Economic & Financial Market Commentary: Q1 2018

“We don’t have to be smarter than the rest. We have to be more disciplined than the rest” – Warren Buffett

How do you feel the markets performed during the 1^st quarter of 2018? If your portfolio return was based on news headlines, I am guessing many of you would be quite nervous. Some of my favorite headlines from the quarter include – “Dow plunges 1,175 - worst point decline in history”; “February was an insane month for the stock market”; 3 reasons why the stock market is having a horrifying week”; “It was the scariest day on Wall Street in years”; and the list goes on... If I woke up to these headlines, armed with no other information, I would fear the worst. I find it ironic that we hate fear, yet news outlets dwell on fear mongering to tempt investors to act irrationally.

Fortunately, Market Street was founded on rational investment behavior with a long-term perspective and I am happy to report that the quarter ended about where we started, with only modest declines in the major averages. The most pronounced losses were in commodities and real estate. The table below summarizes index returns for the first quarter, the past 12 months, and annualized returns for the past 3-year period for some of the major asset classes.

The Good News – Looking Ahead

For any of our clients that have worked with us more than a year, you know that our message remains consistent – “stay the course”. So, you are probably wondering why we would be looking ahead if it’s not going to change our recommendations. My hope is to shed some light on why the headlines are usually nothing more than noise and why you would be best served to ignore them (see my previous commentary titled Market Noise).

On the margin, the economic data continues to look strong.  We are seeing GDP (Gross Domestic Product) growth approaching 3.0% and unemployment numbers that are likely to fall well below 4% into next year. Some economists are actually projecting unemployment numbers could approach 3%, which hasn’t happened since the 1950s.  We are continuing to see the Fed raise interest rates as their dual mandates of maximum employment and stable inflation continue to materialize.  As this bull market reaches its 10^th year, we acknowledge the fact that we are in a late cycle recovery.  However, the strong economic data, coupled with the tax cuts which should boost corporate profits and consumer spending, could provide another year or two of life to this aging bull market. 

We are currently looking at a couple strategic shifts to our model portfolios. One adjustment we are considering is an increase to our international equity exposure.  While the US domestic market has been rallying in recent years, the international markets have remained relatively flat. Our models have been overweight domestic equities and underweight international.  We will be looking to make this adjustment in the second half of 2018.

We are also looking to remove or reduce our commodity exposure within our equity allocation. In the past, commodities were negatively correlated to many of the other asset classes, providing a diversified portfolio. Commodities were also held to act as a hedge against inflation.  As markets have continued to become more globalized, and central banks more unified, the advantages of holding commodities have begun to wane.      

Fixed income is an asset class we expect to be under pressure throughout 2018 as the Fed continues to raise rates. It is quite possible we will see three more rate hikes this year.  As a result, we have continued to favor floating rate and shorter-term maturities as these shorter durations will be less impacted in a rising rate environment.  Similarly, we do not currently hold any long-term fixed income as these investments would be most impacted by higher interest rates under a normal yield curve.      

Volatility Returns

Volatility has been absent the past 1.5 years without any 5% corrections prior to January 2018. In a typical year, it would be common to experience anywhere from 5 to 8 downside corrections of 5%. As a result, the return of normal volatility during Q1 2018 didn’t feel normal as investors grew accustomed to the low volatility environment of recent years. As volatility returned the media took advantage of weary investors with an overdose of doomsday headlines.    

Volatility can be scary to watch as irrational investment decisions can lead to abrupt short-term market fluctuations. The adage “a picture is worth a thousand words” is exemplified by the chart below from JP Morgan’s Guide to Market where they clearly illustrate the normalcy of volatility. As the chart illustrates, the average intra-year price decline over the past 38 years is 13.8% with annual positive returns in 29 out of 38 years, or 76% of the time.  Therefore, it is very common to see double digit corrections during the year while still finishing the year in positive territory. This is the reason for staying the course and remaining disciplined. I will end with the same quote I opened with “We don’t have to be smarter than the rest. We have to be more disciplined than the rest.” – Warren Buffett

Conclusion

I hope this commentary shed a different light than the daily headlines you are inundated with. The truth is that we will face future market corrections and likely a bear market. Our goal is to not avoid these market disruptions, but to ensure you remain disciplined through the correction so that your portfolio can recover to new future highs.  I will close with the following chart, which I feel paints the perfect picture and creates a great summation of what I have attempted to share with you in this commentary.  This chart also comes from JP Morgan’s Guide to Market and illustrates the importance of diversification and the reason volatility shouldn’t be feared over the long-term.

The gray bar chart shows the expected returns of a 50% stocks / 50% bonds and cash index portfolio over a continual rolling 1, 5, 10, and 20-year period between the years of 1950-2017. Over a one-year period, volatility can create a large dispersion in expected returns. However, as you look over the longer-periods you will notice that this dispersion tightens dramatically.  In fact, no 10-year or 20-year rolling periods have ever produced negative returns for the blended 50/50 index allocation.  The lowest annualized return for a 10-year period was 2% and the lowest 20-year rolling period was 5%. Ignore the noise, remain disciplined, and reap the long-term rewards of being a disciplined investor.