800-493-6226 [email protected]

Chris Osmond from our Overland Park office shares his tips about market volatility.

Rewind three weeks ago to the end of the quarter where the S&P 500 and Dow Jones Industrial Average (DJIA) were up 7.71% and 9.63%, respectively.  Now fast forward to yesterday, October 24th, 2018.  When the DJIA sold off 608 points (or 2.41%), leaving the benchmark in negative territory for the year.  When sharp sell-offs like this occur, it’s hard to stay even keeled and not make knee jerk reactions.  Therefore, we find it imperative to pause, take a step back, and ask a couple of questions:

  • What has changed from three weeks ago to today?
    • Fundamentally speaking – not much has changed.
      • The US economy is still growing at a healthy pace; even picking up steam at a rate of 3.5%. The labor market continues to tighten and drive wage inflation higher at a rather anemic pace.  Inflation remains low and at the Fed’s target.  Business spending is finally starting to trend in the positive direction, helping drive growth higher, and both business and consumer confidence are still high.
      • Corporate Earnings are still strong. It’s important to remember that earnings grew more than 26% in the second quarter of this year.  That is not a sustainable rate.  Typically earnings growth of 10-12% is considered very healthy growth.  So, it should come as no surprise to hear companies report positive results for the third quarter and make revisions to future guidance.  By and large, this was expected, yet the market is punishing those companies, and their competitors for making such revisions to future guidance based on the past unsustainable growth projections.  The US economy has not had a recession when earnings growth is in double digits, so we’re not concerned on that front.
      • Interest rates are still historically low. The 10-Year Treasury (currently around 3.10%) is still cheap.  Companies can still make a very good profit with rates this low.  However, there have been three instances this year when volatility in the capital markets spiked, and in all three instances, the catalyst was a sharp spike in rates.  In February the 10-year jumped from 2.4% to just under 3%; then traded in a very tight range.  In May, the 10-Year spiked from about 2.85% to 3.11%, before settling back down in the 2.9% range.  Which leads us to the first week in October when the 10-Year spiked from 2.9% to 3.23%, before topping out at 3.25%.  The sharp spikes strike fear with investors that companies won’t be able to run at a profit at these levels, and the Fed will make a misstep as they transition from Quantitative Easing (QE) to Quantitative Tightening (QT).
      • China is making a transition to a developed economy; one driven by the consumer and not exports like most emerging markets. This transition inevitably will result in a slower growing economy.  This transition has been telegraphed for more than three years now.  So again, a very minor slowdown in China should not come as a major surprise, especially when you witness the increasing strength and stability of China’s middle class.  Yes there are tariff concerns, but the situation has not changed since September.  Communication was cut off and not anticipated to pick back up until after the mid-term elections in the US.
    • What has caused the sell-off?
      • The number one cause – Uncertainty; which markets loath.
        • As previously mentioned, the catalyst was the spike in rates; which creates much uncertainty around corporate growth and the Fed.
        • China and US Tariff and trade war negotiations
        • Mid-Term Elections; which historically cause volatility leading up to the elections, and historically speaking, it’s not uncommon to experience a bear market (pullback greater than 20%) in the period leading up the elections. Of note, as of Tuesday, October 22nd, more than 200 companies within the S&P 500 entered bear market territory.
          • It’s also important to note that historically, the market typically rebounds strong after the elections regardless of the outcome. Why?  Because the market has clarity and can responsibly predict the outcomes of policy for the rest of the presidential term.
          • The effects of a potential earnings slowdown, and what that means for the economy going forward. While perhaps not as robust, as previously mentioned, earnings are still strong and should come back down to earth and perform at a healthy, more sustainable rate.
        • The state of the European Union (EU) and the potential peek in growth. Not to mention concerns over potential contagious impacts the Turkey crisis and Italy’s budget crisis could have on Europe.
        • BREXIT negotiation struggles

While there is a fair amount of uncertainty in the market, it’s critical to go back to our first question – What has changed from three weeks ago to today?  Really nothing.  With the exception of the immediate spike in rates, all this uncertainty existed three weeks ago.  The markets just needed a catalyst.

It’s also important to understand what actually comprises the return of the S&P 500.  The S&P 500 is a capitalization-weighted (or value-weighted) index.  In other words, each company’s weight in the index is determined by its respective market value.  An inherent drawback of this characteristic is that the returns of the index are typically generated by a handful stocks.  Through the first half of the year, five stocks (all NASDAQ constituents) were responsible for delivering 90% of the S&P 500’s return for the year, and a mere ten were responsible for 100% of the returns; while most of the index was actually flat to negative.  If the S&P 500 was equal-weighted, where the weight of every company in the index was exactly the same weight, the S&P 500 returns would be approximately 3.3% lower through the third quarter.  Through the third quarter, the end result of the market-capitalization index has been favorable, but should the growth outlook change on either of those securities, the tides could quickly turn and those same stocks could be the reason the entire index is negative.  In fact, typically, a sell-off from the largest stocks can lead to contagion and produce even bigger losses.  This is precisely what we’ve witnessed in October, led down by technology stocks, and subsequently small cap equities.  Given the broad –based sell-off we’re currently experiencing, we believe that when the market rallies off its lows, the rally will also be broad-based.

We know the first nine months of 2018 has been a difficult environment for asset allocation.  Major US indices were up close to 10%, while international equities and bonds (as measured by the Barclays Aggregate US Index were all negative; resulting in flat to slightly positive returns in balanced allocations (approximately 60% equities and 40% bonds).  When looking at those returns it can be easy to ponder just moving everything to the S&P 500 index and calling it day.  We encourage investors to continue to focus on to the long-term.  During time of volatility investors tend to flock to safe haven assets, like bonds, which ultimately protect the overall portfolio on the downside.  It’s important to remember the value of diversification.  Minimizing losses is extremely important, as it take larger gains to rally from a loss in value.  For example, if the market goes down 25%, a return of approximately 34% is needed to get back to even.

To summarize, we know the last few weeks have been hard to stomach, and naturally create nervousness.  We encourage you to ask yourself what has really changed because we believe you’ll realize not much is different today.  Companies can’t possible sustain growing earnings at a 26% clip, but will most likely continue to operate with positive growth.  We believe this volatility in the markets will continue for the next few weeks, but look for some of the uncertainty to subside after the mid-term elections and the market to rebound to close out the year.

As always, thank you for entrusting us.  Please reach out to your advisor with any questions.

About Prime Capital Investment Advisors

Prime Capital Investment Advisors provides a client-centric, team approach to full-service financial planning, including fee-based asset management and wealth management. The firm currently has 16 locations throughout the United States, with investment advisor representatives serving clients across the nation.

Securities offered through Private Client Services, Member FINRA/SIPC. Advisory products and services offered through Prime Capital Investment Advisors, a Registered Investment Advisor. Prime Capital Investment Advisors doing business as Qualified Plan Advisors, “QPA.” Private Client Services, Qualified Plan Advisors, and Prime Capital Investment Advisors are unaffiliated entities. 6201 College Blvd., 7th Floor, Overland Park, KS 66207

Chris Osmond
Latest posts by Chris Osmond (see all)
Share This