It was bound to happen, wasn't it?
Too much information can be counter productive
SUMMARY OF INVESTMENT THEMES
After a strong start to 2018 in January, February has begun with a reminder that what can go up can also go down. I felt like a broken record over the past year, but most people I talked to would ask me, "This relentless rise can't go on forever...can it?" The truth is, no one knew how long we could go without even a 3% market correction. We made it from the day after the election in 2016 until February 2, 2018. That is a LONG time without even a 3% decline. Many astute advisors had been reminding clients that markets don't move in straight lines and that volatility is a normal part of investing.
That being said, the speed of this correction in February is what had many people caught off guard. When stocks fall this fast just after an all-time high it's often a time to be optimistic, not fearful. Bull markets don't often end this way. Corrections are often scary because they seemingly come out of nowhere without reason. Frustratingly, there may be more on the way...or maybe not. One never knows.
According to Standard & Poor's, in their 92-year history, there have been 49 times that the market fell at least 8% but less than 20%. They typically last between 7 days and 8 weeks and are often opportunities rather than times to run for cover.
Monday, February 5th was a 4.1% decline that felt enormous. It was the worst day in a few years, but its just the sixth worst day within the current bull market! Corrections are often swift and can be over sometimes before you even realize there was one. A good analogy is to think of typical stock market volatility like riding white water rapids. The water flows where it flows. You just need to stay onboard the raft and not get thrown off.
Bear markets are a much different animal from a correction. They often accompany recessions and are much longer and deeper. Usually, they accompany a slowing economy, rising unemployment and some sort of crisis.
The differentiator is often how they begin. In contrast to a sharp, swift market correction, a bear market is usually a slower moving process. In fact, it often is so slow that people don't realize it is happening until it is too late. There is no ringing of a bell with a 1,000 point decline, there often isn't plummeting right off the high. They often begin softly, with slowly rising volatility over a period of months accompanying a slow decline before you realize the market has reached correction territory (off 10%). The pain of a bear market doesn't come out of the gate, it often occurs much later giving investors time to acknowledge them if they are willing to look.
During corrections, investors, the media, financial pundits are always searching for reasons why. By the time they might agree on a supposed cause, the correction has probably passed. In my opinion, the explanations of the financial pundits as to why the market is correcting have about as much value as their prophecies about how the markets will perform in any given year. As humans, we crave certainty. That is why so many individuals look for jobs with a great benefits package or pension. The problem is that in the markets there are no certainties...our brains seek out explanations for everything even when there may not be one.
The difference between corrections and bear markets, in my opinion, is emotion and sentiment. Anything can set off a correction but it often occurs from the unstable footing of overly optimistic sentiment. Often a correction occurs after a long period of declining volatility, similar to what we just experienced. Herding takes over and the pendulum begins to swing. The markets are always in a state of disequilibrium swinging from optimism to pessimism. The long-term investor uses the emotional swings to their advantage.
I will be watching to see how this correction unfolds.
TOO MUCH INFORMATION
Investors these days have incredible access to investment information. In fact, I believe never before have people had so much information at their fingertips. I am sure many of you have your stocks, ETFs and fund tickers logged in to your iPhone or Samsung phone and can check them in real-time anytime you want. Additionally, you can see any news attributed to them at any point in the day. While this is an incredible feature, I believe it completely counteracts our ability to be long-term investors.
However, individual investors have one, single distinct advantage….and that is time. Fund managers and institutions are often judged month to month and quarter to quarter. The “what have you done for me lately” question often daunts investment professionals. In my opinion, that pressure can lead to poor decision making by removing the major advantage individual investors have…time.
I posit that from the perspective of the average individual investor out there, the huge volume of fragmented information often given in short soundbites presents quite a challenge. What is the best way to implement everything while keeping the focus on the longer term? I continue to believe that a globally diversified portfolio with tilts toward value and momentum with an eye toward trend management is often the best way to construct an individual portfolio. But, like any approach, it can and will underperform and outperform at different times.
Very few investors can sit in a 100% stock portfolio through the “bumps” that are routinely 30%, 40%, 50% paper losses and come out the other side intact. By combining other assets such as bonds or alternative investments such as REITs, one can potentially create a portfolio with a hedge against stock market volatility. However, those assets are not without risk as well.
While stocks often can suffer sharp declines, bonds usually erode over time from the effects of inflation. REITs often perform well with inflation but underperform in times of deflation or low inflation. (Investing in Real Estate Investment Trusts (REITs) involves special risks such as potential illiquidity and may not be suitable for all investors. There is no assurance that the investment objectives of this program will be attained.)
The point I would like to make here is that for the long-term investor, having exposure to each of those asset classes can create a well-diversified portfolio that may provide a “smoother ride” to your goals.
With this recent volatility, I am reminded of some advice I received years ago. The most profitable investments are sometimes made at a time when you often feel like you are about to throw up! The more comfortable an investment seems to you, the worse it may end up being because all the “warm fuzzies” are priced in at that point. If you feel sick to your stomach when investing in something because it’s been doing so poorly, in the long term it could potentially end up being a great investment!
LONG-TERM CHART UPDATES
Good portfolio construction starts with solid diversification across asset classes. Further, tilts toward value and momentum factors can keep portfolios focused on those themes and away from those languishing in the middle. Finally, long-term trend analysis can alert you to potential changes in global financial markets. To that end, I am always on the lookout for longer-term changes that may be unfolding before our eyes. The majority overlook them as they unfold until the trend change becomes well established.
Below, I am including a section with chart updates on the 30 Year Treasury Bond Price, The U.S. Dollar, Gold and the U.S. Stock Market.
Here is a chart of the 30 Year U.S. Treasury Price. When looking at this chart since 1982, it appears there is a clear trading channel that has existed for roughly 38 years. 8 previous times it touched the lower end of the channel and bounced. We are currently at the 9th time. I think this could be an important chart to watch over the next six months to see if this channel holds or if we break. In my opinion, markets and our government are not prepared for significantly higher interest rates.
This is a chart of the price of Gold since its peak back in 2011/2012. It sure does look like a rounded bottom was formed over the past few years. I will be watching to see if gold breaks out above its 2017 high. If it does, in my opinion, it appears the potential for much higher gold prices is in the cards.
Here is a chart of the U.S. Dollar since it bottomed against a basket of foreign currencies back in 2011. After tracing out a five wave move higher ending in late 2016, it appears the dollar is close to completing a correction at its trend line of support. If that is the case, one might look for a higher dollar, at least in the shorter term.
This is a chart of the S&P 500 since 2010. The blue line is the 200-day moving average. Other than the sell-off in 2015-2016 the market has stayed above its moving average or bounced within a week of breaching it. In Mid February we tested that moving average and have bounced. When looking at the U.S. stock market from this far back, it does appear that a 5 wave move higher could be marked complete. That is exactly why I think it makes sense to watch how this correction unfolds. A failed rally below the January high followed by a decline that breaches the low could tell us the long bull market is taking a significant pause.
These longer-term charts show that every market, from bonds to U.S. stocks, to the U.S. Dollar, to gold seems to be nearing important inflection points. I will be watching to see how this unfolds in the coming months.
- Rather than trying to “beat the market”, focus on beating inflation and the rate on cash. Plan for safety and liquidity while seeking positive returns.
- Equity valuations are very rich but masked due to the distortion of the Treasury curve. Volatility is returning to the markets and I think long/short managers are best positioned to capture this volatility by owning companies with strong businesses, barriers to entry, and good valuations and selling short weaker companies with high debt loads that have risen sharply with the broad market rally. I think this strategy of hedged equity may have the potential to produce attractive risk-adjusted returns if and when investors begin to question the valuations of companies. Stock investing involves risk including loss of principal. No strategy ensures success or protects against a loss. Long positions may decline as short positions rise, thereby accelerating potential losses to the investor.
- Monsoon country investments. Attempting to take advantage of demographic, educational and investment possibilities in the countries surrounding the old spice routes of the Indian Ocean. International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets.
- A potential U.S. infrastructure upgrade cycle may be around the corner. Moving from our current grade of D+ to B would require an investment of $3.6 trillion by 2020.
- Supply problems remain high across the energy asset class. While there isn’t a current shortage of energy on the planet, it is taking more and more energy and capital to discover, drill, transport and refine it. Long term Demand should continue to grow globally, particularly in China, India, and other developing countries.
- Potential food shortages due to inclement weather and higher demand from the emerging Asian middle class could result in a boon to agricultural land and potash fertilizer companies. International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.
- The rise of E-Commerce has coincided with an increased desire for efficient warehouse distribution real estate. As e-commerce moves toward even faster delivery, positioning of distribution becomes even more important.
- Precious metals mining companies were extremely beaten down from 2012-2015. They just finished their second consecutive year of gains and may offer further opportunity. Mining is an industry that spans hundreds of years. Companies that mine for commodities are often highly cyclical, meaning they have sustained moves both up and down. When investing in the mining space it is important to be a contrarian. Ideally, you would want to accumulate miners when sentiment is poor around them and sell them when sentiment is positive. Historically this has been a good strategy.
No strategy ensures success or protects against a loss.
Colin B. Exelby
Celestial Wealth Management
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