Is Friday’s stock market plunge an ominous sign – a harbinger of a bigger drop yet to come?
The Dow Jones Industrial Average dropped 666 points on Friday, the biggest point drop since the day after the Brexit vote on June 24th, 2016, and the 6th worst decline since 1896. The plunge in the Dow was reminiscent of the Great Recession when the index skidded 679 points on December 1, 2008. But, while the point decline was dramatic, the percentage decline of 2.54% was much less severe than the other eight declines of 600 points or more in history, which have ranged from 3.39% the day after the Brexit vote to 7.87% on October 15, 2008, when the economy was in the throes of the financial crisis.
Wage growth triggers interest rate worries
The stock market decline was triggered by a strong labor market report, especially faster than expected wage growth, which caused fears of rising inflation and interest rates. The U.S. economy added 200,000 jobs in January compared to an expectation of 180,000 jobs. The unemployment rate stayed at 4.1%, its lowest level since 2000. Wages grew 2.9%, the fastest pace in eight years. Wage growth has been the last labor market indicator yet to recover since the Great Recession. In the absence of wage growth, overall inflation has remained low. Now, with wage growth picking up, investors fear inflation could rise at a faster than expected pace, thereby causing the Federal Reserve to raise interest rates more aggressively than anticipated and longer-term bond yields to move higher. The 10-year Treasury yield, a key benchmark of bond market sentiment, spiked to 2.85%, a four-year high. A robust consumer confidence report, yet another signal of an economy heating up, and political turmoil in Washington, added to investor fears, helping spur the decline.
Volatility has finally arrived!
As we have written about for some time, including our most recent year-end commentary, The Flight of the Lamassu: The Investment Outlook for 2018 and Beyond, the stock market has been characterized by an unusual absence of volatility lately. The S&P 500 has had the longest period since 1929 without a correction of more than 5%. In the commentary, we predicted that volatility would return, writing, “In contrast to 2017, we think we will see some volatility crop up at some point this year.” And, sure enough, volatility has arrived, just weeks after we released the piece. The Dow was down not only 2.54% on Friday, but 4.1% for the week, its biggest weekly drop since January of 2016. The CBOE Volatility Index, known as the VIX, has spiked from 9 in early January to 17 currently, its highest close since November 2016. Why was our prediction an easy one to make? Because volatility is the norm, even in bull markets. During a bull market, pullbacks of 3% happen, on average, three times per year. Drawdowns within bull markets of 10% happen once per year on average. The average bull market correction is 13% over four months and takes just four months to recover. Let’s be clear: Corrections can be unsettling. But, they are a normal part of a bull market.
An ominous sign
The key question then is whether Friday’s decline is merely the beginning of a normal, and hence temporary, correction in on otherwise ongoing bull market, or a much more significant event, the beginning of a bear market – a decline of 20% or more. To address this question, we must first deal with the not-so-small matter of the market’s somewhat eerie point decline of 666. Throughout the religious history of the West, the number 666 has been considered an ominous sign. Cryptically referenced in Chapter 13 of the New Testament, it is known as the “sign of the beast”, which in Western popular culture has been associated with the Antichrist or the Devil. Some people are so fearful of the satanic association of the number 666 that they seek to avoid the number at all costs. This is known as hexakosioihexekontahexaphobia. Yes, that’s a real word…and a real phobia! (Don’t ask me how to pronounce it!) Now, I’m pretty sure I don’t have hexakosioihexekontahexaphobia, but having grown up in a Western culture, I must admit to a certain uneasiness when I see the number 666. And so, imagine my discomfort when the market closed Friday down 666 points. And yet, I’m reminded that this uneasiness is merely the product of my cultural upbringing. In China, for example, the number 666 is considered to be lucky. It can mean "everything goes smoothly". I have a colleague at First Foundation, who happens to write our Weekly Insights blog, whose phone number contains the number 666. Every time I dial his number, I think “How can he have a number like that? If I had a number like that, I’d probably change it!”. But, then I remember, he’s Chinese! For him, it’s a lucky number!
So, is Friday’s drop of 666 an ominous sign of a bear market on the horizon or are we “lucky” that it’s merely the return of normal volatility in what is otherwise an ongoing bull market? We’re in the latter camp. We think we could see more volatility yet still, including even a 5%, 7%, or 10% correction, which again, can be unsettling, but we’re pretty sure it will be a temporary correction, not the beginning of something bigger. How can we be so sure? As we outlined in the year-end commentary, the economy remains strong with little evidence of a recession in sight and, without a recession, it’s rare to have a bear market. It is possible that runaway inflation could trigger an overly aggressive Fed, which could lead to a bear market, but that seems unlikely at this point in the economic cycle. Inflation remains low and wages are only now starting to pick up. Moreover, we think various forces such as technology, globalization, demographics, low productivity, and China’s economic slowdown are likely to keep a lid on inflation. However, suffice it to say, despite our skepticism about runaway inflation and interest rates, we will be watching the inflation picture carefully. We do expect some modest pick-up in inflation and rising interest rates and we’ve positioned our fixed income portfolios for that outcome.
Risk controls in place
One of the key principles of our investment philosophy is risk control. We have several layers of risk control in place, designed to help protect and preserve our clients’ capital. The first line of defense is the age-old strategy of diversification, otherwise known as “don’t put all your eggs on one basket.” Most of our clients have balanced portfolios comprised of multiple asset classes, not just stocks alone (or bonds alone). They own both stocks and bonds and various types of stocks and bonds, as well as real estate and other alternative investment strategies. The beauty of a diversified portfolio is that when one asset class “zigs” the other typically “zags,” providing a cushioning effect in times of market volatility. Another key risk control mechanism we have in place, and perhaps the most important one, is our valuation discipline. We carefully consider the valuation of each asset class and seek to invest in undervalued asset classes, and avoid richly-valued and overvalued asset classes. Indeed, as the U.S. stock market has climbed higher and higher, resulting in above-average valuations, we have begun to raise some cash in our asset allocation strategies in an effort to reduce risk. Should we see this pullback continue, we will likely use it as a buying opportunity, putting some of this cash to work, most likely boosting our exposure to international or emerging market stocks, which we think are more attractively valued than U.S. stocks and have a longer runway of growth ahead of them. A valuation discipline like this is no guarantee against a potential decline in the short-term, of course, but it gives you confidence that what you own is likely to recover eventually and go on to realize greater value over time. Still yet another mechanism for controlling risk is our strategy of selecting managers that often have a more conservative approach. These managers are often focused on value, they are willing to hold cash at times to protect against volatility, and their investment philosophy and portfolio construction methodology results in favorable “downside capture” (i.e., when the market declines, they tend to go down less). A good example of this is our FFA High Quality Core Equity Strategy, which as the name implies, is focused on high quality companies. It tends to be more conservative than the overall market, with a lower downside capture. And, right now, it holds a fair amount of cash for protection against a market pullback and as “dry powder” for when opportunities arise. Not all of our managers share these same conservative attributes, of course, but many do. This three-part risk control strategy – diversification, valuation discipline, and the utilization of conservative managers – has served us well in times of volatility.
Experience weathering storms
We should add that we have a lot of experience dealing with market volatility. Suffice it to say, we’ve been here before. Although we haven’t had much volatility lately, we don’t have to look all that far back for volatility. We certainly don’t have to go all the way back to 2008. We saw some significant volatility in late 2015 and early 2016 when oil prices plummeted, China’s growth slowed and its currency devalued, and investors fretted over rising interest rates – all of which increased the odds of a global recession (that ultimately never occurred). We experienced significant volatility before that in 2011 when the eurozone debt crisis reared its ugly head, threatening to collapse the eurozone altogether and possibly bring down the European banking system with it (again, none of which ultimately came to fruition). Our portfolios weathered both of those bouts of volatility well and went on to participate in the subsequent recovery and upward march of the investment markets. We’re fairly confident that Friday’s drop is simply the return of “normal” volatility and not the beginning of a full-blown bear market. The number 666 is not likely an ominous sign, but rather “lucky” in that the market is finally back to normal. After such a long upward trajectory with virtually no volatility, the market needed to take a breather. None of this is to say that things can’t get worse in the short-term. “Normal” volatility can mean a decline of 5-10% or more. We would caution investors to prepare for more days like Friday. However, we think such volatility will prove to be temporary. No matter what, though, rest assured that whatever unfolds, we will be prepared. We feel confident that our portfolios will be able to weather whatever storm might be brewing in 2018.
As always, should you have any questions, please don’t hesitate to reach out to your Wealth Advisor.