Week in Review
Stocks appeared poised to come back from the prior week’s sharp losses, but a sell-off on Friday pushed major indices lower for the week.
Positive developments regarding the ongoing US-China trade dispute boosted investor sentiment early in the week. President Trump stated he would consider intervening in the Huawei case (the major Chinese telecommunications company’s CFO was arrested in Canada last week for allegedly violating Iran sanctions). Also, data showed China was starting to buy US soybeans again after cutting-off purchases several months earlier to retaliate against new tariffs. However, major indices dropped around 2% on Friday on lingering concerns about global economic growth.
The week was characterized by large intraday swings; something that has been a common occurrence this year. So far in 2018, there have been 100 days in which the S&P 500 has experienced a spread of over 1% between high and low prices, compared to only 10 such instances in 2017.
While volatility has picked-up in recent weeks, it is important to keep things in perspective. We are currently in the midst of the second correction of 2018 (defined as a 10% drop from a high-water-mark). Though it is impossible to know exactly what will happen going forward, history shows the average correction is about 13% and takes approximately four months to recover back to new high levels. For reference, as of the end of last week the S&P 500 is about 11.5% off its recent high, and the Index first touched correction territory in late October (less than two months ago). While it can be unnerving, market corrections are inevitable, and heightened volatility is a normal part of this investment environment.
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
So far in 2018, the buzz on the street has been around corrections and interest rate hikes. In this week’s chart, we look at the spread between the 3 & 5, 2 & 5 and 2 & 10-year treasuries. Historically, when the spread between the 2 & 10-year treasury drops below 0 it signals an upcoming recession. This is because the relationship signals a higher return to invest in a shorter duration of bond.
Although recessions typically don’t follow a yield curve inversion immediately, historically one has occurred about 1-2 years after an inversion. Recently, the 3 & 5 and 2 & 5-year yield curve briefly inverted. While these levels are not as reliable as the 2 & 10 year spread for upcoming recessions, the market reacted negatively to this event. The 2 & 10-year spread has fallen from 0.54% to 0.16% this year and has contributed to a lot of negative sentiment around the bull market.
Some analysts believe that due to years of Fed intervention, the 2 & 10-year yield curve is no longer a strong indicator of recessions. Additionally, economic fundamentals remain somewhat strong, supporting a continued bull market. This week, the Fed is due to announce its final interest rate decision for 2018 and release a projected “dot plot” outlining future interest rate hikes.
*Chart source: Bloomberg
Broad equity markets finished the week negative as small-cap US stocks experienced the largest losses. S&P 500 sectors were mostly negative, with defensive sectors slightly outperforming cyclical sectors.
So far in 2018 healthcare, utilities, and consumer discretionary are the strongest performers while materials and energy have been the worst performing sectors.
Commodities were negative as oil prices decreased by 2.68%. It seems that oil has found support around the $50 level in the past weeks amidst the market rout. Pushing prices lower last session was weak Chinese economic data pointing to lower potential demand. Coupled with poor retail and industrial production data, Chinese oil refinery data fell in November. Additionally, as equities sold off, investors sold the commodity to hedge risks against more volatility and uncertainty in riskier assets. The most recent OPEC meeting led to an agreed combined production cut of 1.2 million bpd- which equates to more than 1% of global demand. However, oil will have a hard time rebounding until production cuts are felt in the market and supply levels significantly decrease. Analysts expect price to rebound in 2019 as Iranian sanction waivers fall off and inventories decline.
Gold prices fell by 0.89%, closing the week at $1,241.40/oz. The metal fell the most it has in the last five sessions as a stronger dollar weighed. The dollar rose on the prospects of an interest rate hike this week. Since gold is dollar-denominated it generally performs best when interest rates are low and steady. As the Fed meeting occurs, investors will be looking more to future interest rate hikes as opposed to just a December hike. Amidst the market volatility, the metal still remains a viable method to hedge risk in the short term.
The 10-year Treasury yield rose from 2.85% to 2.89%, resulting in mixed performance for traditional US bond asset classes. Investors in 2018 have become sensitive to interest rate changes as many speculate what the Fed wil do going forward. Historically, prior to the 2008 financial crisis, the 10-year treasury rate hovered around the 5% range for several years. The 10-year rate has not traded above 3.5% since 2011. The current probability for a rate hike either in December or January is 78.4% and 79.3% respectively. 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 positive for the week as credit spreads tightened. As long as economic fundamentals remain healthy, higher-yielding bonds are expected to continue outperforming traditional bonds in the long-run as the risk of default is moderately low.
Asset class indices are negative so far in 2018, with large-cap US stocks 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.
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
In a light week on the data-front, investors will be watching to see how markets react following the recent spike in volatility.
More to come soon. Stay tuned.
Derek Prusa, CFA, CFP®
Senior Market Analyst