2018 Q1 Review - A Resurgence of Volatility
The first quarter of 2018 saw a resurgence in volatility. We review what caused this, our opinions regarding it and how we are planning to manage through it.
Reviewing the Quarter – Our Opinions Regarding the Recent Volatility
Prior to the first quarter of 2018, the market had one of the most remarkable runs in history. Following the election of Donald Trump in November 2016, the S&P 500 began an amazing streak of 15 consecutive months of positive returns and gaining nearly 40%!
I have been saying all along to enjoy it while it lasts, yet would be unsustainable. Things will eventually change, and the first quarter marked that. From peak to trough, the S&P 500 declined about 10%. The biggest news of the quarter centered around a potential trade war. This was sparked by tariffs introduced by the Trump Administration aimed at China. China responded with introductions of their own tariffs aimed at the United States. These news headlines created volatility that the market had not witnessed in years. Reality was back as political turmoil incited market turmoil.
Anyone who has followed the Trump Administration should not be surprised by political turmoil. He is skilled in the art of negotiation. He often makes bombastic statements, drawing the ire of political foe. News outlets sensationalize these statements and political turmoil ensues. Twitter rants and negative news headlines have become the new normal. My suggestion is to ignore the 24-hour news cycle and focus on the facts. Reacting to them will erode your wealth.
“Everyone has a plan, until they get punched in the face”
-Mike Tyson, former Heavyweight Champion of the World
This is my favorite quote when I think about investing. I love it because it was not intended for investing, yet, so relevant. Most people investing in the markets will claim they are invested for the long-term and will be patient. Most investors adhere to a Buy-and-Hold Strategy. It makes theoretical sense but is very difficult to apply in practice.
When volatility emerges and investment losses become a reality (i.e. they get “punched in the face”), things change. The first quarter of 2018 was the first punch investors experienced in a while.
In these types of environments, it is more important than ever to remove your emotions from your decision making and focus on the facts. The most successful investors are extremely good at this. Removing emotions and focusing on the facts is where our Risk Odometer becomes extremely useful.
Our Risk Odometer is a rule based system we use for judging the risks in the stock market. We use it as a guide for making tactical asset allocation decisions between higher returning investments and stable, defensive investments. Our research has shown it has been helpful in minimizing large losses and increasing returns.
Our Risk Odometer is designed to help us ignore scary headlines and focus on relevant and objective facts. We believe this is a better way to build wealth than the alternative of emotional decision making.
Despite the volatility witnessed in the first quarter, our Risk Odometer remains bullish. It’s most relevant factors of Economic Indicators, Earnings and Technical Price Action continue to remain positive. It is signaling to ignore the scary headlines and maintain our current course. We review it regularly to determine when the facts change.
Reviewing the Facts – The Big Three Indicators
I believe the most essential element in investing is identifying the macro landscape. When the economy is doing well, most all stocks do well. There will always be winners and losers but most stocks will appreciate when the economy is doing well. If an investor can get the macro landscape correct, it makes investing a lot easier because it creates tail winds rather than headwinds.
To get an objective gauge of this, I follow three main indicators. These three indicators are the most important indicators within the Risk Odometer. There are 7 indicators in total, yet 90% of the historical relevancy can be derived from the Big Three alone. Those three are Leading Economic Indicators, Earnings and Technical Price Action. I review where they currently stand below.
Leading Economic Indicators (LEI)
According to the Conference Board, “The LEI points to robust economic growth throughout 2018. Its six- month growth rate has not been this high since the first quarter of 2011.” The LEI is one of my favorite indicators. It has historically been very good at identifying turning points in the economy. It’s systematic and disciplined nature ignores scary media headlines and focuses on real economic data. That is exactly how I view investing in the markets. I always try to divorce myself from the emotions of the market and
be objective. It reminds me of the show, Dragnet, when the straight-laced detective, Sgt. Joe Friday, would say,
“Just the facts ma’am.”
The Conference Board’s Leading Economic Indicators does just that. It only looks at the facts. Twitter rants and media headlines are not factors. I believe following the facts are a better way to grow your wealth.
The chart below is a graphical representation of the LEI, produced by the Conference Board. The blue line in the chart represents the LEI. From the chart, you can see in 2000 and 2007 it turned lower prior to the ensuing recessions (shaded in gray) in 2001 and 2008. Currently it is accelerating higher, pointing towards continued economic growth in 2018. This does not guarantee the stock market will continue to climb higher, but it does provide tailwinds rather than headwinds.
Leading Economic Indicators (blue line) is currently accelerating higher, signaling continuing economic growth in 2018
Very simply said, earnings are strong and expected to remain strong as tax cuts work their way through the economy. Again, this does not guarantee the market will continue to climb higher, but it does create more tailwinds than headwinds.
The way I analyze earnings, is by identifying the trend of them. If they are increasing on a year-over-year basis, I determine the trend is positive. Positive trends in earnings have equated to better returns in the market. Negative trends (negative year-over-year growth) have equated to significantly lower returns.
I do not choose to run fancy regressions, or complex formulas to predict stock market returns by analyzing earnings. In my 15 years of researching and investing on Wall Street, I did that. I did not find it to work any better in practice, and often caused more confusion than it was worth.
Economic growth is not random. It cycles. Earnings cycle as well. Identifying changes in earnings trends by year-over-year growth rates may sound too simple, but I will always argue simple is better than complex. Even Albert Einstein argued for keeping things as simple as possible.
Here are some highlights from Thomson Reuters regarding the S&P 500 earnings. They are positive signs for the market.
- Increased 8% from Q4 2016 to Q4 2017.
- 77% of companies in the S&P 500 reported Q4 2017 earnings above analysts’ expectations (64% long-term average, 72% over last 4 quarters)
|S&P 500 earnings continue to display positive year-over-year growth rates (blue line above the red line), a tailwind for the markets.|
Technical Price Action
The last of the Big Three Indicators in the Risk Odometer is Technical Price Action. This indicator can be positive, negative or neutral. Currently is positive. This is largely driven by the fact that the 50-day moving average of the S&P 500 is greater than the 200-day moving average.
Technical Price Action is the most reactive of all the indicators I monitor. It is often the first to turn but can also give false signals. That is why I like to follow more than just one fact. Despite this, it has been incredibly good at side stepping some of the largest market declines.
Our justice system rarely incriminates suspects when there is only one fact, because there is often something else that can create doubt. Yet when many facts line up, the chances of being found guilty increase. I apply the same methodology to investing. I need to see various facts (indicators) align before making significant changes. Technical Price Action may turn neutral or even negative if further downside volatility continues. I would need to confirm its signal with others before suggesting meaningful changes.
Despite the recent drop, the 50- day moving average (orange line) continues to remain above the 200-day moving average (red line), a positive technical signal
Summing it all up, understanding the macro landscape is the most essential element to good investing. I prefer to follow this in an objective way to remove emotions from investment decisions. I believe emotions are our enemy in good investing. Despite the recent volatility, the objective data is still positive, and therefore, I am still positive on risk assets. Good luck investing.