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This Current Bull MarketSubmitted by Integrity Advisory on February 8th, 2018
By Matt Ahrens, CIMA®
The S&P 500 had just eclipsed over 400 days of market growth without a 5% or greater pullback. That all came to a dramatic end on February 5th. The Dow Jones Industrial Average made its own record that day, with a drop of 1,175 points. That’s the largest single day points drop in history. In many ways, it may be a blessing that the painful drop is happening quickly. Better to pull off the Band-Aid quickly than create a slow and agonizing pain.
It’s in these moments that we must keep our investment bearings. Corrections of 10% used to occur with regularity, and as often as once a year. We have been stating for months that a correction would be healthy for this market, but that this is likely a time to invest cash not raise it.
Typically, drawdowns and corrections recover very quickly. Looking at the below chart you can see that since 1945 we have experienced drawdowns of 5 – 10% 77 times. The average amount of time to recover from that decline is one month. As such, making moves in portfolios to become more defensive now would likely just lead to missing the rebound.
Investors have legitimate concerns as to the length of this current bull market. Scott Minerd is the Chief Investment Officer of Guggenheim Partners, and a favored bond portfolio manager at Integrity Advisory. In a recent Barron’s article, Minerd quoted an old stock market adage that “Bull markets don’t die from old age.” They are typically ended by a change in Fed policy or “by some exogenous event.” To that end, we have been keeping an eye on interest rates for a couple of years. In our September 2016 commentary, we suggested that Fed interest rate policy would find itself in a difficult situation. You may recall the following figure:
This figure is a standard, upward sloping yield curve. This yield curve is typical of economic expansion. What we have seen recently is a flattening of the yield curve as short-term rates have risen by Federal Reserve policy, and long-term rates have held relatively steady due to market pressure. Flattening of the yield curve is a cautionary tale, but not the red flag like an inverted yield curve.
As you can see in an inverted yield curve, the rates are lower for longer dated bonds. Banks consider longer dated bonds to be riskier than short term bonds, which is why borrowers are charged more for long term loans. If banks can get more return for short term loans than for long-term loans then what do you think they will do? They’ll make more short-term loans to control their risk which will create a liquidity crisis, and then we will have reason to worry.
HOW WE ARE APPROACHING 2018
When it comes to portfolio construction, one of the biggest questions every investor should ask is “Where is the performance coming from?” When I review active managers for our clients I always ask myself the same question. Some managers beat or keep up with the market because they take more risk. If a manager is beating their index just because they’re taking more risk than the index, then the performance numbers look great, but they’re misleading. These high-risk managers are great in up markets but are cause for heart burn in volatile markets. We prefer to focus on risk-adjusted returns. To put it another way, how much bang for the buck are we getting?
Think of it as having two options. Behind door number one is a portfolio taking the same amount of risk as the market and giving you the same or slightly better returns. Behind door number two is a portfolio matching the market returns but taking less risk. Because they’re taking less risk then they should have less downside risk than the market. In recent months, we have opted for door number two. Not because we think this bull market is done, but because we think volatility is back to stay and the bear market is likely 18-24 months away.
Before you start worrying about the approaching bear market please remember that there should be red flags indicating the end is near...bear markets usually end in euphoria not fear. Fear remains in this market, so the end is not here now. As such, we are not making any major changes in portfolios based upon market activity these past few days. If anything, we are investing available cash in preparation for a market bounce. But we already made changes to portfolios in preparation for more volatility. 2018 still has the potential to be a strong year, and despite the poor start to February there are still plenty of reasons to be optimistic.
1 Copyright 2017 Ned Davis Research, Inc.