Review and Outlook
During the third quarter, the market continued the choppy uptrend that started in April after the broad sell off in February. The first few days of Q4 have ended that, and the uptrend is now in question. The fundamentals for the economy and earnings continue to be positive, against a backdrop of the Fed continuing to tighten monetary policy. The tug of war between these two opposing forces has increased!
It’s difficult to put a finger on the cause for the -5%, 2 day sell-off – it’s not like economic data has suddenly rolled over or earnings data has plummeted. Our best guess is that the market is pricing in forward expectations of an economy and earnings backdrop that looks weaker six months from now than it does currently, given how hawkish the Fed has sounded lately.
While the S&P 500 is still up a little over 4% % for the year, this is largely due to the largest tech stocks. The non-cap weighted S&P 500 is up less than 1% for the year. More than half of the 500 companies in the S&P Index are down 10-20% YTD, and over half are below their 200 day moving averages. US Mid-Caps are down -1% and the Russell 2000 Small-Caps are only up 1 ½%. The rest of the world is doing even worse – Developed International is down – 7% and Emerging Markets are down -15%. We have commented in the last few Outlooks that the rally has become very narrow, and while it doesn’t doom the bull market, bear markets often start with fewer and fewer stocks participating in the uptrend as more and more sectors fall into bear markets – just what we are seeing now.
The rate of selling we’ve seen over the last week is historically significant, and we expect a bounce could develop at any time as the market is very oversold. But we are now more concerned about our longer-term outlook given the technical damage to the uptrend that has occurred. There’s likely more volatility to come in the weeks and possibly months ahead.
We still favor this recent move as a correction and not a new bear market given the economic backdrop. However, a potential outcome over the next year or so is a high degree of volatility with little forward progress – just what we have seen this year! The market has been running for 9 years with largely above average returns, so every investor should make sure they are comfortable with their asset allocation. We never recommend tinkering with your asset allocation in the short term, based on future expected market returns, but we would hardly be surprised with more significant volatility over the next few years.
Equity and Fixed Income Strategy
While our stock selection process – which features high-quality companies with good growth at a reasonable price – has not materially outperformed this year, this is atypical. If our outlook for a future of increased volatility develops, that should benefit our stock picking process and a resumption of longer-term outperformance. Our ETF strategy has outperformed its benchmark (Int’l, Small and Mid-Cap) and our Long /Short strategy may be a source of protection if volatility picks up significantly. Our fixed income approach has been quite conservative given our view for higher rates, but now that rates have moved up, we are looking for opportunities to improve income as yields move higher by extending duration, especially if we get weaker economic news at the margin.