Week in Review

US stocks suffered the worst week since 2011 as the Fed disappointed investors.

All eyes were on the Federal Reserve announcement Wednesday afternoon. Early in the session, markets received a boost as investors expected the Fed to back off further rate hikes in 2019. While expectations dropped from three to two rate hikes next year, signaling a more dovish approach to monetary policy, this was still more aggressive than many investors hoped. Broad US equity markets dropped immediately following the announcement, resulting in a tailspin through the end of the week.

Government shutdown worries further weighed on sentiment on Friday. Early in the week, it seemed there would be another temporary spending bill passed to avoid a potential shutdown. However, a disagreement in Congress over whether to fund President Trump’s border wall stalled efforts to keep the government running. This resulted in a fresh bout of volatility late in the week as uncertainty clouded markets.

By the end of the week, major US indices were down around 7% – 8%. Following the sharp decline, the tech-heavy Nasdaq Composite fell into bear market territory (a drop of more than 20% from recent highs). The S&P 500 and Dow Jones Industrial Average are still in correction territory, down about 18% and 16% from recent highs respectively.

Markets have been particularly sensitive to headlines in recent weeks, making it difficult to navigate through these heightened levels of volatility. However, as long as the economy remains healthy and earnings continue to grow, there is the potential for further market gains (though it is reasonable to expect volatility to persist in the foreseeable future). While short-term trends and market noise can make it tempting to make knee-jerk decisions, as investors we need to stay committed to our long-term financial goals and risk tolerance. Staying focused on our long-term investment objectives and maintaining a disciplined investment strategy can help reduce market noise and increase the odds of a successful outcome over time.

 

Chart of the week

Markets dropped over 2% within an hour of the Fed decision to raise interest rates on December 19th. This came as a surprise as analysts were expecting “upper and lower bound” responses to range from 0 to -0.45%. Investors were hoping for a pause in interest rate hikes with fears of a global economic slowdown in 2019 mounting. However, the Fed is still projecting two rate hikes next year, though this is down from the original projection of three hikes. A silver lining – investors believe these hikes would take place in the latter half of the year, giving the Fed more flexibility to change course if needed.

*Chart source: Bloomberg

 

Market Update

Equities

Broad equity markets finished the week negative as small-cap US stocks experienced the largest losses. S&P 500 sectors were negative, with defensive sectors outperforming cyclical sectors.

So far in 2018 utilities and healthcare are the only positive performers while materials and energy have been the worst performing sectors.

Commodities

Commodities were negative as oil prices decreased by 10.96%. Although some technicians thought oil would find support around the $50/bbl level, the recent rout has proved otherwise with prices currently hovering around $45. A combination of high US crude oil inventories and increasing Russian production pushed prices lower. As we head into the final week of 2018, investors are watching for a catalyst to see if the recent negative pressure will reverse. Currently, analysts expect prices to rebound in 2019 as Iranian sanction waivers fall off and inventories eventually decline.

Gold increased by 1.35%, closing the week at $1,258.10/oz. The metal rose as stocks experienced sharp declines and the US dollar fell against a basket of foreign currencies. The dollar weakened as the prospect of interest rate hikes in 2019 fell from three to two. Additionally, due to the nature of recent economic data, investors believe interest rate hikes will come in the latter half of 2019. Since gold is dollar-denominated it generally performs best when interest rates are low and steady. Gold has been a viable method to hedge risk in recent weeks, unlike during the correction in February.

Bonds

The 10-year Treasury yield fell from 2.89% to 2.79%, resulting in positive performance for traditional US bond asset classes. As the fed raised interest rates for the fourth and final time this year, many spreads continued to tighten due to the risk-off shift in markets. Currently, the 2 & 10 year spread sits at 0.12%, 42 basis points lower than the beginning of the year. Although the 2 & 10 year spread inversion has historically preceded recessions, years of fed intervention has some analysts believing this time could be different. In the upcoming weeks, investors will be watching geopolitical and market events in order to gauge the need for safe-haven treasuries.

High-yield bonds were negative for the week as riskier asset classes fell and credit spreads loosened. However, as long as economic fundamentals remain healthy, higher-yielding bonds have the potential to experience further gains in the long-run as the risk of default is still moderately low.

 

Most asset class indices are negative in 2018, with US Treasury Bonds leading the way and international stocks lagging behind.

Lesson to be Learned

Your success in investing will depend in part on your character and guts and in part on your ability to realize, at the height of ebullience and the depth of despair alike, that this too, shall pass.”

 

– Jack Bogle

Over time, stock markets have experienced swings from extreme optimism to extreme pessimism. Some of the greatest opportunities can be found at these extreme levels, but it can often feel like the wrong decision at the time when things continue to go very well or very poorly. It is important to understand various investment environments do not last forever – markets tend to work in cycles. This is why it is important to stay disciplined as an investor, sticking to an emotion-free investment strategy and long-term plan. By taking emotions out of the equation, we can avoid making irrational decisions based on market noise and improve our odds for success in the long-term.

 

FFI Indicators

FormulaFolios has two simple indicators we share that help you see how the economy is doing (we call this the Recession Probability Index, or RPI), as well as if the US Stock Market is strong (bull) or weak (bear).

In a nutshell, we want the RPI to be low on the scale of 1 to 100.  For the US Equity Bull/Bear indicator, we want it to read least 66.67% bullish.  When those two things occur, our research shows market performance is strongest and least volatile.

The Recession Probability Index (RPI) has a current reading of 24.46, forecasting further economic growth and not warning of a recession at this time. The Bull/Bear indicator is currently 100% bearish, meaning the indicator shows there is a slightly higher than average likelihood of stock market decreases in the near term (within the next 18 months).

 

The Week Ahead

It will be a holiday-shortened week, with US markets closing early on Monday and closing entirely on Tuesday. Investors will be looking to see if stocks can rebound following the sharp sell-off last week.

 

More to come soon.  Stay tuned.

Regards,

Derek Prusa, CFA, CFP®
Senior Market Analyst