Q3 2018 Economic and Market Perspective

Normally I'd start this note by looking back at the behavior of the market and economy over the prior quarter but given the tumult and maelstrom of October it seems more appropriate to look at recent developments first. It seems the market has finally realized that interest rates are likely to rise more and faster than expected and the "I" word (inflation) along with uncertainties of a trade war with China caused the market to do its customary October sell off.

In the month of October, we had the following take place according to Bloomberg:

  • The S&P 500 lost 6.9%
  • The Dow dropped 5.1%
  • The Nasdaq plunged 9.2%
  • The Technology SPDR lost 12.8% for the month, led by Amazon’s staggering 23% decline, Alphabet’s 9.7% decrease and almost 10% sell off in Facebook
  • The Communications Services SPDR shed 10.2%, while the Energy sector SPDR lost a staggering 12.9%
  • The largest sector decline in October was in Biotechnology with the IBB losing over 16%

As I have written on more than one occasion, fear mongering remains rampant and anytime the market takes a tumble the Chicken Little's of the world come out and spread fear. Because market corrections are quite common, they get this forecast right roughly one out of ten times, if that often.

I view the markets and the economy quite differently. The Fed is trying to maintain economic growth to enable more unemployed workers to find jobs, yet must raise interest rates to moderate the pace of growth so it doesn't overheat and lead to increased inflation. If they raise rates too much, the economy could slide into a recession with cyclical disinflation. If they don't raise rates enough, inflation could surge, which erodes our precious purchasing power. The Fed has a very tough job on their hands as we have not had an increasing interest rate environment in 30 years and NEVER have we started the tightening process when the Fed Funds Rate and the Discount rate were in the 0% range. For those of you who have stayed in an old hotel, turned the shower on hot and attempted to adjust the water temperature with the customary 5 minute lag now have a feel for what the Fed is facing, not unlike a super tanker that can't be turned easily.

Hiring remains solid and wages are rising at a moderate pace, that allows households to spend which boosts retail sales and that leads to increased productivity and employment. This scenario makes for a classic self-reinforcing, self-perpetuating business cycle generally leading to increased profits. Corporate profits have been setting new records every quarter. As reported from CNBC in recent commentary, excluding the 5 FAANG stocks, the S&P 500 was recently trading at a mere 13.3X 2019 earnings, a rather low historic valuation.

I'd like to point out that the S&P and Dow Jones indices implemented a major sector reclassification for all benchmarks effective September 24. The telecommunications services sector was renamed "communications services" and now includes media and internet companies- including Facebook, Alphabet and Netflix- previously of the technology and consumer discretionary sectors. Interesting to note that MSCI will undergo a similar change with its indices this month. While there are no implied correlations of Octobers crash to this reclassification, I do believe they were related.

I'm not going to elaborate on the strong third quarter returns like I normally do, as the correction of October has taken it all away and much more, so there is no reason to look backwards. I do want to prepare everyone for the sticker shock of their October ending statements given the broad-based beating almost everything took in October as illustrated from my first paragraph. That being said, a strong third quarter could be a good omen for the rest of the year. When the S&P 500 rises in the third quarter, it has advanced an average of 3.8% in the fourth quarter of all years since 1945 according to CFRA research. In midterm election years, the S&P 500 rallies an average of 7.1% in the fourth quarter, also according to CFRA research.

Our markets (and we) must live with cacophony, especially now with the many ways information is disseminated to the investment community. But as long as economic growth remains solid, interest rate increases stay moderate and corporate profits keep rising, there is every reason to believe stock prices will move higher in the long term. While the markets today are carrying an extra helping of fear, that fear is actually helpful in keeping things on track. It is fear of the unknown, not to mention memories of the financial crisis of 2008, that has induced investors to pull more than one quarter of a TRILLION DOLLARS out of stocks, mutual funds and ETF's over the past decade. This resulted in over $8.2 TRILLION of inflows to bond and money market instruments of various types. This is a tragedy, since it's highly damaging to the long-term financial health of the typical household. The stock market has fully recovered and more since the darkest days of 2008 and early 2009 and set new highs, but many investors have not participated because they were terrified by the experience.

As you know we continue our effort to educate and inform. Stocks perform far better than bonds over the long run, albeit with vastly more volatility. Investors must choose the blend that meets their investment objectives at a level of volatility they can reasonably tolerate. There is no one answer suitable for everyone, as everyone differs in needs and time horizons. That is why we customize your investment holdings, and no two blends are alike. If your risk appetite or investment approach change, we can modify that mix on the fly to adapt to your needs. The key is creating a good plan and sticking to it, we’re here to help.