For investors February was a horrible month. The equity markets we follow, both domestic and foreign, posted significant negative numbers. Bonds, normally what stabilizes a balanced portfolio during equity market drawdowns, were lower as well. The commodity index and the US Dollar index were also down for the month.
U.S. & International Stock Index Returns
|Index February 2018 Year-to-Date|
|Dow Industrials (4.54%) 1.25%|
|S&P 500 (4.12%) 1.50%|
|S&P 400 (Midcap) (4.70%) 2.81%|
|S&P 600 (Small Cap) (4.06%) 2.47%|
|MSCI World (4.53%) 5.22%|
|MSCI EAFE (4.94%) 4.99%|
|Bloomberg Agg. Bond (2.09%)|
|CRB Commodity Index 0.04%|
|US Dollar Index (1.51%)|
All data as of 02/28/2018
After the longest period in history of benign equity markets, February 2018 saw the return of volatility in a big way. For the month we witnessed all the equity indices we follow drop at least 4%. Earlier in the month the losses were more than 10% from the January market peak. In 2017 the largest drawdown from peak levels was 3%. A loss of 10% in six trading days is unusual but so is a year in which we never experience a drawdown of more than 3%.
The question we face right now is where we go from here. Experience tells us a quick recovery to new all-time highs is not very likely, nor would it be particularly healthy for the markets. A continued move lower is possible. In Chart #1 we show some technical levels that could become support – The correction’s closing low (2580), the correction’s low (2532) and the August/September 2017 consolidation (2450-2475). Chart #2 shows the relevant technical levels for the Dow Industrial Average.
More likely, in our opinion, is a market that continues to correct over time with continued sideways action. We see the move lower to be less viable due to the underlying fundamentals of the stock market. Since the passage of tax cut legislation publicly traded companies have overwhelmingly reported the positive effects the cuts will have for both earnings and free cash flow. We expect earnings to be noticeably higher than in 2017 while a big chunk of the additional free cash flow is being allocated to increased dividends and stock buybacks. With such a positive forward earnings outlook we feel there is a floor under the market at these levels.
In our January Stock Market Review we stated that we saw the strength in bond yields as being the start of a new bear market for bonds. The move higher on the 10-year Treasury bond yield that began around September 2017 has continued over the first two months of 2018. Markets don’t move in one direction forever. In February yields peaked mid-month at 2.94% before easing off to “just” 2.86% at month’s end.
We cannot be sure how high rates will go. Our expectation is that the move above 2.60% will hold and very well could be tested in the coming months. We think it is likely that at some point this year we will breach the 3.03% yield discussed last month as the technical break necessary to confirm a bond bear market. Add in the strong economy, The Fed indicating three short-term interest rate increases this year, and inflation concerns, the probability of lower rates further diminishes.
The US Dollar Index rebounded in February after a weak start to the year. While the 1.84% gain during the month of February is positive, we question the firmness of the recent strength. Technically the positive divergences in RSI and MACD give hope for the dollar going forward, but we also know that fundamentals can also be powerful at times of change. Currently we see two fundamental issues that could decide the fate of the dollar.
Interest rates, which have been increasing since the start of the year have been moving higher at a faster pace than rates over in Europe and Japan. If this trend continues it may lead to more foreign funds coming into the Treasury market and have a strengthening effect on our currency. We will continue to monitor not just the trajectory of rates, but the spread as well.
The other issue of concern is trade in general and specifically President Trump’s announcement of tariffs on imported steel and aluminum. The fear we have about the president’s proclamation is that this could be the start of a trade war. European government officials have forcefully pushed back. Former Nucor CEO Dan Dimicco, who has been closely aligned with the president and helped develop his economic plan, recently indicated on CNBC that the March 1 tariff announcement was just the beginning of the United States “fighting back” against unfair trade practices. How this turns out or the effect on the dollar is anyone’s guess at this point.
Last month the commodities index looked like it was breaking out to the upside from a cup pattern that formed over the entire 2017. For better or worse the index broke down, attempted to break back above the 196 level, before failing to again hold this key technical level. Heading into March the only positive we see is that the 50-day moving average (the indicator we use as an indicator of short-term strength or weakness) has so far held.
As we stated earlier in this piece, while we do expect there to be more stock market volatility with a possible retest of the February lows, we also see continued strong economy and tax-boosted corporate earnings as protection against a full-blown bear market. The February correction, albeit a very quick move downward, was only seen as out of the ordinary because of the speed of the move. Normal bull markets see drawdowns on a fairly regular basis.
We enter March with the bulls and bears battling for control of the stock market. We believe that the bulls will win this battle. How long this fight lasts we cannot predict.
Of more interest to us right now is the reality that we are in a time of change. For better or worse the background for the equity markets from the 2009 trough until late last year was basically the same – fear of deflation, extraordinarily low interest rates, no fiscal stimulus from the Federal Government, low commodity prices, and a relatively strong US dollar. All of this, it seems, has been flipped on its head, making the longer-term outlook murkier than we would like.
The stock market is affected by all these things. With change comes uncertainty. For example, when rates were pinned at very low rates the markets knew what that would mean and could adjust. Now that we have a rising rate environment there is more risk. The risk that an overstimulated economy will require steeper increases; the risk of higher inflation or a weaker dollar; the risk of larger federal government deficits and a flood of new debt being issued as a result. Markets are interrelated and do not exist in a vacuum.
This could all turn out just fine. Or not. This is the reality of investing in a time of change.
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Robert I Cahill, Managing Partner Rob.Cahill@wfafinet.com
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