An Update to the Current State of the Market
By Greg Berg, CFA, CAIA – Senior Vice President & Senior Portfolio Manager
After an extraordinary advance in the S&P 500 of nearly 60% from the low in February 2016, which included gains of 21% in 2017 and 6% in January 2018, the stock market had a long overdue 10% correction in the last week from the recent record highs.  Ironically the correction has occurred at a time of strength in global growth and corporate earnings.
Corrections are normal, healthy, and to be expected when investing in equities.  Historically, a 5% correction occurs three times a year, a 10% correction once a year, and a 15% correction once every fifteen months. A correction has been overdue as the stock market has not had a 5% correction in two years, which is highly unusual. We entered 2018 expecting a typical 5 -15% correction at some point during the year.
The main driver of the recent market selloff was the sharp rise in interest rates as the 10-Yr. U.S. Treasury Yield spiked 45 basis points from 2.41% at the beginning of the year to the 2.85% level.  Bond yields are rising due to strong economic fundamentals and firmer inflation data that includes a jump in wage growth to a 2.9% annual rate, the fastest since 2009.  The perception of a continuing rise to 3% or higher in 10-Year yields and higher inflation began to stoke investor concerns that the Federal Reserve would raise rates more aggressively this year increasing the risk of a slowdown or possibly a recession.  We see inflation slowly rising toward the Fed’s 2% target and interest rates moving gently higher.
An additional driver of the speed of the selloff is the surge in leveraged passive investments (ETFs, ETNs) and algorithmic trading strategies (short volatility, risk parity) in the market over the last decade.  The recent spike in market volatility to more normal levels from a historically low level caused many of these strategies to reallocate and rebalance exacerbating the market selloff.
Economic Fundamentals Remain Strong
The good news is that economic fundamentals continue to be strong.  Global growth is expanding and is remarkably synchronized and broad, which is extremely rare. The current economic environment is the best in a decade.  In the U.S., growth is expanding with low and gently rising Inflation and interest rates.  The risks of a recession are low at present.  Corporate earnings have been excellent and earnings are poised to gain 15 to 20% in 2018 aided by the tax reform act passed in December.
Valuations are More Reasonable
Valuations have been a concern. The forward price-earnings (“PE”) ratio at the end of January was 18.4 times earnings compared to the 25-year average of 16 times earnings.  After the recent selloff, the forward PE ratio dipped to 16.9 times earnings and is more in-line with long-term averages.  Stocks still look more attractive than long-term bonds especially as interest rates are beginning the long path of normalization higher.
Asset Allocation and Portfolio Positioning:  Keys to Long-Term Success
At Central Trust, we have been actively rebalancing accounts in recent months as equity weightings have grown after the strong stock market advance in the in 2017.  We continue to be dynamic in our asset allocation, making adjustments as changes occur in the investment landscape.
Our base case for 2018 calls for continued synchronized, improving global economic growth, still accommodative monetary and fiscal policy, and low, but gently, rising inflation and interest rates. We remain moderately overweight equities and underweight bonds in globally diversified portfolios. At this stage in the cycle, we see benefits from global diversification and have increased exposures to international developed and emerging markets equities.   Within fixed income, we favor shorter duration, high quality bonds and up-in-quality credit sector bonds.   Gold, alternatives and cash act as portfolio diversifiers.  In a late cycle environment, we continue to be watchful for signs of deterioration in economic and financial market data.
Higher short-term volatility doesn’t require changes by clients/investors with a solid investment plan in place that fits their financial situation, goals, risk tolerance and timeline. If anything has changed in your personal financial situation, please don’t hesitate to reach out to your team at Central Trust.
In summary, the days and weeks ahead in the stock market are likely to be bumpier than the period of unusually low volatility we have experienced in recent years.  We remain constructive on the stock market but expect lower returns and more volatility compared to last year.  A balanced portfolio between stocks and bonds, as well as other assets, that is diversified globally will dampen volatility in client portfolios.  We view the recent stock market volatility as a correction in the context of an ongoing bull market that has additional time to run as global growth continues to expand.