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From our Investment Team | Weekly Commentary 2.12.18

by: Investment Team - Rfg Advisory Group .
published: February, 12th 2018


Investment Team – Weekly Commentary

Investors got of taste of renewed volatility last week with price declines across asset classes and geographies. While the week ended on a positive note with Friday's rally, the Dow and the S&P 500 both entered into new territory last week – Correction – and so the investment team wanted to provide historical context and background on corrections in financial markets.

Corrections in financial jargon are a 10 percent decline in market values. Thus, they are only an arbitrary marker of the current trend of market performance. Bear markets, in comparison, are a 20 percent decline. Both terms by themselves do not foreshadow any future price movements, they simply indicate a downward trend in prices.

Historically corrections are a standard part of any market cycle. The recent smooth rise in prices experienced from February 2016 until last month was the exception, not the norm. For context the current correction is the fifth in this current bull market cycle, with the others being 1) 2011- The S&P Ratings Services downgrade of U.S. debt 2) 2013 - “taper tantrum” over Federal Reserve stimulus-reduction plans 3) 2015- Devaluation of the Chinese yuan, and 4) 2016 - Response to the spread of negative interest rates. All of these corrections were event-driven market moves that had a narrative supporting the market behavior, and in every case markets returned to trend after participants absorbed the new information. Looking past this current market cycle since WWII shows that, on average, corrections have resulted in a 13 percent decline in prices, and have lasted four months with a subsequent four-month recovery time (Goldman Sachs). However, the most interesting historical precedent is Black Monday back in 1987.

Black Monday is an analogous correction because of the factors which drove it. First, the economy had experienced growth which pushed interest rates higher after a period of relatively low rates, similar to the recent rise in 10 year Treasury yields from 2.06% in September to 2.85% currently. Second, in 1987, the markets were weighing the effect of a major United States tax overhaul which occurred in 1986. These factors combined to lead to uncertainty in the market which led to a quick and global sell-off.

It is important to note that corrections can happen even in times of economic growth and increasing earnings per shares (Earnings per share on the S&P 500 rose from $14.48 at the end of 1986 to $17.50 at the end of 1987). Encouragingly, markets frequently return to trend even after a violent sell-off. In the case of 1987, the Fed stepped in with two interest rate cuts which stabilized the situation. While we doubt that the Federal Reserve will need to interfere to save the financial markets in the current environment, it is certainly possible that they may put their interest rate increases on hold if they sense that the real economic recovery is under pressure.

As we have commented on previously, our house view remains that once market participants reach equilibrium, the focus will shift from inflation and Federal Reserve rate hikes to the strong fundamentals supporting the economy. All that said, the past week is a reminder that 1) Corrections are a regular part of market cycle, 2) Markets are more sensitive than ever to yields and central bank policy, and 3) volatility, which has long been absent from our markets, has come back and is likely to stay at elevated levels for at least the near term.

 

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. Investing involves risk including loss of principal.