Apr 17, 2018 1st Quarter 2018 Commentary

 

Market Summary

After an unusually quiet 2017, market volatility increased in the first quarter. U.S. stocks, as measured by the S&P 500, reached an all-time high in late January before finishing the quarter down approximately 8% from this high. From January 26th through February 8th, the S&P 500 was down more than 10% which marked the first 10% correction since 2016. However, for the full quarter U.S. stocks were down less than one percent. This ended a streak of nine consecutive quarters of positive returns and February’s loss ended a record streak of 15 consecutive months of positive returns.

Stock market breadth and momentum deteriorated during the quarter, but the longer-term trend of stocks remained positive. Growth stocks outperformed value stocks – the S&P 500 Growth Index returned 1.9% and the S&P 500 Value Index returned -3.6%. Smaller stocks outperformed larger ones as the Russell 2000 finished the quarter down -0.1% versus -0.8% for the S&P 500. Internationally, a weaker US dollar helped support international indices as emerging markets rose 1.3%[1].

Bonds, as measured by the Bloomberg Barclays U.S. Aggregate Index, lost 1.5% for the quarter – their first negative quarterly return in over a year. This marked the first time since 2008 that both U.S. stocks and bonds were down in the same quarter[2]. This has happened only eight times over the last thirty years. The Federal Reserve continued its policy of steadily raising interest rates as Jerome Powell became the new Federal Reserve Chairman. He replaced Janet Yellen on March 21 and announced another .25% increase in rates from 1.25% to 1.5%. Market expectations are for the Fed to raise rates two more times in 2018. Below is a summary of returns for the major indexes[3].

 

The Return of Market Volatility

Stock market volatility rose during the quarter as stocks made some of their biggest moves in months. Over the past three months, the CBOE Volatility Index (the VIX index shows the market’s expectations of 30-day volatility by using the price of options on the S&P 500.) posted its largest quarterly rise since the third quarter of 2011, jumping 81%[4]. The big jump in percentage was mostly due to its low starting value and not its ending value. In fact, the VIX finished the quarter near its historical average[5].

After going all of 2017 without a one day move of 2% or more in either direction, the S&P 500 had six such moves in the first quarter of 2018 (one day with a 2% gain and five with 2% declines)[6]. The increase in volatility was due to several factors including Federal Reserve rate hike fears, trade tensions with China, inflation pressures and the prospect of new regulations on tech firms like Facebook and Amazon. Below is a chart comparing the S&P 500 Index to the VIX. January 26th represents the peak of the S&P 500 index[7].

 

Stock Market Corrections Are Normal

Many academics have argued that stocks produce a return above the risk-free rate precisely because they are riskier. This concept is based on the idea of a risk-reward tradeoff. The excess return of stocks compared to bonds compensates investors for taking on the relatively higher risk of equity investing. One of the risks of stock investing is that correction can and do occur relatively frequently. For example, last quarter’s correction marked the sixth market correction during the current bull market from 2009 to today. The S&P 500 has fallen an average of 14% in the last five selloffs and the average correction period was about 200 days[8].

The chart below shows how often downturns have occurred over the past 117 years. It uses the Dow Jones Industrial Average as a proxy for U.S. stocks and shows that 10% corrections have occurred about once every year and they have lasted 115 days on average[9].

In addition, from 1980 through 2017, the S&P 500 had an average intra-year decline of 14% and in over half of the years it had a correction of 10% or more. The chart below demonstrates this. The gray bars represent the S&P 500 return for the year while the red dots show the maximum intra-year decline[10].

Current Conditions

After a strong 2017 and strong start to 2018, some investors may have become slightly unnerved by the increased volatility. While we acknowledge the risk associated with protectionist U.S. trade policy, we expect positive economic growth this year. Inflation remained moderate, interest rates remained low by historical standards and unemployment numbers were near record lows. In addition, corporate earnings growth reached record levels last quarter, in large part due to the effects of the new tax law. Finally, although the trend in stocks deteriorated, the overall trend remained modestly positive

The biggest risk we continue to see is that stock market valuations (particularly U.S. stocks) finished the quarter near all-time highs. While valuations are not a good indicator of short term returns and they are not a precise tool, they are a reasonable indicator of future long-term returns. The high valuations of today skew the probabilities toward lower future returns. The below table shows that most measures of U.S. stock valuations are extremely overvalued compared to their history[11].

Response to Recent Volatility

Times like these may cause investors to question their holdings and ask “what should be done?” We did not make any broad portfolio allocation changes since the correction began in late January. We made changes to our models late last year and early this year before the correction began. The specific changes were slightly different for each model, but the broad impact of the changes may have added diversification and made sure we hadn’t developed excessive equity risk.

Given today’s environment of high stock valuations and low bond yields, it is important to manage these risks. Especially in retirement accounts, where tax distributions are not a problem, our models rebalanced into alternative asset classes. The alternatives we selected can have less equity risk than stocks, can have lower interest rate risk than bonds and may help diversify portfolios. However, they do not offer a silver bullet and they have their own risks to consider. They tend to be more complicated, more expensive, and can be less liquid. We acknowledge these issues and believe we have the proper tools and processes to effectively manage them.

Over the course of a normal market cycle, far larger stock drawdowns than last quarter should be expected. It is important to find the proper allocation for your specific risk tolerance and time horizon rather than trying to avoid short term losses.

As always, please call if you have any questions or would like to discuss in more detail.

 

[1] Mstar Direct. As of 4/2/2018

[2] David Schawel

[3] Morningstar Direct. As of 4/2/2018

[4] Wall Street Journal

[5] Historical average of 18.5, ended the quarter at 19.97. CBOE data from 1/2004 – today

[6] MarketWatch

[7] Both the 2018 peak and the all-time peak. Charles Schwab. As of 3/27/2018

[8] Bloomberg, “The Lesson From Stock Market corrections Past? 200 Days of Pain”

[9] Capital Group

[10] JP Morgan, Guide to the Markets

[11] Ned Davis Research using the S&P 500 Index

IMPORTANT DISCLOSURES

Leonard Rickey Investment Advisors, PLLC (“LRIA”), is an SEC registered investment adviser located in the State of Washington. Registration does not imply a certain level of skill or training. For information pertaining to the registration status of LRIA, please contact LRIA or refer to the Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov).

This newsletter is provided for general information only and contains information that is not suitable for everyone. As such, nothing herein should be construed as the provision of specific investment advice or recommendations for any individual.  To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced herein is historical in nature and is not an indication of or a guarantee of future results. All indices are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment.

Your experience may vary according to your individual circumstances and there can be no assurance that LRIA will be able to achieve similar results for all clients in comparable situations or that any particular strategy or investment will prove profitable.   As investment returns, inflation, taxes and other economic conditions vary, your actual results may vary significantly. The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful. There is no guarantee that the views and opinions expressed herein will come to pass. This newsletter contains information derived from third party sources. Although we believe these third party sources to be reliable, we make no representations as to the accuracy or completeness of any information prepared by any unaffiliated third party incorporated herein, and take no responsibility therefore.

Stock investing includes numerous specific risks including the fluctuations of dividend, loss of principal, and potential illiquidity of the investment in a falling market. International and emerging markets investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. Small cap stocks may be subject to a higher degree of risk than more established companies’ securities. The illiquidity of the small cap market may adversely affect the value of these investments. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. This newsletter should not be regarded as a complete analysis of the subjects discussed. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price. The risks associated with investment-grade corporate bonds are considered significantly higher than those associated with first-class government bonds. The difference between rates for first-class government bonds and investment-grade bonds is called investment-grade spread. The range of this spread is an indicator of the market’s belief in the stability of the economy. The fast price swings in commodities and currencies can result in significant volatility in an investor’s holdings. There is no assurance that the techniques and strategies discussed are suitable for all investors or will yield positive outcomes. The Value investments can perform differently from the market as a whole. They can remain undervalued by the market for long periods of time.

Any projections, forecasts and estimates, including without limitation any statement using “expect” or “believe” or any variation of either term or a similar term, contained here are forward-looking statements and are based upon certain current assumptions, beliefs and expectations that LRIA considers reasonable or that the applicable third parties have identified as such. Forward-looking statements are necessarily speculative in nature, and it can be expected that some or all of the assumptions or beliefs underlying the forward-looking statements will not materialize or will vary significantly from actual results or outcomes. Some important factors that could cause actual results or outcomes to differ materially from those in any forward-looking statements include, among others, changes in interest rates and general economic conditions in the U.S. and globally, changes in the liquidity available in the market, change and volatility in the value of the U.S. dollar, market volatility and distressed credit markets, and other market, financial or legal uncertainties. Consequently, the inclusion of forward-looking statements herein should not be regarded as a representation by LRIA or any other person or entity of the outcomes or results that will be achieved by following any recommendations contained herein. While the forward-looking statements here reflect estimates, expectations and beliefs, they are not guarantees of future performance or outcomes. LRIA has no obligation to update or otherwise revise any forward-looking statements, including any revisions to reflect changes in economic conditions or other circumstances arising after the date hereof or to reflect the occurrence of events (whether anticipated or unanticipated), even if the underlying assumptions do not come to fruition. Opinions expressed herein are subject to change without notice and do not necessarily take into account the particular investment objectives, financial situations, or particular needs of all investors.

For additional information about LRIA, including fees and services, please contact us for our Form ADV disclosure brochure using our contact information herein. Please read the disclosure brochure carefully before you invest or send money.

INDEX DEFINITIONS

The Barclays Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment-grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. It cannot be invested into directly.

The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell Index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.

The MSCI Emerging Markets Index is a float-adjusted market capitalization index that consists of indices of approximately 800 stocks and is designed to measure equity market performance in 23 emerging economies: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, , Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey, and the United Arab Emirates.

The MSCI EAFE (Europe, Australasia, Far East) Index is a free float-adjusted market capitalization index of approximately 900 stocks and is designed to measure equity market performance in 21 developed market countries outside of North America.

The Dow Jones Industrial Average (DJIA) is a price weighted average of 30 significant stocks traded on the New York Stock Exchange (NYSE) and the NASDAQ.

The S&P 500 Growth Index is a market-capitalization-weighted index developed by Standard and Poor’s consisting of those stocks within the S&P 500 Index that exhibit strong growth characteristics. The S&P 500/Citigroup Growth Index is a numerical ranking system based on three growth factors and four value factors to determine the constituents and their weightings.

The S&P 500 Value Index is a market-capitalization-weighted index developed by Standard and Poor’s consisting of those stocks within the S&P 500 Index that exhibit strong value characteristics. The S&P 500/Citigroup Value Index uses a numerical ranking system based on four value factors and three growth factors to determine the constituents and their weightings.

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Important Disclosures

Leonard Rickey Investment Advisors, PLLC (“LRIA”), is an SEC registered investment adviser located in the State of Washington. Registration does not imply a certain level of skill or training. For information pertaining to the registration status of LRIA, please contact LRIA or refer to the Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov).

This is provided for general information only and contains information that is not suitable for everyone. As such, nothing herein should be construed as the provision of specific investment advice or recommendations for any individual. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. There is no guarantee that the views and opinions expressed herein will come to pass. This newsletter contains information derived from third party sources. Although we believe these third-party sources to be reliable, we make no representations as to the accuracy or completeness of any information prepared by any unaffiliated third party incorporated herein and take no responsibility therefore.

Any projections, forecasts and estimates, including without limitation any statement using “expect” or “believe” or any variation of either term or a similar term, contained here are forward-looking statements and are based upon certain current assumptions, beliefs and expectations that LRIA considers reasonable or that the applicable third parties have identified as such. Forward-looking statements are necessarily speculative in nature, and it can be expected that some or all of the assumptions or beliefs underlying the forward-looking statements will not materialize or will vary significantly from actual results or outcomes. Some important factors that could cause actual results or outcomes to differ materially from those in any forward-looking statements include, among others, changes in interest rates and general economic conditions in the U.S. and globally, changes in the liquidity available in the market, change and volatility in the value of the U.S. dollar, market volatility and distressed credit markets, and other market, financial or legal uncertainties. Consequently, the inclusion of forward-looking statements herein should not be regarded as a representation by LRIA or any other person or entity of the outcomes or results that will be achieved by following any recommendations contained herein. While the forward-looking statements here reflect estimates, expectations and beliefs, they are not guarantees of future performance or outcomes. LRIA has no obligation to update or otherwise revise any forward-looking statements, including any revisions to reflect changes in economic conditions or other circumstances arising after the date hereof or to reflect the occurrence of events (whether anticipated or unanticipated), even if the underlying assumptions do not come to fruition. Opinions expressed herein are subject to change without notice and do not necessarily take into account the particular investment objectives, financial situations, or particular needs of all investors.

For additional information about LRIA, including fees and services, please contact us for our Form ADV disclosure brochure using our contact information herein. Please read the disclosure brochure carefully before you invest or send money.