October/November 2018 Market and Economic Update

For more detail of what’s been happening in the markets, as well as how we are looking at things going forward, I wanted to share this from a Weekly piece put out last week by CLS Investments, a well-known 3rd-party money manager. For those just looking for a high level overview, there are some good bullet points if you scroll down to the end.

 “As of this writing, with a few days left in the month, October has lived up to its scary reputation as one of the worst months of the year for the stock market. There is a bevy of reasons commonly cited for the stock market weakness with each holding some truth, but the leading reasons are surely the uncertainty associated with the upcoming midterm elections and the overvaluation of some of the high-flying stocks that led the market earlier this year. The anticipated happy ending to 2018, however, is that November and December tend to be among the best months of the year, especially after midterm elections. As of 10/29, the overall U.S. stock market (Russell 3000 Index) has lost over 9%, with larger companies (S&P 500 Index) down by less than 9% and smaller companies (Russell 2000 Index) losing nearly 13%. Growth stocks (Russell 3000 Growth Index) lost nearly 11% and value stocks (Russell 3000 Value Index) lost over 7%. International equity markets were down by nearly 10% in October (MSCI ACWI ex-U.S. Index) as developed international markets (MSCI EAFE Index) lost less than 10% and emerging markets (MSCI Emerging Markets Index) were down by more than 10%. The bond market (Bloomberg BarCap Aggregate Bond Index) lost less than 1% as the 10-year U.S. Treasury yield has basically run in place with a yield just above 3%, but corporate bonds have underperformed. The three-month U.S. Treasury Bill yield also rose, with yields now over 2.3%. Real assets were mixed. Commodities (Bloomberg Commodity Index) had a slight loss, while real estate investment trusts (REITs) lost nearly 4%.

The market declined rapidly in October, and as always nobody really knows why. Narratives explaining performance abound, but they are being told in hindsight. It is rare to find accurate market explainers in advance of market movement. Let’s review some of the reasons cited for October’s weakness.

One of the most popular is that the Federal Reserve (Fed) has raised short-term rates. But that’s an old story. Another is that longer-term interest rates are also rising. That has been known for a while. How about negative trade rhetoric? That story has been around for months. Fear of slowing Chinese growth? That one’s been around for years. Overvalued technology stocks? This may be the closest. But many market watchers, including CLS, have been aware of this situation, and many of the top technology stocks have underperformed since early summer.

 The uptick in market volatility could amplify short-term market movement, but market volatility and direction have a chicken and-egg relationship. One typically leads to the other before the relationship reverses. It’s important to note that October’s volatility (as defined by the VIX index) approximates the market’s average since 2004. That’s right. The recent day-to-day volatility has been “normal.” It just doesn’t seem so because volatility over the past two years has been exceptionally low. Given the stock market’s overwhelmingly positive long-term return expectations, I sometimes wonder whether the primary purpose of negative news is to move money from the hands of nervous investors into the hands of “smart,” long-term investors. I’ll concede that each factor above can add to market pressure, but the catalyst for price declines is often not precisely known.

 One thing we do know, however, is that prices are often weak in September and October, especially before midterm elections. The happy ending to this story is that postelection, regardless of who wins, the market usually finds its footing and finishes the year strong. The uncertainty that the election brings will have passed. That sets the stage for what is typically the best year for the stock market during the four year presidential cycle: the year after the midterm election. This is the rule, but there are exceptions, of course. Given what we’ve seen in October, what should investors expect from the markets moving forward? Quite frankly, the most helpful advice holds true regardless of the market’s experience last month:

 1.Expect the market to be volatile. - That’s the price to pay for participating in a global economy that grows over time. It’s a fair price and a good long-term investment.

 2.Expect short-term losses. - Money in the market that is needed for short-term bills (that could mean liabilities due over the next few years) should be removed as soon as possible. Not doing so is akin to gambling. Sure, the market moves higher approximately 75% of the time (according to trailing 12-month returns since 1871), but why take a 25% chance that it won’t?

 3.Expect long-term gains. - Over long time periods, the stock market has a powerful tendency to move higher – much higher than money sitting in cash. The goal of investing is to help investors reach their long-term goals. Beating the bank is the performance goal, not necessarily beating the market. To do so, investors should take the appropriate amount of risk based on their goals and financial and emotional capacities to take risk.

 4.Valuations matter. - The price paid for a dollar of revenues or earnings makes a big difference when it comes to expected future returns. Currently, the U.S. market is in a bull run that is 10 years old – the longest and strongest ever. (It would take a 20% loss – the classic definition of a bear market – for the bull market to end.) Thus, valuations are on the high side. That doesn’t mean a bear market is imminent, but it does mean that expected returns are unlikely to match the recent experience. The long-term return for the stock market (depending on the time frame measured) is about 8-10%. Over the last 10 years, the U.S. stock market has performed well above that average. A reasonable expectation for the next five to 10 years is half of the long-term average (don’t be shocked if it’s even lower).

 5.It’s best to see the glass as half full. - There’s always something to worry about, but there are also always market opportunities. The stock market has been an incredible wealth-building machine, and that’s unlikely to change. The U.S. market may experience below-average returns in the years ahead, but there are still opportunities to enhance risk-adjusted returns. For instance, international stocks are priced at much lower valuations; because of this, they have higher expected returns. Within the U.S, value stocks are inexpensive, especially on a relative basis versus growth stocks, such as technology. Thus, they also have higher expected returns.”


From here moving forward, what are the triggers we are all keeping an eye on to get a sense of market direction?

 “CLS’s Top Reasons Markets Could Rise or Fall

 Reasons Markets Could Rise

1. Trade deals are made, reducing negative sentiment toward international trading partners

2.Global economic growth and recovery strengthens

3.Fundamentally-sound international companies outperform expectations

4.Healthy domestic economic growth

5.Low probability of a U.S. recession in the next 12 months

6.Value stocks converging to fair value

7.Emerging markets stocks benefitting from higher commodity prices and relatively low valuations

8.China’s stock market recovering


Reasons Markets Could Fall

1. U.S. companies with excessive valuations (i.e., FAANG stocks) missing Wall Street’s high expectations

2.The Fed tightens more and faster than the market is pricing in

3.Yield curve inverting

4.Global debt levels

5.An acceleration of a trade war, more tariffs

6.Midterm elections looming, leading to increased volatility

7.Regulatory pressure on technology firms

8.Investor sentiment getting very optimistic”


Another piece last week from Horizon Investments covered reasons to still be optimistic in the face of the market drops and uncertainty we have seen in the last few weeks.  To be clear, at some point this 10 year old bull market has to come to an end.  It will be determined to officially come to an end via a “bear” market which is defined as a 20% decline from peak.  A 10% decline as we have seen in parts of the market is defined as a correction.  We have now seen 6 corrections after the S&P briefly dipped there from the peak in mid-late September before coming back strong the last couple of days.  While this decline could reverse and continue down further, the data doesn’t seem to back that up right now.  Bear markets most often coincide with a recession and most of the data seems to show the chances of recession to be low for at least the next 12 months.

By Greg Valliere
Horizon's Chief Global Strategist


GDP (Global Domestic Product - the measure of growth of the economy) probably grew by 4 percent in the third quarter (it actually grew about 3.5%)

GDP probably is growing by about 3-1/2 percent in the fourth quarter.

WAGES FINALLY have picked up; the private sector is hiking the minimum wage.

WORKERS HAVE MORE MONEY in their paychecks; consumer spending still looks solid.

THE LABOR MARKET is in the best shape in over a generation; anyone who wants a job can get one.

HOUSEHOLD NET WORTH is growing, along with the savings rate.

INFLATION and inflation expectations are still well contained.

CORPORATE EARNINGS may slide from spectacular to simply very good.

THE FEDERAL RESERVE may reconsider its pace of rate hikes in the wake of the market selloff.

A TRADE WAR WITH CHINA could shave only a couple tenths of a percent off GDP growth – hardly a disaster.

SLOW GROWTH IN CHINA may drive Beijing back to the bargaining table; a thaw is possible later this year.

AN UGLY TRADE WAR with Canada, Mexico and the EU apparently has been avoided.

THE U.S. BUDGET DEFICIT as a percentage of GDP is still manageable for another year or two.

THE U.S. ELECTION is unlikely to produce a market-rattling tidal wave (update - it produced basically what the markets expected).

EFFORTS TO KILL DONALD TRUMP'S ECONOMIC AGENDA will fail; his veto power looks solid.

HOUSE IMPEACHMENT IS POSSIBLE, Senate conviction is very unlikely.

THE GREATEST GEOPOLITICAL THREAT as this year begin – North Korea – has greatly diminished.

BOTTOM LINE: Obviously there are concerns; markets can always find a wall of worry. But our bottom line is that the euphoria genie – always a warning signal – is back in the bottle after this summer's frothiness. A significant selloff was inevitable, and now expectations are more realistic. Some air has seeped out of the bubble, and that's a good thing.

THE FUNDAMENTALS ARE STILL VERY GOOD: There's enough stimulus in the pipeline for the economy to grow briskly – still not weighed down by significantly higher interest rates, which are remarkably low for this stage of the longest economic recovery in U.S. history.

Some additional articles to shed some light on the October market volatility.

American Funds – Market Volatility update

Economic indicators, such as this one from Astor, still show very strong economic activity.

Corrections vs Bear Markets Historical Graph