3rd Quarter 2018 – Market Review

I recently distributed a client survey with a simple question in mind:  how can I make the Firm more helpful for clients?

I received some great feedback, particularly as it relates to the markets.  Clients want a market update, but brief, and of course as relevant as possible to them.  

With that in mind, this is the first in what will be a regular quarterly summary of markets and some portfolio education.  There are already too many resources where you can read a generic update, my goal is to make this short and emphasize some specifics, focusing on how global markets translate into your life.  I aim to inform but not put people to sleep, so if you’re still awake by the end, please let me know how I do.

The Economy

The economic growth that started during the depths of the Financial Crisis continued into its 10th year, with the most recent GDP figures making a significant jump:

It’s not hard to find evidence of this right in your backyard.  New cars in driveways, new boats on the water, new additions on houses.  Housing prices have been on a similar trajectory since just after the Crisis:

Unemployment remains near generational lows:

Unsurprisingly, consumer confidence reflects that people feel pretty darn good about things:

With all of these indicators flashing ‘strong economy,’ we’re also in the part of the cycle where the Fed begins to pump the brakes.  At their most recent meeting in September, they raised rates for a third time this year and reiterated their intention to continue to raise in the near future:

What Does it Mean For You?

You probably are working, getting paid well, your house price and/or rent is high, and things feel pretty good.  However, it’s at this point in the cycle where consumers begin to see the first ‘cracks’ in the sunshine daydream, and that is by design.  The Fed begins placing those cracks deliberately through interest rate hikes, as part of their mandate is to control inflation.

For example, the 30-year mortgage rate:

Shopped for a home recently?  You likely noticed that the ‘basically-free’ money we’ve all been borrowing since the Crisis isn’t so free anymore.  The Fed’s rate moves are beginning to filter through the economy, where you will now pay more to borrow money. If enough people choose not to buy the house because rates feel too high, that changes house prices, and that’s usually when Main Street begins to realize things aren’t running as smoothly anymore.  And the cycle begins anew…

The Market

Let’s start with the obvious:  Our market, seen here as the S&P 500, has risen almost unabated for the better part of a decade, and that’s continued this year:

That’s the good news.

The bad news, this quarter was yet another chance to live the phrase “diversification means always having to say you’re sorry.”  If you hold a diversified portfolio (and you should), that means you’re not just invested in the US, you’re holding a global basket of stocks and bonds.  Let’s just say that the rest of the world isn’t feeling as warm and fuzzy as we are:

As you can see, last year (left side) showed strong performance in nearly every equity market around the world, with the US lagging its counterparts.  This year (right side of the pic) is a far different story, with only Japan showing a (small) positive return internationally.

That’s not all.  

The Barclays Aggregate index is an index meant to represent the bond market as a whole.  Since the Barclays Agg was created in 2003, this is the first time it’s been down 3 quarters in a row.  Bonds are supposed to be a form of ballast in a portfolio, meant to cushion the volatility of the stock market.  This year, they’ve been no help:

What Does it Mean For You?

We build portfolios by diversifying across all global assets, and this quarter is a very pure example of why that works.  Not all things can go up at the same time, and if they do, you’re probably not truly diversified.

The Fed is intent on slowing down inflation in the near future.  The change in the yield curve over the last 5 years reflects that:

The market will react.  No one is ever sure exactly when, but it will.  Interest rates rising this much in a short time is rare, and will eventually have an impact, as people begin to trade their stocks for (now) higher-yielding bonds, and borrowing gets more expensive.

The Portfolios

Having discussed the bond and international markets above, I want to dig a bit deeper into how this is applied at the portfolio level.

‘Emerging Markets’ is the definition applied to the asset class of stocks of developing countries.  What exactly does developing mean? As Phil Huber notes in this excellent, two-part post, the original idea was:

“A set of promising stock markets, lifted from obscurity, thereby attracting the investment they needed to thrive”

Phil goes on to show, emerging market investing comes with an expectation of volatility, it is not for the faint of heart, but when applied to a diversified portfolio using risk management, the

“return enhancements would have been accompanied by volatility not materially higher than owning the S&P 500…”

Buy it by itself?  You better hold on tight.  Buy it as a part of a diversified portfolio with some risk protection?  You can achieve some decent returns.

What Does it Mean for You?

We use trend following in our models as a risk management tool.  Trend following is simple in concept, but with many complex and complicated permutations.  We use two methods to evaluate trend:

  • How is the asset performing?
  • How is the asset performing compared to a risk-free asset (a treasury bill)?

We were invested in Emerging Markets…until this summer.  Around that time, the positive trends started to breakdown, until we fully exited our position.  I’ve added simple trend arrows into this pic of EEM, an emerging market ETF.  I’m doing no math here, and you really don’t need my handy arrows to spot the trend reversal:

As we saw above, the bond market has changed over the last 5 years.  Looking at this picture of a 20-year treasury ETF (TLT), though the trend isn’t quite as clean, it’s still very clear that things have shifted,and we’ve eliminated longer bond positions accordingly:

When will we reinvest in these assets?  Not sure.

When do I predict they’ll come back?  No idea.

Can we buy at the bottom?  Probably not.

As Ben Carlson discusses here, buying emerging markets after a big selloff can be very rewarding.  But when to buy?

We manage portfolios under the mantra ‘perfect is the enemy of good.’  There is no perfect portfolio. Trying to time the bottom is a fool’s errand (as it is for the tops), you may get lucky once in awhile, but you’re just guessing.  We use trend following to help guide our decision-making, we use math to avoid emotion. Why trend-following? A lot of evidence shows it helps with the risk management of a portfolio.  This article by Wes Gray and Jack Vogel is a perfect ‘starter course’ in the research. Please jump down the rabbit hole and let us know what you think!

Disclaimer: All written content on this site is for information purposes only. Opinions are solely those of Innovate Wealth unless otherwise specified. Material presented is believed to be from reliable sources and no representations are made by our firm as to another parties’ informational accuracy or completeness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation.  

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