2018 First Quarter Market Summary
By Jon Aldrich
It has been a long time coming, but for the first time in nine calendar quarters, most of the major stock and bond indexes were down. So far we have only seen modest declines for the year but it does remind us that yes, markets can and do go down from time to time. It also reinforces what we have been telling clients for the last several months, that 2018 was likely to be a lot choppier than 2017, because 2017 was an abnormally calm year. Years like 2017 that have only brief rough patches do not come around very often.
Even though the stock markets have dropped about 10% from their highs in late January, most stock indexes are only down modestly for the year. Going back to 1980, a period of 38 years, the S&P 500 had an intra-year drop of at least 10% in 22 of those 38 years. In 14 of those 22 years with a greater than 10% drop the S&P finished with a positive return on the year. Also, of note, that the S&P has been positive in 29 of these total 38 years since 1980.
As you can see in the chart above, the only major asset classes that escaped the first quarter of 2018 with a green (positive) return for the quarter were Emerging Markets stocks (represented by VWO-Vanguard FTSE Emerging Markets), Commodities (DBC-PowerShares Commodity Tracking ETF) and short-term bonds (MINT-Pimco Enhanced Short Maturity Active ETF).
Emerging Markets have been a laggard for the last 10 years, but in the last year and a half are really coming on strong as many of these economies are really starting to hit on all cylinders as the world economy continues to improve. Commodities have also been abysmal for most of the last 10 years, but with some signs of inflation appearing they have started to perform better (Commodities generally do well when inflation picks up).
Short-term bonds were able to manage some modest gains, as bonds with very short maturities will usually do better than bonds that have longer maturities when interest rates rise like they have for the last several months. As interest rates go up, bond prices generally fall and when interest rates fall, bond prices rise. You can see in the chart below that from the start of 2018 the 10 year Treasury Rate (blue) has risen from 2.46% to 2.74% and was as high as 2.94% in February. The 5 Year Treasury (red) has gone from 2.25% to 2.56% and the 2 Year Treasury (orange) has gone from 1.92% to 2.27%.
The list of asset classes in the “red” for the first quarter is a lot longer. Leading the way on the downside were REIT’s (VNQ – Vanguard REIT Index) which consists of the commercial real estate market. Real Estate can be sensitive to rises in interest rates in the short term as there is a lot of borrowing in real estate and when borrowing costs go up it can have an adverse effect in this sector at least in the near term.
The Dow Jones Industrial Average (DIA-SPDR Dow Jones Industrial Average) which is the index you hear about the most on the news and in conversations was the next worst performer, losing about 1.7%. The Dow underperformed most of the other indexes as companies like General Electric (GE), Exxon Mobil (XOM) and Procter & Gamble (PG) which are large components of the Dow, really struggled. Remember, the Dow Jones Industrial Average only consists of 30 stocks and is not a good gauge of the overall stock market because of the limited amount of companies in this index. The S & P 500 with 500 stocks or the Russell 1000 with 1,000 stocks are better barometers of how the U.S. stock market is behaving.
Next on the list was the Bond Market Index for taxable bonds (represented by BND-Vanguard Total Bond Market Index) which was down -1.37%. As I mentioned above, as rates rise, longer term bonds do not do as well as bonds with shorter maturities and the bonds in this index have an average maturity of about 8 years or so, while the bonds in the Short Term Fund in the chart above have an average maturity of under 1 year. The Municipal Fund Index of tax-free bonds (MUB-iShares National Muni Bond ETF) fared just a touch better being down -1.06% for the quarter. The average maturity of bonds in this fund are around 6 years. On the positive side, now that rates are rising, it will allow these bond funds and purchasers of individual bonds the opportunity to reinvest in bonds with higher yields and thus generate more income in the years to come.
As you get into some of the more broad based U.S. stock indices, the S & P 500 (SPY-SPDR S&P 500 ETF) was down just about -1.0%, but many individual stocks did much worse as the index has been powered primarily by the FAANG technology stocks of Facebook, Amazon, Apple, Netflix and Google. (Although Google is now called Alphabet, but that would screw up the FAANG acronym). These 5 stocks have powered 25% to 30% of the total gains of the S & P 500 over the last couple of years. Now that these stocks have hit an “air pocket” lately it has also dragged down the indices.
U.S. mid size stocks (IJH-iShares Core S&P MidCap ETF) were down -.80% and small stocks (IWM-iShares Russell 2000 ETF) were just about flat, only being down -.2%. These indexes do not have the FAANG stocks in them, so they could continue to hold up better than the S & P 500 if the FAANG stocks continue their “correction”.
As you go overseas, foreign developed large company stocks (EFA-iShares MSCI EAFE ETF) were down -.9% and foreign small company stocks (DLS-Wisdom Tree International Small Cap Dividend ETF) were down just slightly at -.28% for the first quarter of the year.
So, what the heck is going on? The first quarter saw the first correction—that is, a decline of more than 10%–in three years, which dragged returns down from a roaring start to the year. Industry pundits have many triggering effects to point to, from chaos in the White House to the possibility of a global trade war, to fears of inflation or higher interest rates, to the simple fact that U.S. stocks have been priced much higher than their historical averages. They aren’t getting much explanatory data from the economic statistics; the unemployment rate is testing record lows and new jobs are being created at record levels. More importantly, annual earnings estimates for S&P 500 companies rose 7.1% during the first three months of the year—the fastest rise since FactSet began keeping track in 1996.
Ironically, the small downturn plus the jump in earnings may have forestalled a bigger corrective bear market later. The S&P 500, by some measures, is now trading at 16.1 times projected earnings for the next year, compared with 18.6 in late January when the markets were extraordinarily bullish. Stocks are not as overpriced as they once were, and the corporate tax cut could lead to higher reported earnings throughout the year.
In any case, it appears that investors have become increasingly nervous about their stock investments. Over the past three months, the CBOE Volatility Index–the VIX index–widely known as Wall Street’s “fear gauge,” posted its biggest quarterly rise since the third quarter of 2011, jumping 81%. The VIX reflects option traders’ collective expectations for the S&P 500 index’s volatility over the coming 30-day period, and by this measure, traders had been very calm for the 18 months before early February. Now the VIX is at or near its historical average, which suggests that the equities markets are going to experience a totally normal bumpy ride going forward. This is a good time to fasten seat belts, and also consider whether you’d have the patience to ride out a bear market. We can’t predict when that will happen, of course, but I think everybody realizes that the bull market cannot last forever. A bear market also does not mean the market has to crash. It could also just continue to be very choppy for the next couple of years, never really making much progress in either direction.
All this being said, the long-term trends of the stock market are still positive as the 200 Day Moving average of the S&P 500, which many investors use to analyze the longer term direction of the market is still sloping upwards. (See blue line in chart below which shows the S&P 500 Index going back to the beginning of 2017). This moving average is simply calculated by taking the index’s average closing price over the last 200 trading days. When this average is sloping upwards (as it is now) the market trend can still be considered positive. If the 200 Day Moving average starts sloping downward it would start to raise a little more cause for concern. It is not doing that yet.
The other indicator that is still positively sloped is the Yield Curve, which is the difference in the yield of the 10 year Treasury compared to the yield of the 2 Year Treasury. As long is the yield curve is positively sloped, meaning the 10 Year yields more than the 2 year, as it does currently (2.74% to 2.27%) things are probably good in the economy and also the markets. However, the last several recessions (and bear markets) have occurred within 12 to 18 months of the yield curve “inverting” or becoming negatively sloped. This occurs when the 2 Year Treasury yields more than the 10 Year Treasury. The last two times this occurred were 1999 and 2007. Hmmm.
So, all in all, it was a challenging start to the year, with January being really fantastic for most of the month, but February and March showing a lot of volatility and the stock market entering “correction” territory of a 10% drop from the highs. However, the overall quarter only showed modest losses in most areas of the markets. Expect the volatility and large market swings to continue for some time as it appears we will need to embrace a new market “regime”.