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As we finally say goodbye to winter in Rochester, will we welcome back the bear after a long, long hibernation? This feels like a possibility, as the bull market run may have hit highs in January that we won’t be seeing again for a while. The extreme volatility we’ve seen in the past three months could be a symptom of an underlying shift in the market cycle from a bull to bear market, as opposed to just some normalizing and correcting. Just two months into the new year, the market had seen 15 days in which it moved one percent or more in either direction. That number has only increased throughout March and the start of April. In the couple of weeks bookending quarterend, the S&P 500 index rose or fell more than one percent eight times, the same number as in all of 2017. You may have heard a reference to “Charlie Brown’s shirt” by pundits, suggesting the rapid upward and downward intraday movements by the market. The CBOE Volatility index (known colloquially as a “fear gauge” of investors) has been moving accordingly, gradually rising since the beginning of the year with a spike during February’s correction.
This is the market attempting to correct for the inflated optimism that we talked about last quarter. Even companies that are beating earnings estimates (which is normally a large predictor of stock prices at least in the short term) are seeing their stocks decline or sell off. Corporate earnings have been notably robust for several months now, and expectations are for continued positive results going forward, but shakiness is really starting to take over after many months of resilience (or in our opinion, complacency). That resilience in 2017, as we intuited, was based on optimism surrounding the election and deregulation, the overhaul of the tax code, and comfortability and familiarity with Fed Chair Janet Yellen. Although the fundamentals of our economy haven’t changed much from 2017, those three factors certainly have. President Trump’s rhetoric has proven powerful in moving the market in both directions (but negatively as of late), tax reform has been coupled with a sizable increase to the government’s spending deficit, and the new Fed Chair is anything but familiar in a time of newly rising rates, neutralizing policy, and general uncertainty surrounding the effects of such monetary policy.
Headlines Add to Turbulence
If no news is good news, this quarter has been one for the books. Political and company-specific headlines (and the intersection of both—i.e., Trump’s public criticism of Amazon and its discounted shipping prices through the United States Postal Service, and Facebook’s data breach and CEO Mark Zuckerberg’s subsequent testimony before Congress) have been testing investors’ confidence on a near-daily basis, resulting in huge intraday swings in the market. This has only reinforced our “Jenga” reference in that the stock market is very prone to tumbling in this environment of volatility and turbulence. Concerns over a possible trade war have colored market swings the past few weeks. What began with President Trump’s aluminum and steel tariffs has progressed with a couple of rounds of tariff leveling from some of our allies, as well as China. The newest development was the US and China unveiling plans to impose tariffs on billions of dollars of exports. The US listed over a thousand items that will be subject to penalties while China retaliated by targeting hundreds of goods, including nearly $23 billion worth of soybeans and other products from the Midwest. Several economists have said that these developments, along with the possibility of retaliatory tariffs by other countries on American exports, could drive up consumer prices and reduce trade overall. Despite advice and concerns from economists and advisors, President Trump seems committed to reinforcing protectionism. We will continue to look out for the effects of these policies over the coming months as China and the US attempt to establish a new normal in trade relations. This week’s developments helped quell some fears; in what’s being seen as an act of conciliation, China’s President Xi Jinping pledged to open China’s markets further for trade and investment. However, at the same time we’ve moved away from fears of a trade war, we’ve apparently moved onto fears of a real war. Over 40 Syrian civilians were killed (and several more injured) over the weekend in a chemical attack on Douma, a rebel-held town in war-torn Syria. The attack is being denied by President Assad, who is backed by Russia. To make matters worse, President Trump then tweeted threats of firing missiles into Syria. Russia responded equally aggressively, leading many to fear imminent escalation of, and involvement in, an already dangerous situation that has been going on for over seven years. We will be following the development of this state of affairs very closely.
Fundamentals Remain Stable
Despite such geopolitical commotion, our domestic economic fundamentals remain strong, evidenced by the Labor Department’s jobs report released in early April. While March’s hiring slowed slightly, the unemployment rate, a seasonally adjusted 4.1%, held steady at its lowest level since December 2000 for the sixth straight month. The labor market remains relatively positive. Consumer-price increases are edging toward a healthy level consistent with solid demand, and manufacturing and industrial production are growing. According to the Fed’s most recent Federal Open Market Committee meeting minutes, all participants see the economy continuing to grow and inflation continuing to edge higher, supporting the notion that the Fed will likely stick to its planned path of interest rate hikes. Members approved another .25% increase in the target range, and expectations are for an additional 2-3 hikes this year (in June, September, and possibly a third before year-end). Sentiment about the economy seemed generally positive, albeit it with some reservation about the same potential issues we’ve touched on here.
Our Game Plan
We are not surprised by the recent movements in the market (the market has been overdue for a correction and cyclical shift for a long time), and instead are poised to take advantage of the current environment. When appropriate, we’re using the volatility to get into new names or add to our current positions at an undervalued price. Furthermore, we are aware of our tactical exposure to different kinds of risk and are positioned to hedge such risks where possible. That’s why stock picking is so important in this kind of market environment. We’re favoring value and income stocks slightly in situations where it’s appropriate, especially when prices seem to materially exceed fundamentals (making growth more difficult to achieve). As we’ve mentioned in other communications, our expectations are for a mostly flat or slightly down market for the second half of the year. We continue to believe that complacency is the real enemy of the bull, not the bear, so we posture ourselves every day to attempt to stay on top of market currents.