Client Letter – What is Behind Recent Market VolatilitySubmitted by Alsworth Capital Management, LLC on February 14th, 2018
We have recently experienced a string of bad days in the stock market, that has created anxiety for some clients. We started 2018 on a strong footing, with the first three weeks of the year up very strong. Investors bid up stocks, reflecting a continuation of global growth trends. Growth in the US has been positive, albeit tepid, and there are no signs of recession or a slowdown. Over the past year, growth in Europe has surged, outpacing the US and Emerging Market economies are picking up steam as well. US stocks got a further boost from the Republican tax law, as estimates of corporate profits surged on the news of dramatically lower tax costs. The stock market was looking rather exuberant. Then all of a sudden, we had a big drop in stocks on Friday February 2nd, dropping 666 points in the Dow Industrial Average index. Though, some outlets were reporting this as a 665-point drop, to avoid the negative connotation of the biblically significant number! Then on the next trading day, the Dow Industrial Average dropped 1,175 points, the largest ever point drop in a single day for the index. This was newsworthy, and I understand the anxiety. However, to put this in perspective, the two-day decline merely wiped out the early January gains in the market, leading to an index value that was barely lower than the value at the start of the year. As of this writing, the market has had some further declines, followed by some strong up days and currently stands about flat on the year.
So, what happened? First and foremost, the US stock market continues to trade at high valuations. This isn’t a metric that can be used to time the market, but it does leave the market vulnerable to “air pocket” large declines like we just experienced. Historical patterns indicate that this probably isn’t the last air pocket decline in the foreseeable future and you should be psychologically prepared for that possibility. The most significant development, in my mind, was in the bond market. Just a month ago, I wrote about the spike in yields in the bond market and the fact that the stock market seemed to ignore it. When bond yields rise, it makes the present value of future income worth less. In other words, the value today for an asset that pays you income in the future (stocks, bonds, real estate, etc.) should decline. Stocks are particularly reactive to higher interest rates, just as they benefited tremendously from the low interest rate environment of the last decade.
In recent months, bond investors have been demanding higher interest income to buy newly issued government bonds. When the US Government spends more than it brings in from taxes, it must borrow the money to cover cash flow. The way they borrow is to issue new bonds. These are just pieces of paper that say that they promise to pay back the money to any buyers of their bonds, along with interest. As the risk to repayment goes up, the interest that investors demand must go up. However, the US Government can’t really go bankrupt. They could just print more money to pay back their bond obligations. So, they are considered, risk-free. But, everything in finance is interconnected. As the government prints more money or becomes less solvent, it reduces the value of the US dollar currency, making investments that pay back US dollar’s in the future less attractive. If you buy a 10-year bond today, you might give up 1,000 US dollars now in exchange for getting a stream of US dollar interest payments of perhaps $28 per year (2.80% interest rate). You also expect repayment of the bond at maturity in ten years, receiving back your 1,000 US dollar initial investment. If you worry about a weak dollar in the future, which will buy less stuff, you will demand more interest income for taking the risk of giving up your US dollars today. Long story short, the value of US Treasury Bonds declines as the government’s finances look more dubious. As the value of the bonds decline, the interest rate that needs to be offered to induce a buyer, goes up. Almost every asset in the world is going to trade in relation to the bell-weather, risk-free, US Treasury Bond. So, any changes in that market have a big impact on all assets across the globe.
So, what changed? The US National debt is approaching $21 Trillion now and it is rising more rapidly as interest rates rise. The government keeps running huge deficits and needs to issue new debt constantly, now at higher interest cost, to fund expenses. Corporations loved the recently passed tax cut and their profits are going up as a result. This is great for stocks. However, that also means the government is collecting less revenue to pay off old debt. In addition, Congress passed a spending bill last week that could add an additional $300 billion to the debt. According to the Committee for a Responsible Federal Budget, the spending deal and the tax bill combined could add some $4 trillion to the national debt in the next 10 years. One statistic that doesn’t need to rely on forecasts is our current funding need. The US Government is going to need to borrow nearly $1 trillion in 2018 just to pay the bills. This is an 84% increase versus 2017 and the increase is solely attributed to the new tax cut law. It does not yet factor in the recent spending bill. There doesn’t appear to be a plan to reduce spending and instead there are proposals for badly needed infrastructure spending to the tune of trillions of dollars in new spending. The bond market is getting spooked.
While this is worrisome, it doesn’t necessarily mean the stock market is destined to drop or that the economy is going to fall into recession. I am concerned about the long-term implications of expanding debt and reckless spending on non-productive means. However, the market has plenty of good news to chew on in the short term as well. The good news, which continues to be the case, is that the economy continues to exhibit positive growth. The big change over the last year has been the recovery of international economies. This has created an environment of coordinated global economic growth. The stock market rightly reflects this positive development. What it may not fully grasp is the magnitude of these developments. The fundamentals of the economy remain strong, but the valuations being afforded most stocks are historically high, not reflecting normal cycles, let alone concerns for developing trends like rising interest rates. For this reason, we remain cautious and underweight US stocks. We are not selling our current holdings, as a result of the recent dip. We also are not buying more, since valuations remain too high. We believe that we are positioned to better reflect the risks that remain in the market and we continue to emphasize the areas where we see opportunities, like international markets.
If the recent news has you feeling anxious, I recommend that you look at your account values to make sure you are reacting to your actual experience versus what the news cycle is projecting. If you are still anxious, please give me a call or setup an appointment. We can rationally review our assumptions and your portfolio allocation plan. If your circumstances have changed or our assessment of your risk tolerance is incorrect, it is worth talking through the implications and trade-offs, especially in the context of your long term financial plan.
Shane M. Alsworth, MBA, CFP®, CLU®, CIMA®
The views and opinions presented in this article are those of Shane Alsworth & Alsworth Capital Management, LLC only
Investments are subject to market risks including the potential loss of principal invested.
Asset Allocation does not assure or guarantee better performance and cannot eliminate the risk of investment losses.