Q1 2018: PFM Quarterly Commentary
At the close of our previous quarterly commentary, which detailed the impressive worldwide equity gains of 2017, we set forth the premise that downside market volatility would increase in the coming year. We were quick to add that this bold prediction was an attempt at sarcasm given that markets last year were the most tranquil on record.
Admittedly, we were feeling humbled after the first 26 days of January saw the S&P 500 rise a staggering 7.5%. Perhaps our prognostication may have been a testament to the folly of predicting the market’s behavior. The 27th day of January began a period that ultimately affirmed our view. From its peak on January 26th through February 9th, the S&P 500 fell 11.8%, introducing the first correction since February 2016. While the end of those ten fateful days saw the S&P down 5.3% on the year (hardly a seminal event), it is how we got there that caused quite the commotion. We’ve noted in earlier communications that the stock market generally “takes the stairs up and the elevator down”, and that proved to be the case in the first quarter. The downside movements were breathtaking with several 1,000 point down days being recorded on the Dow Jones Industrial Average. Of course, the “carnage” always makes for good TV as market pundits are easily excitable.
The reality is that the S&P 500 rose an unprecedented 15 months in a row. This was a feat unmatched in U.S. stock market history, so one can hardly blame the market for taking a breather. In fact, official market corrections (meaning a drop between 10% and 20%) are perfectly normal, even within bull markets. Since the end of World War II, there have been 27 corrections in the S&P 500, all of which were reversed in just four months on average. Over the same period, there have been eight pullbacks between 20% and 40% which were completely recovered in only 14 months on average. The moral of this story is that the stock market doesn’t go up all the time and every decline, whether small or large, has been remarkably temporary. While going through these corrections can be uncomfortable, putting them into historical perspective should serve to calm emotions and provide optimism.
Many were quick to blame the market selloff on popular narratives. Tariffs, trade wars, and many well-known companies (think Facebook) caught behaving as less than stellar corporate citizens took top billing as catalysts for the downturn. While these issues certainly played a role in roiling the markets, we would be remiss not to point to the selloff’s main culprit and one of our favorite quarterly commentary topics over the years: the Federal Reserve.
Since the end of the Great Recession in 2009, the Federal Reserve’s emergency Quantitative Easing programs have pushed trillions into the monetary system. Like water, excess liquidity seeks the least resistance, so large, highly efficient markets such as high end real estate and the stock market became the biggest beneficiaries of these newly printed dollars, pushing prices to record levels.
Beginning in October 2017, the Federal Reserve began reversing this nine year-long experimental policy through a program coined by the finance industry as “Quantitative Tightening” or QT. QT signaled that the Fed was going to stop suppressing longer term interest rates and begin withdrawing liquidity from the monetary system for the first time since commencing emergency stimulus measures during President George W. Bush’s final days in office. The Federal Reserve enacts this change in policy by selling bonds from its $4.6 trillion balance sheet. Initially, these bond sales were minor, totaling just a few billion dollars each month. However, the Fed sold its largest block of bonds to date, $20 billion, beginning January 29th, 2018 through the first week of February. Why is this so important? When bonds offered for sale increase in quantity, interest rates typically rise, which can act as a headwind to the economy and the investment markets.
So, for those keeping track, the Fed’s first ever meaningful bond sale as part of its Quantitative Tightening program corresponded perfectly with the stock market’s first correction since February of 2016. It stands to reason that if Quantitative Easing helped the stock market go up, Quantitative Tightening may have the opposite effect. While the Fed hasn’t set a target level for its balance sheet, some speculate that it is somewhere around $2 trillion, which means $75 billion gone and only $2.4 trillion more to go.
The expected side effect of the Fed’s Quantitative Tightening program came to pass with longer term interest rates having increased sharply from the day Janet Yellen first announced the program in September of 2017. In fact, in 2018 alone, the benchmark ten year treasury yield rose from 2.40% on January 1st to 2.95% on February 21st which is a substantial increase in a short period of time. In response, many interest rate sensitive areas of the economy such as housing and durable goods weakened during the quarter as many items became more expensive by virtue of higher financing costs. The sensitivity of the overall economy to interest rate increases calls into question how high rates can go before they inflict too much damage, forcing the Fed to change course once again.
Seemingly, no asset class was immune to the wild gyrations of both the stock and bond markets as interest rates fluctuated. When the stock market was riding high during the first three weeks of the year, emerging market equities, Master Limited Partnerships, and healthcare stocks followed suit, returning 11.04%, 10.99%, and 10.60%, respectively. Concurrently, as interest rates accelerated to the upside, yield sensitive sectors in mortgage REITs, traditional REITs, and longer dated bonds sold off, falling 4.20%, 3.96%, and 1.37%, respectively.
However, as noted above, circumstances changed dramatically in all markets once the Federal Reserve began its Quantitative Tightening program in earnest on January 26th. Initially, bonds continued to fall alongside stocks which is unusual given that these two asset classes are generally inversely correlated. These few weeks were especially disappointing for many as both risky and conservative investments fell simultaneously, leaving very few places for refuge. But as the stock market weakened further, interest rates finally moderated and the dispersion of returns between assets classes tightened significantly. By the end of the quarter, emerging market equities, broad commodities, and low volatility international stocks turned in returns of 2.52%, 1.90%, and 0.97%, respectively. On the other end of the spectrum, yield and inflation sensitive sectors such Master Limited Partnerships, REITs, and materials stocks fell 11.21%, 8.18%, and 5.51%, respectively.
The first quarter of 2018 demonstrated that quite a lot can happen in the investment markets in a short period of time. Moving from dizzying highs to crestfallen lows can happen in just a few days, so it can be difficult not to get caught up in the accompanying despondency. Discerning if market fluctuations and dislocations are fleeting or more structural in nature is the difficult part of asset management. This is why we feel so strongly about Peak’s disciplined investment approach. Interestingly to note, despite all of the gyrations the market has experienced in 2018, most major indexes for stocks and bonds, both international and domestic, finished the quarter clustered within a couple percentage points of a flat return. Now, we’ll roll up our sleeves and see what the second quarter brings.
Regards,
Peak has created a monthly “quilt” of returns to track the performance of the major areas of the investment markets over time. We believe that this table best illustrates the fundamental tenets of Peak’s investment philosophy, namely the futility of predicting which investments will outperform over the short term and the unremitting cyclicality of markets. These truths support our firm belief that broad based diversification over many areas of the world economy is the best path to investment success over the long term. Asset Class Quilt of Total Returns – March 2018
This presentation is not an offer or a solicitation to buy or sell securities. The information contained in this presentation has been compiled from third party sources and is believed to be reliable; however, its accuracy is not guaranteed and should not be relied upon in any way, whatsoever. This presentation may not be construed as investment advice and does not give investment recommendations.
Presentation of these indexes is for illustrative purposes only. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor’s results will vary.
Additional information, including management fees and expenses, is provided on Peak Financial Management, Inc.’s Form ADV Part 2. As with any investment strategy, there is potential for profit as well as the possibility of loss. Peak does not guarantee any minimum level of investment performance or the success of any portfolio or investment strategy. All investments involve risk (the amount of which may vary significantly) and investment recommendations will not always be profitable. The underlying holdings of any presented portfolio are not federally or FDIC-insured and are not deposits or obligations of, or guaranteed by, any financial institution. Past performance is not a guarantee of future results.