Greetings! I hope and trust that this finds you well and enjoying life.
It’s easy to get caught up in complacency when conditions are good, the sun is shining and the market is rising without interruption. But, as we know intuitively (but often still forget), such conditions aren’t realistic or even desirable. In theory, markets that moved upward without any risk of an occasional slide would eventually become prohibitively expensive as discounts would be wrung out of the system and create a market situation far more fragile than one with a healthy balance that reacts, digests/disregards and interprets news as it occurs. Good or bad, this is the essence of how markets have operated over the course of the last few centuries.
Historically, pullbacks of -5% have occurred almost once a quarter through modern market history. Deeper corrections of around -10% have happened close to once a year. Whether markets are moving upward or downward, there is never an absence of something to worry about. But if one believes that markets are reasonably ‘efficient’, market prices can be a fairly good reflection of their general esteem by the public at any given time. That can imply a lot of things, including simply the weighted average of various probabilities of upside and downside cases, and can, of course, be colored by positive or negative investor sentiment towards an asset—which can’t always be quantified—but is quite fickle and can change on a dime.
History has also shown that performance for stocks have been largely driven by fundamentals—specifically, by earnings growth. As long as earnings growth has remained positive, we’ve tended to experience positive returns from equities. This year, FactSet has pegged earnings growth at 20% with 10% slated for 2019. Since markets have the tendency to look forward rather than backward, increases in downside volatility are often focused on possible threats to earnings. Today, those threats are higher interest rates (which imply higher borrowing costs and tighter credit conditions for governments, businesses and consumers) and continued worries about U.S. trade policy (namely relative to China). If taken to the extreme, both issues have the potential of trimming global growth, which, in turn, would reduce earnings. However, the impact of either on growth is more complex than straightforward—meaning neither is a straight recipe for a growth slump or recession.
The reasons for and pace of interest rate increases is as important as the movements themselves. Higher rates resulting from higher growth and happening at a more gradual pace have tended to be less disruptive to an economic cycle than rate moves reacting to high inflation. Thursday morning’s CPI report provided another mixed bag of news, with the pace of headline inflation over the past year falling back toward trend. While no one is readily cheering on a return to a high-inflation world, which would certainly raise concern of even sharper and faster interest rate moves upward, seeing some inflation is a byproduct of economic growth. This is why the Federal Reserve’s inflation target is set at 2% and not zero. However, if inflation comes in too low, worries over the sustainability of growth come into question. This is a difficult balance, but actual inflation readings have come in remarkably close to target over the last several years.
Environments described as ‘Goldilocks’ (like today) never stay that way forever, but rarely do conditions change overnight from one regime to the next. These changes generally occur over quarters, and sometimes, years. While growth next year isn’t expected to match levels of this year, the dashboard of usual near-term recession signals remains almost predominantly green.
If you have questions about the above or any retirement-related planning give us a call.
Jeff Christian CFP, CRPC
Quality means doing it right when no one is looking.