[Investment Quarterly] Stand Ready

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Stand Ready

“Success breeds complacency. Complacency breeds failure. Only the paranoid survive.”  – Andy Grove, founder and CEO of Intel, author and science pioneer (1936-2016)

Bill Hornbarger Chief Investment Officer

As we conduct due diligence and market research, we have the opportunity to talk to a wide variety of investment professionals about the markets and investing. One of our standard “get acquainted” questions is, “What currently worries you as it relates to the investment climate?” There is a fair amount of consistency in the answers we receive: North Korea, a policy mistake by the U.S. Federal Reserve (the Fed), political gridlock, valuations, and a more vague comment on the lack of volatility and the investor complacency it can potentially breed.

This month marks the 10th anniversary of a then-record-high closing for the S&P 500 (October 9, 2007) before it lost more than 55% during the Global Financial Crisis (GFC). After bottoming in March 2009, domestic equities have marched steadily higher, and in 2017 alone, the S&P 500 has hit more than 40 new highs (record closes). The S&P 500’s value has more than tripled since the GFC, and the emotional and mental trauma of those dark days has receded into distant memory for many investors.

Since the spring of 2009, equity markets have generally experienced steady gains with very few extended periods of weakness. In recent months, by almost any measure, equity market volatility has been very low, and valuations have extended above what we would consider long-term averages. More than 325 days have passed since a 5% correction in the S&P 500 (fourth-longest streak since 1928). This low volatility when paired with stretched valuations and a general feeling of well-being can breed a sense of complacency.

While we certainly aren’t forecasting an imminent market crash, we do think it’s a good time to remind ourselves that market corrections do happen (on average the market experiences a 10% correction about once every 357 days, per Deutsche Bank), and that stock market volatility is a fact of life. It’s also important to remember that the current low-volatility environment is not unprecedented—but not common either.

One of the most often-cited measures of market volatility or stress is the Chicago Board Options Exchange Volatility Index, more commonly referred to as the “VIX.” The VIX, simply put, is a mathematical measure of how much market participants collectively think the S&P 500 index option will fluctuate over the next 12 months. While, in theory, that sounds like a useful anxiety indicator, our experience suggests
that it’s a coincident indicator and not a predictive tool. Movements in the price of gold and U.S. Treasury bonds are also cited anecdotally to indicate increased anxiety.

But how does one measure complacency? This is a difficult and maybe even an impossible task. The accompanying chart (Display 1) is one way we measure how low volatility currently is. (It’s also worth noting that most of the volatility that we’ve seen recently has been predominantly in one direction—up.) The chart shows the percentage of days in rolling three-month periods where the market return (S&P 500 and Russell 1000) has deviated less than 25 basis points (one quarter of 1%). This is a 16-year chart, and, as you can see, volatility by this measure is currently very low—in fact, the lowest during this span.

 

 

 

 

 

 

 

How does an investor deal with the fact that volatility is low, valuations are above average and the market hasn’t experienced a meaningful correction (10% or more) in more than 18 months?

A good analogy may be the recent response, or lack thereof, by Equifax to
the massive cyber breach that the company experienced. In light of all of the struggles that Equifax has had following the news that more than 140 million customers were impacted, it clearly was ill-prepared to handle both the initial breach as well as the aftermath. It makes one wonder if Equifax would have benefited from taking some time to review pertinent details and having at least the outline of a breach response plan “just in case.”

We feel strongly that now is a good time to make preparations for a more difficult environment—while the markets are healthy, near all-time highs, with good liquidity and low volatility. While we sincerely hope it doesn’t happen, history shows it inevitably will. Now is the time to review asset allocation guidelines, have a hard conversation with oneself about the emotional ability to deal with volatility and declines, or to map out a plan in terms of rebalancing strategies or deploying new cash during a correction or severe market event. Why wait until the markets are less forgiving?

 

Market Recap

 

Stocks’ resiliency continued in the third quarter as global markets maintained their steady upward journey, with the S&P 500 Index experiencing at least a 1% daily decline in only two of the trading days and the MSCI ACWI Index in only one of the trading days.

Both developed international and emerging-market equities outperformed U.S. equities yet again as their economic and earnings growth prospects seem relatively brighter to market participants and the U.S. dollar sustained its decline for the majority of the quarter.

Reported earnings during the quarter were robust, though growth expectations have declined slightly for the remainder of the year.

Credit led fixed-income categories during the quarter, benefiting from an elevated investor risk appetite and the ongoing tightening of credit spreads to U.S. Treasuries.

Discussion of tax reform has re-emerged in the U.S. Capitol, which was one of the key components of President Trump’s agenda and potentially a major source of fiscal stimulus. Despite some modest enthusiasm from the release of the tax reform blueprint, market expectations for the ability to deliver stimulus remains subdued, indicating that the equity rally has been more a reflection of reactions to U.S. and global growth this year.

On the economic front, domestic reports have been generally positive; however, this will likely be skewed to the downside over the next couple months due to the recent hurricanes.

Outside the U.S., economic and corporate growth is on point, especially in Europe and Japan, with GDP, jobs and consumer data all pointing positive.

Inflation continues to be a sore subject for the Fed as it remains below its target level. Although members have noted in the past that the low levels may be transitory, some have expressed concerns that progress toward the target may have slowed and that the softness may persist.

The Fed voted not to raise the federal funds rate over the past quarter, leaving the benchmark rate in a range of 1.0%-1.25%. The median projection of the Federal Open Market Committee (FOMC) members is for the target range to end the year in the same range; however, the futures market is currently predicting one more rate increase at the December FOMC meeting.

The Fed plans to initiate its balance sheet normalization program in October, with the intent to gradually decrease its balance sheet holdings of U.S. Treasury, agency and mortgage-backed securities by reducing the principal amount that is reinvested from maturing securities.

Outside the U.S., both the European Central Bank (ECB) and the Bank of England (BoE) left rates unchanged, but both have indicated further slowdowns in expansionary policies, including a reduction in the ECB’s quantitative-easing purchases and the BoE’s suggestion that it will raise rates by the end of the year (also reflected in the futures market predictions).

Leading Economic Indicators

 

Consistent with continuing growth in the U.S. economy, the leading economic indicator index reached its highest year-over-year growth rate in August 2017 (the latest reading) since June 2015.

Seven of the ten components were positive, with the largest positive contributions coming from building permits, the yield spread and consumer expectations for business conditions, which more than offset the large negative contribution from initial claims for unemployment insurance.

It’s worth noting that the August reading does not reflect the impact of the recent hurricanes, which could dampen the growth of the index in the near term.

Job Openings

 

U.S. job openings, as reported by the monthly Job Openings and Labor Turnover Survey (JOLTS) report, rose to a record high in its latest release (July 2017).

The July JOLTS report suggests that the slowdown in job growth reported in August, as measured by the nonfarm payrolls, was an aberration and that the labor market was strong before the recent disruptive hurricanes.

Strong labor-market fundamentals could encourage the Fed to continue tightening monetary policy this year despite inflation persistently running below the U.S. central bank’s target.

This may point to a skills mismatch given the low unemployment rate and, per the recent National Federation of Independent Business survey, that small businesses have cited a lack of skills as one of the main reasons for job vacancies.

Inflation

 

Inflation, as measured by the core personal consumption expenditures price index, remains well below the Fed’s 2% target (1.3% as of August 2017).

New measures have been developed with an attempt to more accurately forecast inflation trends, including the New York Fed’s Underlying Inflation Gauge (UIG), which shows prices behaving quite differently from traditional indices this year.

The UIG, a metric that incorporates dozens of additional variables outside of prices, including the unemployment rate, stock prices, bond yields and purchasing managers’ indices, has steadily increased over the past year and most recently registered a 2.7% reading for August.

This could be a good indicator for why Fed Chair Janet Yellen noted that “we don’t fully understand inflation” during a recent press conference and why they have used employment more as a guide for interest-rate decisions.

Global GDP Growth

 

Amid geopolitical tensions, both Europe and Japan continue to show steady economic expansion.

GDP growth in the 19-member euro zone rose to an annualized rate of 2.2% in the second quarter, and Japan’s economy expanded at an annualized rate of 2.4%, the country’s sixth consecutive quarter of growth.

In addition to stronger economic growth, the euro zone’s unemployment rate stood at 9.1% in July, matching the lowest level since February 2009, and job availability in Japan climbed to a 43-year high.

Currency

 

The U.S. dollar (USD) continued its steady decline relative to both developed- and emerging-market currencies, a trend that started after the election last November.

Weakness has been the result of multiple factors, including, among others, turmoil in the Trump administration and the slowdown in the U.S. economy early in the year, in combination with stronger economic growth expectations internationally.

The USD showed some strength during the final month of the quarter amid slightly easing geopolitical tensions and expectations that the Fed will raise rates for a third time later this year.

Equity Performance

 

 

 

In general, those investors who took the “sell in May and go away” approach missed out on solid and steady returns across the board during the quarter.

Volatility remained extremely low as only 30% of the trading days had movement of more than 25 basis points (100 basis points = 1%), and less than 20% of the days had movement of more than 50 basis points.

International markets continued to outperform the U.S., benefiting from weakness in the U.S. dollar against most international currencies and stronger earnings and economic growth.

In Europe specifically, one of the driving forces behind the outperformance was improving labor conditions.

Emerging markets were led by Brazil and China, which both benefited from investor sentiment for economic growth potential, as well as Russia, which received support from a commodity price recovery.

Growth stocks finished ahead of value, though mainly in the U.S. Even though energy companies—a heavier allocation in value indices—received support from a recovery in commodity prices, they were unable to match the strength of tech companies.

The sectors recording the worst performance in the third quarter included consumer staples, which suffered from weak earnings reports, and real estate, driven by a weakness in the retail REIT sub-sector.

Trailing 12-Month and P/E Ratio

 

Although U.S. equities recorded strong returns during the quarter, the S&P 500 price/earnings (P/E) ratio finished only slightly higher as corporate earnings maintained their upward trajectory.

U.S. earnings growth expectations have declined slightly for the remainder of this year and through 2018; however, the forecasts still
remain strong.

Valuation Blend

 

All style valuations, as measured by our four-factor blend, finished higher at the end of the quarter.

Opposite of the previous quarter, U.S. small-cap equities increased the most as their fundamentals growth (e.g., earnings, cash flow) did not offset their gains. Additionally, given its strong performance, emerging-market valuations, relative to their own history, jumped significantly during the quarter.

Although shifting higher, developed international equities remain the cheapest relative to other equity asset classes, partly a result of their low valuation levels just one year ago. Year to date, both developed international and emerging markets have shown the largest increase in their valuations relative to the other equity segments.

Fixed–Income Sectors

 

Even though they started off strong, government bonds sold off in September as market participants took the prospects of monetary policy tightening a little more seriously, leaving government bonds essentially flat for the quarter.

Given the generally “risk-on” environment in the second quarter, corporates and high yield led the fixed-income sectors.

 

The yield curve flattened slightly during the third quarter with short rates continuing to inch higher and long-term rates dropping by a small margin.

Inflows into taxable bond mutual funds and exchange-traded funds have been positive for the past 21 months (with an average monthly inflow of more than $8 billion per month), even as yields continue to grind sideways to lower.

Outside of the “Taper Tantrum” in 2013, overall flows into taxable fixed-income liquid vehicles have been generally positive since the GFC.

Corporate Bond Spreads

 

Both investment-grade and high-yield credit spreads compressed further during the third quarter and remain below their respective average levels over the past 20 years.

On a sector basis, financials (senior debt) are trading at the lowest spreads to
U.S. Treasuries in both the investment-grade and high-yield categories. Energy, followed by consumer staples and healthcare, are trading at the highest spreads in the high-yield category. Within investment-grade credit, subordinated financial debt is trading at the highest spreads, followed by the communications and energy sectors.

 


Please note, these materials were prepared for informational purposes only and do not take into consideration your individual circumstances. This not an offer to purchase/sell securities. Past performance is not indicative of future returns. Alternative investments possess features and risks distinct to the individual investment vehicle, and any decision to invest in such vehicles should be made based on your individual circumstances in consultation with appropriate financial professionals.