We believe education is the strongest defense against the vagaries of the market. Each quarter we’ll share with you our perspective and some context about the economy and markets. We hope you find our Relative Strength newsletters interesting and informative.
4th Quarter 2018
The choppy U.S. market conditions of the first and second quarters of 2018 finally began to resolve themselves to the upside in the third quarter. The S&P 500 was up nicely albeit driven by just a handful of Technology names. However, the broader U.S. market gained some traction and performed positively for Q3. International stocks continue to be under pressure and we trimmed our International positions back further in Q3. While Commodities as an asset class did not gain any more strength versus other asset classes, they did perform positively primarily due to the rally in oil prices.
U.S. Equities remain firmly in the number one spot and show no sign of relinquishing that title any time soon. Despite constant news of trade wars and tariffs, the economy has been strong enough for the Fed to continue raising rates. The conventional wisdom is that rising rates are bad for equities but the actual relationship is much more complicated than that. Based on research from JP Morgan Asset Management, rising rates are positive for stock returns until the 10-year U.S. Treasury yield reaches 5%. Rising rates from low levels signal economic strength rather than the Fed applying the brakes to an overheating economy. At quarter end, the 10-year yield was 3.08%. Certainly things don’t unfold the same way every time but the evidence is clear that rising rates do not necessarily mean weakness in equities.
As the economy matures it is likely that we will enter a more volatile period than one that we have experienced recently. This is not uncommon as investors become a bit more skittish about slowing growth and seek to invest in areas where earnings momentum remains positive. Our process is designed to absorb these shifts and unemotionally transition to stronger areas when necessary.
A primary bull market is defined as a long sustained advance marked by improving business conditions that elicit increased demand for stocks. In a primary bull market, there will be secondary movements that run counter to the major trend. There have been five secular bull markets since 1896 and they average 14 years in length.
Stage 1 - Accumulation
The first stage of a (secular) bull market is largely indistinguishable from the last reaction rally of a bear market.
Pessimism, which was excessive at the end of the bear market, still reigns at the beginning of a bull market. It is a period when the public is out of stocks, the news from corporate America is bad and valuations are usually at historical lows. However, it is at this stage that the so-called "smart money" begins to accumulate stocks. This is the stage of the market when those with patience see value in owning stocks for the long haul. Stocks are cheap, but nobody seems to want them. This is the stage where Warren Buffett stated in the summer of 1974 that now was the time to buy stocks and become rich. Everyone else thought he was crazy.
In the first stage of a bull market, stocks begin to find a bottom and quietly firm up. When the market starts to rise, there is widespread disbelief that a bull market has begun. After the first leg peaks and starts to head back down, the bears come out proclaiming that the bear market is not over. It is at this stage that careful analysis is warranted to determine if the decline is a secondary movement (a correction of the first leg up). If it is a secondary move, then the low forms above the previous low, a quiet period will ensue as the market firms and then an advance will begin. When the previous peak is surpassed, the beginning of the second leg and a primary bull will be confirmed.
Stage 2 - Big Move
The second stage of a primary bull market is usually the longest, and sees the largest advance in prices. It is a period marked by improving business conditions and increased valuations in stocks. Earnings begin to rise again and confidence starts to mend. This is considered the easiest stage to make money as participation is broad and the trend followers begin to participate.
Stage 3 - Excess
The third stage of a primary bull market is marked by excessive speculation and the appearance of inflationary pressures. (Dow formed these theorems about 100 years ago, but this scenario is certainly familiar). During the third and final stage, the public is fully involved in the market, valuations are excessive and confidence is extraordinarily high. This is the mirror image of the first stage of the bull market. A Wall Street axiom: When the taxi cab drivers begin to offer tips, the top cannot be far off.
Given the current climate and investor attitudes, we are firmly convinced that we are still in Stage 2 of this current Bull.
As of the writing of this newsletter (October 15th), there has been a lot happening as we transition from the Q3 to the Q4. Both the Dow Jones Industrial Average DJIA and the S&P 500 Index SPX violated their trend lines with Thursday's (Oct. 11, 2018) trading. SPX had been trading in a positive trend since February 2016, while DJIA had been in a positive trend since November 2016. The Nasdaq Composite NASD violated its trend line in Monday's (Oct. 8, 2018) trading; meaning that all three major US equity indices are now in overall negative trends. While the trend reversal of all three indices is certainly a notable event, and definitely merits examining one’s overall positioning in and exposure to the US equity market, it also doesn't necessarily mean that the death of the bull market is at hand.
You may be wondering "When was the last time SPX and DJIA went negative on the same day?" It actually happened not too long ago - both indices violated their trend lines on 1/6/16 (and in similar fashion to this most recent trend change, NASD had violated its trend line two days earlier). The negative trend was short-lived however, as both SPX and DJIA returned to positive trends on 2/22/16 (it took NASD a bit longer, as it did not return to a positive trend until 3/2/16). Between 1/6/16 and 2/22/16, SPX and DJIA were down -2.12% and -1.58%, respectively. Not stellar returns, but, a far cry from a bull killer. Three months after going negative? (1/6/16 - 4/6/16) SPX and DJIA were up 3.84% and 4.79%, respectively. Six months out? SPX: +5.5%, DJIA +5.99%.
Obviously, it's highly unlikely that we will get the exact same outcome this time; however, it does demonstrate that this is not a novel situation. And, while there was a bit of discomfort last time DJIA and SPX went negative on the same day (and all three indices were negative at the same time), ultimately the market recovered and made notable gains inside of three months.
Tumlin Levin Sumner Wealth Management of Raymond James