The market continued to grind higher in the third quarter, dodging several bullets along the way. Among the market’s many potential setbacks were an increasingly provocative North Korea, devastating hurricanes, dysfunction in Washington D.C. (not sure if this is even worth mentioning anymore), and a more hawkish tone and policies from the Federal Reserve. Ordinarily, any one of these could have triggered a garden variety 5% market pullback.
For the quarter, the S&P 500 advanced 4.44%, representing the 8th consecutive quarter with positive returns. Small cap stocks played catch up with a 5.61% quarterly return and non-U.S. stocks fared well with a 5.35% return. Bonds were relatively flat gaining 0.84% for the quarter.
We head into the fourth quarter with the U.S. and global economic expansion on seemingly solid footing. By most measures, the U.S. stock market remains pricey. However, investors remain willing to pay a premium for the solid growth prospects and the stability of U.S. companies; at least for the time being. Inflation and interest rates remain low, and corporate earnings are growing at a steady clip both in the U.S. and abroad, all providing a decent backdrop for global equities and supporting a low volatility environment.
Outside of the potential for an international incident involving North Korea, Congress, the Federal Reserve, and of course, the President, will likely be driving the news flow and the markets in the fourth quarter. Congressional debates on tax reform, which include a proposed reduction in the corporate tax rate to 20% (currently 35%), are set to take center stage. Furthermore, the Fed will have an active last few months of the year as it begins to undo its massive stimulus program by reducing its over-enlarged $4.5 trillion balance sheet in October and consider another .25% interest rate hike in December. Not to mention the fact that Janet Yellen’s term expires on February 1, 2018. President Trump has begun interviewing candidates for the position including Yellen herself. The markets will be watching and responding to these real time developments.
Investors should stick with their targeted allocations to U.S. and foreign stocks. However, those with heavy exposure to the blistering U.S. large cap growth sector should consider taking profits. Furthermore, maintaining some exposure to U.S. Treasuries and high quality bonds is an effective means of shielding your portfolio in the event the situation with North Korea takes a more serious turn or another unforeseen shock develops.
Steady Global Economic Activity
It took a while, but the global markets have made up some lost ground against the surging U.S. markets. You can see from the chart below that the S&P 500 has been bested by the All Country World Index (excluding the U.S.) by a fairly wide margin in 2017.
Favorable valuations, a weakening U.S. dollar, and an upswing in economic activity have attracted investors after several years of uninspiring performance of international markets. The chart below shows the PMIs (Purchasing Manager Index) for both developed and emerging markets. In 2016, both surveys, which reflect the strength of underlying economic activity, turned positive and continue to improve in 2017. Readings above 50 indicate economic expansion; whereas, those below 50 suggest contraction.
This trend will likely continue into 2018, suggesting investors maintain decent exposure to non-U.S. developed and emerging equities.
What about North Korea?
Trying to invest around a possible geopolitical shock, like the current situation with North Korea, can be difficult at best. Nobody knows if, when, or how a potential crisis may unfold and all the ramifications. Sure, it’s possible the current situation with North Korea gets worse and some type of full-blown crisis develops, sending global stock reeling. It’s also possible that the current situation lingers on for years or even improves with some unforeseen diplomatic breakthrough, resulting in a relief rally. So what’s an investor do?
If a war or another negative event does take place, it will likely result in investors’ selling risk assets which do poorly in uncertain times and buying safer assets such as U.S. Treasury bonds. Treasury bond prices will likely go up as yields fall given the heightened demand. Therefore, incorporating government and other high quality bonds into a diversified portfolio to serve as a form of stability makes sense even if you don’t require the income from the bonds.
History is riddled with wars, international conflicts, and other negative geopolitical events (e.g. Brexit). Depending on the nature of the event, some last longer and have more pronounced effects than others. Over the long run, the markets adjust and recover. The longer an investor’s time horizon, the greater the ability to ride out negative market-moving events. Those with shorter time horizons require more safety; thus, a higher allocation to Treasuries and higher quality bonds (but lower return) investments. Those with longer term horizons (greater than 10 years) should be prepared to ride out the inevitable storms that come and go over time.
Where has all the Volatility Gone?
Other than a few bumpy days over the summer, it’s been a remarkably quiet ride up this year. In fact, the S&P 500 hasn’t had a minor 3% pullback since the week before the election last November. On November 10th, this will become the longest stretch without a 3% or greater correction since 1928, eclipsing the record 256 trading days set in 1994-1995. This data point in itself doesn’t mean that a market correction is imminent; rather, it does suggest this period of exceptionally low market volatility has been anything but typical.
September exemplified the lack of volatility in the markets this year. For September, which is typically the worst month of the year for the markets, the S&P 500 gained 2%. According to The Wall Street Journal’s Market Data Group, the trading range (from highest to lowest close) for the month was a mere 2.1%, marking the least volatile September in 66 years.
The lack of a minor or major pullback in the market has created an uneasy feeling amongst investors that a significant market drop is lurking around the corner. Indeed, the queasiness isn’t without merit. Historically, 5-10% corrections in the market have happened quite regularly. As you can see from the chart below, since the 2008 financial crisis, there have been 10 corrections (shaded in blue) where the market has dropped by 5%-20%.
That chart also makes it quite evident that following 2016 that it’s been a while since we’ve had a market pullback. The takeaway from this chart is not that a correction is imminent. For all we know, the market may rise for several more years before the next major downturn. Will we ever have another significant drop in the market? Definitely. Can anyone accurately predict when it will occur? No.
The best we can do is not let the relative calm lull us into taking more risk than we would otherwise take under more normal (i.e. volatile) market conditions. Or, the opposite situation, where we avoid taking any risk because we expect a significant fall in the near future.
With the global recovery on track, investors should maintain both U.S. and foreign stock exposure. However, those with high exposure to large growth companies should consider taking some profits and potentially redeploying to large value stocks if currently underweight.
Despite their banner year, emerging market stocks and bonds still reflect decent risk/return profiles as opposed to junk bonds which are trading with very thin spreads with relatively low absolute return profiles. Despite uninspiring yields, short to intermediate term U.S. Treasury and investment grade bonds offer the safety that stocks and low grade bonds don’t in the event of a market setback.