Covenant Weekly Market Synopsis for February 2, 2018

February 5, 2018

After a long (15-month), virtually uninterrupted run higher, equity markets had a “challenging” week. Losses were broad and deep, with little discernment regarding asset type or geography as stocks, bond, commodities, and precious metals declined simultaneously. Last week’s price decline of 3.9% was higher than any such drawdown in the S&P 500 for all of 2017. But considering the terrific run in equities in 2018 (the S&P 500 gained 7.5% in the first 18 trading days of the year) on top of a fantastic 2017, a pullback should not have been unexpected even as it was an unpleasant reminder that risky assets are not mandated to move unidirectionally higher in price. The S&P 500 has gone 404 days without a 5% cumulative decline. I suspect that record will be challenged this week.

For more detail on weekly, month-to-date and year-to-date asset class performance, please click here.

Why? It is common to want to know the reason for a market sell-off. But, rarely is there one thing that causes investors to shift their sentiment from risk-seeking to risk-averse. The pithy answer to the cause of a selloff is “there were more sellers than buyers.” But even as that is technically accurate, it is an unsatisfying explanation. So, for what it’s worth, my opinion is that the current market sell-off is the result of investors fears about higher interest rates. We learned last week that average hourly earnings increased by 2.9% in January and that sparked fear that outsized inflation is imminent and will force the Fed’s hand to raise interest rates aggressively. Combined with the pre-existing condition of stretched equity market valuations, many investors thought it would be an opportune time to take profits.

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Source: Bureau of Labor Statistics and FTN Financial

What? After evaluating the “why” of a sell-off, the next natural question to ask is what to do about it. While the market decline is likely to continue, from an investment perspective, it’s worth keeping in mind that domestic economic data remains on the upswing and that global synchronized growth conditions are intact. In other words, this is probably not the beginning of a bear market for stocks unless some exogenous event (e.g., a geopolitical flare-up) exacerbates what can be characterized as a healthy off-gassing by an overheated market. Although markets are capable of extreme moves regardless of fundamentals, if you believe in probabilities, take the under on this as the beginning of an economically-induced bear market.

How? And of course, there is the question of how to invest going forward. The nastiness of this selloff notwithstanding, of more significant concern to investors and asset allocators should be the rise in correlation between equities and bonds at a time when both are expensive asset classes.

During the last eight years, consistently falling bond yields (yields move inversely to bond prices; hence lower yields result from higher bond prices) have, with few exceptions, buffered portfolios when equities sold off. Bonds have actually played this role for much longer… ever since yields peaked in the early 1980’s, bonds have provided a very steady tailwind to a traditional portfolio mixture of bonds and equities as declining yields generated price gains in the debt instruments. Rising bond prices tempered portfolio volatility over any reasonable timeframe for the past 30 years. But as last week illustrated, at historically low levels, bond yields have a higher propensity to rise than to fall meaningfully. Moreover, the Fed is withdrawing liquidity from the system by reducing the size of their balance sheet at the same time they are raising interest rates, with a target of 3 additional raises this year. And, oh, by the way, the European Central Bank cut its bond-buying program in half in January.

At the same time that liquidity is being withdrawn from the global economy, equity market valuations are stretched.  As investors who fundamentally believe the price you pay directly influences the returns you receive, the expected returns from the stock market over the next 10 years has gone down as the price of the market has gone up.  While valuation is a lousy predictor of performance in the short-term, its clairvoyance into long-term (i.e., 10-year) returns is unrivaled – see the chart below which highlights the increasing correlation between present valuation and future returns over longer time horizons. 

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From today’s valuations (both equities and fixed income) the probability is extremely low that traditional mixes of stocks and bonds will be able to produce returns necessary to meet investor’s return requirements. In short, investors need to think differently. They can fail conventionally, or succeed unconventionally by expanding the range of assets in their portfolios, a topic we explore in this white paper.

I’m trying to free your mind, Neo. But I can only show you the door. You’re the one that has to walk through it.

–Morpheus, The Matrix

The financial markets are incredibly innovative. During the last 20 years, a number of new asset classes have been created or made accessible to individual investors, including reinsurance, absolute return strategies, private lending, private equity, and venture capital. Yes, these assets are less liquid than stocks. But, in a market rife with overvalued publicly traded assets, there is still value to be had in non-exchange traded assets. Allocators and investors need to ask themselves, is having access to daily liquid investments for 100% of their portfolios worth the price of not meeting their return objectives? Or, might they be better off investing a portion of their portfolio in asset classes with a higher expected return, even if it comes with less liquidity.

Be well,

Jp.