“Good investors gather information, put that information into current and historical context, then make sound decisions.”
Equity markets spent the entire month of October searching for support. Finally, on October 30th, we saw a significant bottom develop. By that time it had become clear that this was not going to be just another quickie correction, with a one to two week decline and a one to two week recovery. After a -7% decline in the first week, followed by a less than +3% four-day bounce, the Russell 3000 declined for two additional weeks by almost -8%, bringing the total decline to -12% by the 30th. Finally, we saw a significant recovery of over 8% in just one week, only to be followed by another two-week decline of almost -7%. For short-term investors, the past two months has been exhausting. For long-term investors, it has been exasperating.
It has been exasperating for a couple of reasons. First, the timing of the correction. We are at the tail end of the year and suddenly, the modest but comfortable gains realized year to date are missing. Instead of building on those gains into what has historically been the most profitable three-month period, we are going to have to settle for a recovery rally. Second, there were no warning signs whatsoever that a major correction was on the doorstep. Third quarter corporate earnings were coming in better than expected. Third quarter GDP was strong. Mid-term elections held no surprises. Major markets trends were all positive, with fresh breakouts to new highs occurring in several equity market sectors. Fundamentally and technically, the seat belt sign had been turned off.
‘Clear air turbulence’ is the number one reason some people don’t fly, and the number one reason some people don’t invest. All investors understand that financial markets are subject to corrections. Market fluctuations create opportunities. But severe fluctuations can be disturbing, just like severe turbulence. We work to manage the turbulence by diversifying and by paying close attention. Most importantly, we maintain perspective and understand that the reason we invest is for the long-term journey, not in spite of the risk. Corrections come and go. The journey goes on and is its own reward.
International equity markets are having a much rougher time than U.S. equities. According to Morningstar, the average U.S. Tactical Allocation Fund is now down -4.59% year-to-date. Meanwhile, the average Europe Stock Fund is down -10.69%, the average Diversified Pacific/Asia Fund is down -11.37%, and the average Diversified Emerging Markets Fund is down -15.13%. So even in the midst of a major equity market correction, the U.S. equity markets are outperforming the rest of the world.
Bond markets are moving lower to the beat of an entirely different drummer, as interest rates continue to creep higher. Once again referring to Morningstar, year-to-date the average Corporate Bond Fund is down -3.34%, the average Long-Term Government Bond Fund is down -7.13%, and the average High Yield Bond Fund is down -0.79%. Only Short-term Bond Funds and Bank Loan Funds are in positive territory.
Which brings us back to the U.S. equity market and the ongoing correction. Large cap equity indexes are outperforming mid and small cap indexes. The equity market’s strongest performing sectors just prior to the correction were sold down the hardest, which is an indication of rebalancing as opposed to capitulation. The hardest hit sectors were energy and technology. The strongest sectors were utilities and consumer staples. From a technical perspective, the basing formation most resembles a double-bottom. From a time frame perspective, equity indexes are two months in and, should this double-bottom hold, that projects to a two-month recovery period. We certainly don’t want to miss that recovery rally, and we are not interested in making any tricky adjustments in this highly volatile period. The watchword is patience.
© 2018 Edward D. Foy
Sources: Bloomberg, Marketwatch, StockCharts