First Quarter 2018 Commentary – A Changing of the Guard

The markets make the news—the news does not make the markets. 2017 was a year of historical complacency and much of January 2018 marched to a similar beat. As January turned into February, volatility reintroduced itself as the Dow Jones Industrial Average had its biggest single-day point drop in history on February 5th, falling nearly 1,600 points intra-day. To frame that correctly, a 1,600 point drop roughly amounted to a 6% total drop in the Dow. Not a record breaking number, but the message was clear – volatility had risen from its slumber.

Looking at the fundamental picture, not much has changed since last year—earnings remain strong, employment is robust and wage gains continue to tick up moderately. The market has become more sensitive to news surrounding Washington’s agenda, despite the fact that most of this news around trade wars and protectionist policies elicited space on the front page a year ago. It didn’t necessarily matter then, but it seems to matter now. Nobody ever said markets had to make perfect sense and for the first time in two years, the major averages posted negative returns in a quarter.

 

Equity markets met gravity in the first quarter as a nine-quarter streak of positive returns in U.S. equities came to an end. In addition to finishing down 0.76% in the first quarter, the S&P 500 experienced its first 10% fall from an all-time high since February 2016. International stocks were not immune and fell nearly 1.5%. Emerging Market stocks, however, finished positive as China and Brazil (nearly 40% of the Emerging Market Index) led that group higher. In fixed income, the 10-year U.S. Treasury yield touched 2.94% in late February – its highest level since 2013 – leaving both U.S. taxable and municipal bonds down more than 1% for the quarter. Speculation is growing that the final chapter of the great bond bull market that began in 1981 is being written. While rising rates present a problem for bond investors initially as principal declines, it should only be viewed as a short term inconvenience because those who stay the course should be rewarded by higher coupons. Lastly, among the biggest victims from the move in rates has been Global Real Estate Investment Trusts, or REITs, which finished the quarter down 5.5%. As rates rise, bonds begin to offer more competition to traditional yield oriented sectors. In addition to real estate, other high dividend payers – such as utilities, energy and consumer staples – were among the weakest sectors in the market this quarter.

After a year of historically low volatility, the pendulum has swung aggressively in the opposite direction. The explanations for this new volatility regime are endless and depend on the party who is asked. Interest rates, valuations and politics are often cited but the simplest explanation is that, like a treadmill, the stock market has multiple speeds. Historically, the VIX (common measure of market volatility) has averaged a reading of 16. Last year’s average was around 11 and it spent a significant amount of time in single digit territory. In the same way that most things tend to revert to the mean, excesses in one direction in the stock market often lead to excesses in the opposite direction when the market charts a new course. It’s not uncommon for periods of low volatility to be followed by periods of high volatility. In February and March, the VIX held an average reading around 21 and closed as high as 37 in February, the highest close since August 2015.

While the market can change speeds without notice, it’s important to remember the stock market is not a referendum on the current state of Washington D.C., Facebook’s public relations issues or any other major event the media agonizes over. In its simplest form, the stock market is a discounting mechanism, which is a fancy way of saying it’s a collective daily wager among millions of people trying discern the future performance of publicly traded businesses. Ultimately, very little effort should be geared towards trying to predict an unknowable future. A better use of energy lies in understanding the present and thinking about the various paths that may evolve from it. With some of the painful days this past quarter, equities got a little cheaper and bonds set themselves up for higher returns in the future. When the market has been trending consistently higher with low volatility, it’s hard to keep recent price declines in perspective. In reality, when the market breached its lowest levels this past quarter, it only took us back to where we were last November – a time when investors were delighted. Most would agree that rising markets are more fun than falling markets but often times a change of pace is necessary to set up the good that will come in the future.

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