienced its largest pullback in almost two years.

The average intra-year decline is around 15%, when the markets haven’t pulled back more than 3% since 2016. Stocks are called risk assets for a reason. Sometimes they do go down. And when they go down, it’s usually sharp and fast. Investors need to be aware of this and not allow themselves to get caught up in the short term noise, even though this is much easier said than done! If you’re prone to get anxious on days like this, it’s best to shut down the computer screen and change the channel to something else until the dust settles. Remember, not every correction leads to a crash. A crash is a low probability event in and of itself, and even rarer to experience one without an economic recession. You’d have to go back to 1987 (30+ years) to find such an event.

So what happened?

Two things in my opinion:

1) Overdue for pullback.

As I mentioned in the intro, the market hasn’t pulled back more than 3% in almost two years. This is highly unusual and a reversion to the mean is to be expected at some point.




Take a look at the above chart to see how far above the market is/was trading above its 50 and 200 day moving average. This is unsustainable in the near term.

2) The sharp increase in interest rates.




The benchmark 10 year treasury rate has risen almost 50% since September. This is because of good reasons, the economy is improving, corporate profits are at all-time highs (expected to grow 16% for 2018) along with tax reform and infrastructure spending benefits as well.

However the rapid pace of the advance in rates is what the market needs to now “reprice”. Cash flows are discounted by the risk free rate, and the 10 year treasury rate is subtracted from the earnings yield on the S&P 500 to come up with the “equity risk premium”. Which basically means that as rates rise, fixed income becomes more competitive to stocks, thus potentially reducing valuations on stocks. I don’t see this as being an issue unless the 10 year treasury rate gets above the 3.5% – 4% range.




Some good news. If we look at historical returns on the S&P 500, each year that included a positive January performance is included in the attached chart. The outcome looks impressive. 82.6% of the time the stock market closes the year above the January highs. The average annual gains are around 16%, and the average gain above the January close has been about 12% higher.




Also looking at the market performance during midterm election years since 1950, we see precedence for volatility.

The average and median intra-year pullback is 16-17%, while the total return a year later averages 32%. This means we should be ready for a correction, but staying the course should prove most prudent in the end.

This is good data to look at, especially on a bad day like today. It doesn’t tell us what the future holds (this year could be one of the 18% of times the market closes the year below the January close) though.

Investors should also keep in mind there’s positives about stock declines. Dividend yields and future expected returns go up.


Conclusion: No one knows whether Friday’s decline is the end of the pullback, or the beginning of a correction in the 5-15% variety. Economic fundamentals continue to improve, financial stress is low, corporate profits are high, interest rates are rising but are still well below average, and valuations are reasonable in comparison to rates and inflation.

The key point is to not let yourself be swayed by short term market reactions in either direction. Don’t get caught up in the hype and get aggressive when markets are rising rapidly. And don’t get too low when the inevitable volatility events occur either.

Financial Markets Chart Package…

Here is a quick review of the global markets. Most markets are in the midst of a pullback within a broader uptrend.

S&P 500 (US)


The S&P 500 is down about 3% from it’s recent all time highs. Currently fighting to stay above the 50 day MA. A break below 2417 makes the 200 day ma (red line) likely to come into play.

Nikkei Average (Japan)


After breaching the 20,000 level earlier this year, Japan’s stock index is currently testing the 200 day MA on a pullback closer to 5%.

CAC 40 Index (France)


France’s stock index has retraced all of the gains post election. It’s down about 6.6% from it’s recent highs, but still trading above the 200 day MA for now.

DAX Composite (Germany)


Germany has a similar setup, also down 6.5% from recent highs.

FTSE Index (UK)


UK is also in a similar setup, only down 3.50% from recent highs.

Shanghai Stock Exchange (China)


Bucking the trend is China, which has broken out of its recent trading range and making new highs.

Internals (Advance – Decline line)


The NYSE advance decline line continues to show strength overall. A short term bearish divergence could be setting up (possible lower high) if the cumulative average breaks below the recent low.

Equity Performance


A currency adjusted performance chart shows US stocks under-performing International developed and emerging market stocks by a wide margin year to date.

The reason for this has to do with the performance of the US dollar.


The trade weighted average peaked in late 2016, right around the prior high in 2001.


If we drill down and look closer at recent price action, we can see the decline more clearly. This accounts for much of the international equity out-performance.


The 10 year treasury rate has also stalled this year. In fairness, it was quite a run in rates post election. So some consolidation was necessary. But it’s also possible that although the stock markets have largely ignored what is going on in Washington, perhaps the bond and currency markets are reacting to it. I’d like to see the 10 year stay above 2%.


Global equity markets continue to trade on decent fundamentals (increased global GDP and corporate profit growth). Recession risk is low and valuations compared to alternatives and inflation are positive. I expect the secular uptrend to continue, although with stops and starts along with way (of which no one can predict with any consistency).

One of the pressing things that does concern me is the debt ceiling debate. Although this has more short term implications. For investors, any serious disruption should be short lived. So take advantage of the opportunity if it presents itself.

Thanks for reading.

Volatility Index takes out its pre-crisis lows…


The S&P 500 volatility index shows the market’s expectation of volatility over the proceeding 30 days. Since volatility is attributed to declining markets, a rising VIX usually coincides with market sell-offs, and vice versa.

Today the VIX fell to 9.37, which took out the low of 9.39 that occurred on December 15, 2006. I want to stress that this is simply an observation and not a market prediction. The VIX can stay low for a long time, and even a rising VIX is not always a precursor to a bear market.

The observation; are we becoming too complacent to the risks that equity investing represent? The fundamentals continue to improve and confirm a recovery in it’s middle to late stages. But on the flip-side, the expansion is now over eight years long, and global central banks will soon be moving to tighten unprecedentedly easy monetary policy conditions at the same time.

Chances are your not going to be able to time the next major correction or serious bear market. So the better course of action is to take a look at your portfolio now and assess whether your taking more risk than you’d be comfortable with in a bear market. It’s better to prepare now (when stocks are at all time highs) then try to re-balance in the middle of a serious volatility event.