Recent Market Sell Off

The S&P 500 has officially crossed over into correction territory (1), which is generally defined as a decline of -10% to -20% over a reasonably short period of time, generally a few weeks to a month. The breadth of the market has deteriorated immensely with many stocks down 40% or more over the last quarter (2). As I have written recently, little has changed fundamentally over the past weeks with regards to interest rate expectations, earnings expectations and the potential length of a trade war with China. Yet, the market is acting like all three of those factors turned sharply negative overnight: in my view, they did not. I suggest avoiding the urge to get caught up in day to day movements, and instead focus on economic data releases, earnings reports, and other economic fundamentals.

While I don’t want to mislead and say this time is different, let’s look at some of the most commonly cited equity market concerns, debunking them one at a time.

1. The yield curve inversion sparks fears of eminent recession. The brass tacks on this investor concern is that it stems from a valid historical fact: the yield curve has inverted prior to each US recession over the past 50 years.

The thinking follows that an inversion today can only mean one thing: a recession and impending bear market. I believe there are problems with jumping to such a conclusion so quickly. The first is that the period of time between a yield curve inversion and a subsequent recession has typically been fairly significant ranging from 14 to 34 months. But perhaps more importantly, stocks have historically gone up around 15% on average in the 18 months following a yield curve inversion (3), underscoring the fallacy of using a yield curve inversion alone as a rationale for going defensive.

It is also critical to note that past recessions saw inverted yield curves accompanied by a variety of other negative economic signals, from layoffs to contracting PMI and credit deterioration.

But perhaps most importantly, the yield curve has not even inverted yet! For all the talk of yield curve inversion, I believe it is premature as the 30-year US treasury is still higher than the 10-year, which is also higher than the 2-year.

2. Peak Economic Concerns - The US economy added 155,000 jobs in November, which fell below expectations, and the unemployment rate remained at 3.7%. Softer jobs reports, coupled with the growing sense that the impact of tax cuts on corporate earnings has almost fully run its course, has many investors convinced that US economic activity may have peaked. I agree with the sentiment, but with one clear difference: peaking does not necessarily mean turning negative. Earnings expectations are almost certain to continue moving lower in the coming quarters, which I believe could limit return expectations in the coming year (the bar has been lowered).

3. China, Trade and the Fed - These are what I like to refer to as “recycled fears”, or the ones you will most commonly hear about in the day to day financial news cycle. The more you see these stories dominate the headlines, the less pricing power they actually have do to saturation. Fears over trade and the Federal Reserve raising interest rates too quickly have been around all year, and I believe that they are likely fully priced into stock prices already. If anything, the dominance of these stories in the headlines leaves room for positive surprises in the coming months and quarters, when the fears fade and do not have as bad of an economic impact as originally feared.

4. It is also worth noting that we are in a period of time that has increased volatility due to tax loss selling, final profit taking, index rebalancing, and major mutual fund redemptions. All this activity at year’s end can exacerbate price fluctuations along with junior and unseasoned traders manning the desk while their bosses are in the Hamptons and vacationing in Vail.

The bottom line - I believe it is imperative for investors to remember that you should make investment decisions based on changing fundamentals, not on changing prices. For now, we believe the economic fundamentals remain intact, and we urge patience.

If the volatility is truly bothering you, and you are considering making changes as a result, here are a couple of things you might want to do:

A. Revisit your investment plan and your goals. Doing so might make it clear that you do not need the amount of equity exposure that you currently have, or that your plan could use some adjusting in an effort to reduce volatility while still addressing your growth needs.

B. Rethink your risk tolerance. As of this writing we have experienced a shallow correction, but if the downside and volatility is making you lose sleep at night, perhaps your allocation is not in sync with your actual tolerance for risk.

C. For longer term investment dollars that have been allocated to produce income, looking at investment products that mitigate market risk and abate longevity risk could be beneficial to the success of your long-term plan.

If you feel like any of these adjustments or re-examinations could benefit you today, please do not hesitate to reach out at any time.

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