Now that the dust has settled on the first quarter of 2018, investors are trying to figure out what this renewed volatility means. Although we experienced a drop of roughly 10% in February, the overall return for the first quarter was a negligible loss: if you invested in an S&P 500 Index Fund, such as SPY, you had a return of -1.00% through March 31.
For the most part, portfolios were close to flat for Q1. Nevertheless, investors are quite concerned about where we go from here and worry that we may have more losses ahead in 2018. Here’s what we think:
1. Technical Analysis. The 200-day moving average, a key level of support, has held since February. The market went straight up in December and January, and the subsequent pull-back simply returned prices to the longer-term trend line. We have not seen a crossover of the 60 and 120 day averages, which would be expected to precede a prolonged downturn. Presently, the Q1 pullback appears to be a temporary correction and is not worsening.
While that could change in the months ahead, we will continue to use an evidence-based process to examine the trend. For investors who want to be more nimble, we are now offering the Equity Circuit Breaker, which uses Technical Analysis to move in and out of the market based on these trends.
2. Fundamentals. The economy remains strong. Leading Economic Indicators suggest that the potential for a recession in 2018 is extremely unlikely. Unemployment is so low that many employers are now finding it difficult to fill positions and are having to raise wages. All of which provides a positive backdrop for the stock market.
3. Bonds, however, have turned negative in the past six months. The Federal Reserve has increased short-term interest rates through the Fed Funds rate, and has planned another two or so rate hikes in 2018. As rates go up, the price of bonds goes down. The total return of the US Aggregate Bond Market, if you invested in the AGG exchange traded fund, was -1.47% for Q1.
Short-term rates have crept up to nearly 2% on a 1-year T-Bill, but the yield on the 30-year Treasury bond has hardly budged and is only 3.03% today. If the yields on long-term bonds had moved as much as short-term rates, the return of the bond market would have been worse than it was in Q1.
Anticipating more rate increases ahead in 2018, I think investors would be smart to seek out the safety in short-term, high quality bonds, like 0-2 year Treasuries. There remains a high risk for those in long-term bonds. The chase for yield in recent years drove the price of junk bonds to very high levels. We sold our position in high yield last summer, as we posted here on August 13. Since that time, prices have moved down on junk bonds. If you really want to understand the economy, follow the bond market.
4. Total Return. While a large drop in the price of the bond market is unlikely, it seems very possible that returns could be zero or negative for 2018. This is a tough market for investors who want income, and what income is available today comes with elevated risks. We think that investors would be well served to invest with a total return objective rather than investing for income or yield.
5. Volatility is back. Three thoughts on risk and investing:
- Diversification is crucial. That’s why we invest in broad-based ETFs as our core holdings. Don’t risk too much on any one stock, sector, or country.
- Asset Allocation, specifically your weighting in bonds, remains the best measure to achieve a targeted level of risk and return for a portfolio.
- Quarterly fluctuations are mostly just noise for long-term investors. Focus on what you can control and the markets will likely serve you very well over your decades as an investor.
2018 is already proving to be a harder year than 2017 for investors. We will continue to watch the market closely so that we can provide informed, timely guidance for you. What is most important, however, is to have a strategy in place for your personal situation. Is your investment allocation optimized for your needs, time horizon, and risk preferences? If you don’t know – or know that it is not – we need to sit down and go through our financial planning process first, before we make any conclusions about how you are invested today.