Second Quarter 2018
The first quarter ended with a thud.
Thus ending an unprecedented period of low volatility where stocks closed higher and higher for nine consecutive quarters. Well, nothing goes straight up (or down) and the recent past was not the a "new normal".
Seasoned investors suspected a period of low volatility would be followed by one of high volatility, and they were not disappointed. While there were only 10 days in 2017 where the Dow Jones Industrial Average (DJIA) posted a gain or loss of 1% or more, there were 25 such days during the first quarter. Contributing factors...
- Pent Up Profit Taking
As 2017 ended, this bull market was closing in on its 8th anniversary. This meant a lot of investors had a lot of unrealized capital gains. The new tax year gave them a fresh opportunity to realize some of those gains and take money off the table. In early January, we rebalanced client portfolios for this reason.
- New and Unknown Fed Chair
In January, Jerome Powell became the new Chairman of the Federal Reserve. An attorney and private equity executive, he became the first non-economist to take the helm since 1981. He represented an unknown and unknowns make Wall Street jitter.
“At this point, we have 4.1 percent unemployment. The things we don’t want to have happen is to get behind the curve, have inflation move up and have to raise rates too quickly and cause a recession."
-- Current Fed Chair Jerome H. Powell
In February, Powell delivered his first monetary policy report to the House Financial Services Committee. Although he indicated the Fed would maintain its current monetary policy, he cautioned that wage inflation may start emerging as unemployment continues declining. Of course, Wall Street interpreted these comments to mean the Fed will hike rates more than three times this year and they reacted negatively. Historically, the Fed has often gotten behind the inflation curve and had to play catch-up, killing the economy in the process.
The recent naming of John Williams, San Francisco Fed Executive Vice President and Director of Research, to lead the New York Fed may help to soothe Wall Street jitters. Whereas Powell is an unknown quantity, Williams is a well-known and highly-regarded economist with intimate knowledge of our financial system.
- Tumult and Trade Wars
North Korea and Iran were (and remain) nuclear threats. A Trump-Kim Summit is likely later this spring with an agreement to denuclearize the Korean Peninsula on the table. Iran has threatened to resume its nuclear weapons program if Trump pulls out of the 2015 nuclear deal. Dictator Bashar al-Assad attacked his own citizens with banned chemical weapons in Syria's civil war, key allies being Hezbollah of Iran and Russia. Trump has responded with his own threats, as well as decisive action supported by key allies and the United Nations.
The simple truth is that China (and other countries) has engaged in abusive trade practices for decades, devaluing its currency and imposing stiff tariffs on U.S. imports. Trump's America First policies aim to level the playing field.
If you have not read, The Art of the Deal, you might. It reveals a lot about Trump's negotiating style and, make no mistake, there is a lot of negotiating going on. Although his style may not be yours or mine, it has yielded some results.
- Rates Rose
Bond market math is simple. When interest rates rise, bond prices fall. As a general rule, if interest rates rise by 1%, they will fall by 1% for each year of duration. For example, if
“We are in a bond market bubble that’s beginning to unwind.”
-- Former Fed Chair Alan Greenspan
interest rates rise by 1%, a bond with a 1-year duration will fall by 1% and a bond with a 10-year duration will fall by 10%. In other words, the longer the bond, the greater the fall.
Interest rates have not risen for a long time. This means a lot of investors have forgotten this basic lesson (or they may be too new to investing to have learned it) and been lulled into a false sense of bond market security. They are likely to be rudely surprised if they fail to shorten maturities.
The correction has arrived.
On January 26th, the DJIA posted an all-time high of 26,616.71 but closed the quarter at 24,727.27 (↓ 7.1%). By definition, a correction is marked by a stock market decline of at least 10%. On April 2nd, the long-awaited correction was confirmed with the DJIA closing at 23,644.19 (↓ 11.2%).
Although corrections are normal and healthy, they can be unnerving. But, they almost never turn into bear markets especially when the economy is growing and inflation remains tame. That said; most corrections last from three-to-nine months, meaning we may or may not have seen the last of this one. Time will tell.
 A bear market is marked by a stock market decline of at least 20%.