Monday Morning Minute ~ November 5, 2018
We update our WCA Fundamental Conditions Barometer for October and consider what might be driving some of the recent pickup in equity market volatility.
Foreign Conditions Remain Weak
Evidence continues to mount that much of the global economy is coming under pressure. Last week brought news that China’s manufacturing sector worsened in October, along with output in September in South Korea,Japan, and Taiwan. A chill is also taking hold in Europe, evidenced by a halving of the third quarter growth rate, just as inflation is picking up.Emerging markets finished out October with losses, evidencing growing doubts about growth. Our WCA Fundamental Conditions Barometer (graph, below) continued to tread water as a result of these factors. Given the near-50 level for the near-term forecast path of our barometer, tactical ETF allocations remain near neutral with respect to stock vs. bond allocations (versus an overweight position throughout most of 2017 and early 2018).
Source: Washington Crossing Advisors
What is Behind the Volatility?
The decline in U.S. markets in October is enough to make anyone sit up and think about what might come next. It is natural to wonder if the Dow Jones Industrial Average’s (Dow) 2,400 point slide (about 10%) to 24,400 on October 26 from 26,800 on October 4 could signal the beginning of a more difficult period for stocks. We wrestle with these questions every day and keep coming back to a relatively simple answer, which is to follow our discipline. This discipline focuses on quality, value, and objective and timely analysis of information. During times of market stress, it is important to take a step back, take a look at the numbers, and not be afraid to take an action, but only if our process leads us to conclude some change is necessary.
So what is causing the pickup in volatility? Could it be higher rates? A long overdue tech sector correction? A problem with the outlook for U.S. growth, perhaps tied to upcoming midterm elections? Or are we in the midst of a general, worldwide “flight to quality?”
It is hard to blame October’s rout on rising interest rates, as most rates across the U.S. Treasury curve were little changed throughout the month. A delayed reaction to higher rates throughout the year is possible, but why would the market not have taken notice of higher rates earlier? It is also hard to point to a sharp correction of “high flying” technology, or “FANG,” stocks as the root cause because those stocks did not lose any more during the month than the market overall. We can’t pin the market’s decline on a poor performance by the United States’ economy, either. The Atlanta Federal Reserve (Fed) expects the U.S. economy to grow at an above 3% during the current quarter, and the unemployment rate is at a half-century low — hardly a picture of weakness. Nor can we blame the selloff on domestic midterm elections in the United States because the selloff was seen across every area of the globe. And what about “flight to quality?” If this latest correction was truly a world-wide “risk off” market event, we would expect to see U.S.
This all brings us back to our core bottom-up discipline which emphasizes buying high quality stocks when the market offers them to us at reasonable prices. The top-down tactical ETF discipline has already moved from a strong-overweight in stocks in 2016-2017 to a neutral allocation today. Moreover, we continue to see a better risk-reward trade-off in domestic equities versus foreign and emerging markets and continue to tactically tilt toward value over growth
We would not be surprised for the market to continue to exhibit greater volatility than previously given less even global growth,higher short-term rates, and geopolitical uncertainties (midterm elections,Brexit, trade, etc.)
Kevin Caron, CFA, Senior Portfolio Manager
Chad Morganlander, Senior Portfolio Manager
Matthew Battipaglia, Portfolio Manager
Suzanne Ashley, Analyst (973) 549-4168
WCA Fundamental Conditions Barometer Description: We regularly assess changes in fundamental conditions to help guide near-term asset allocation decisions. The analysis incorporates approximately 30 forward-looking indicators in categories ranging from Credit and Capital Markets to U.S. Economic Conditions and Foreign Conditions. From each category of data, we create three diffusion-style sub-indices that measure the trends in the underlying data. Sustained improvement that is spread across a wide variety of observations will produce index readings above 50 (potentially favoring stocks), while readings below 50 would indicate potential deterioration (potentially favoring bonds). The WCA Fundamental Conditions Index combines the three underlying categories into a single summary measure. This measure can be thought of as a “barometer” for changes in fundamental conditions.
The information contained herein has been prepared from sources believed to be reliable but is not guaranteed by us and is not a complete summary or statement of all available data, nor is it considered an offer to buy or sell any securities referred to herein. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. There is no guarantee that the figures or opinions forecasted in this report will be realized or achieved. Employees of Stifel, Nicolaus & Company, Incorporated or its affiliates may, at times, release written or oral commentary, technical analysis, or trading strategies that differ from the opinions expressed within. Past performance is no guarantee of future results. Indices are unmanaged, and you cannot invest directly in an index.
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All investments involve risk, including loss of principal, and there is no guarantee that investment objectives will be met. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager. Equity investments are subject generally to market, market sector, market liquidity, issuer, and investment style risks, among other factors to varying degrees.
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Washington Crossing Advisors LLC is a wholly owned subsidiary and affiliated SEC Registered Investment Adviser of Stifel Financial Corp (NYSE: SF). The Dow Jones Industrial Average is an index that shows how 30 large, publicly owned companies based in the United States have traded during a standard trading session in the stock market.