What's Going on in the Markets October 7, 2018

Last week was one of the "worst" for the stock markets in many months, even though the S&P 500 index was barely down 1%, and the Dow Jones Industrial average remained virtually unchanged. However, the tech-heavy NASDAQ lost 3.2% and small capitalization stocks were down 3.8%. International stocks declined about 2.35%.

The proximate "cause" of the weekly decline was blamed on fast rising bond yields (when bond yields go up, that means bond prices go down). The ten-year treasury note yield rose 0.16% to 3.2%, while the 30-year treasury bill rose 0.20% to 3.4%.  These are their highest levels since July 2011 and August 2014 respectively.

Despite a weaker than expected September monthly jobs report, with 134,000 jobs added in September (185,000 were expected), we are seeing wages grow 2.8% year-over-year, while the unemployment rate has declined to match the low of 3.7%, last seen in 1969. Wage inflation is the biggest threat to stable prices, and portends more aggressive interest rate hikes by the federal reserve in the future.

Too Much of a Good Thing?

With the economy hitting on all cylinders, jobs are plentiful and consumers are extraordinarily confident. In fact, the latest survey from the Conference Board puts the September reading of the Consumer Confidence Index at the highest reading since September 2000. Paradoxically, frothy confidence and complacency typically coincide with a run up to a final bull (up-trending) market peak.  With five out of the last seven bull market tops over the last 52 years, exceptionally bright consumer outlooks peaked coincidentally with the S&P 500, and declined with the onset of a bear (down-trending) market. The only exceptions were 1980 and 1987, when the bear declines were driven by an abrupt monetary shock.  So even though we are in the midst of a “Goldilocks” economy, a significant downturn in consumer confidence could negatively impact the economic outlook.

Since the financial crisis of 2009, the Federal Reserve has kept interest rates abnormally low, and is currently committed to a gradual path to normalization. There is a fear, however, that the Fed might fall behind the curve and could be forced to move faster than expected. That increases concerns that interest rates might push the economy into a recession.

Time to Get Defensive?

Over the past couple of weeks, as the number of stocks that were advancing (versus those that were declining) saw deterioration (despite the indexes setting new all-time highs),  we started getting more defensive in client (and my personal) investment portfolios by selling some partial positions and increasing market hedges. This past week, we saw some further stalling and heavier volume selling in the markets than we have seen in quite a few months. For client portfolios, we already had reduced exposure to the markets, and with the recent increased institutional selling, I plan to slightly further reduce exposure on rallies in the coming weeks.

Everybody seems to be expecting a 4th quarter (November/December) post-mid-term election rally, which makes me a bit suspicious that we might not get one. The 3rd quarter of a mid-term election year is usually biased to the downside, but instead, this time around, we went on to make new all-time highs. Did we pull forward 4th quarter returns into the 3rd quarter? We'll soon find out.

If you're not inclined to sell anything, thereby recognizing capital gains this year, you could consider 1) making use of inverse funds (also referred to as bear market funds); 2) buy put options to hedge your portfolio; and/or 3) sell call options against stock and ETF positions on bounce-backs, the first of which I expect to see early this coming week.

But don't let the tax "tail" wag the investment "dog"; take some chips off the table while you can, not when you're forced to. In these algorithmic and high-frequency trader driven markets today, the velocity to the downside, as we saw in January earlier this year, can be stunning. Also, don't forget that if you sell something in your IRA or 401(k), you won't be generating any taxable capital gains.

With interest rates clearly headed higher, I wouldn't be moving money from stocks to bonds as a defensive measure right now. As this past week attests, both bonds and stocks can go down at the same time, leaving cash or inverse funds as a couple of feasible places to "hide out" on a fraction of your overall investment portfolio. A buy point in bonds will be coming soon, but one should wait until they stabilize. If you find yourself overweight in bond exposure, a rally is sure to come, which you should take advantage of to reduce exposure.

Know Your Risk

To be clear, I may be early & wrong, but growth and bellwether names have been getting hit hard of late. Any measure of risk management over the last 9-1/2 years has reduced overall returns to be sure. And if you have a very long term time horizon, this may turn out to be a garden variety 5-15% pullback on our way to new highs, so you may choose to do nothing.

With interest rates finally rising meaningfully, institutions showing some inclinations towards selling (which we haven't seen since January-February), some key sectors  faltering (such as financials and housing), and consumer confidence at all-time highs, this is a time to protect market profits and capital. If you're fully invested, it can't hurt to take some of your bull market gains off the table.

As mentioned above, the current period around mid-term election years is usually a strong one, and economic and corporate profit strength are at record highs, so this may be a normal correction on our way to new stock market highs. The last quarter of this year and first quarter of next year have historically been very strong, and that's what I'm expecting. But just in case it isn't, it may be prudent to somewhat reduce exposure here.

I am not calling for a bear market or market crash. I see nothing out there to panic about right now. You can bet that if I see anything like that brewing, you'll be hearing from me again, urging you to drastically reduce market exposure.

As always, this article is not a recommendation to buy or sell any securities. I may not be your portfolio manager or financial planner, know little to nothing about your risk tolerance, time-frame or financial goals, so I can't really advise you. I am only sharing what I'm seeing after a prolonged run in a persistently accommodative monetary environment, which is getting less so (central banks, federal reserve tightening monetary policy and raising rates). This might turn out to be the pull-back to buy instead of sell, but if you don't have cash ready on the side to invest, can you really take advantage of it?

If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first. If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch. We start with a specific assessment of your personal situation. There is no rush and no cookie-cutter approach. Each client is different, and so is your financial plan and investment objectives.