FCE Group Market Outlook - February 2018
Volatility is Back
The S&P 500 has drawn down by just over 10% as of the time of this writing. This is commonly referred to as a 'correction'. This represents a significant reversal in momentum in both equity prices (which had gone pretty much straight up, and reversed sharply in early February) and volatility. Market uncertainty, a signal of investor risk aversion, had drifted down to historically low levels but has recently spiked.
Interest rates have finally moved. The ten year US Treasury yield has risen to just above 2.8%, up from a low of 1.4% in mid 2016. By way of perspective, this yield is substantially below the historical average of 6.5% for the past 50 years
Higher interest rates have been widely expected. The US economy is growing and unemployment is low. It seems logical that the post-crisis environment of rock bottom interest rates would at some point come to an end. Nevertheless, rising interest rates can lead to lower equity prices due to price-earnings compression. In addition, arithmetically, higher interest rates mean lower bond prices, since the higher discount rate for fixed income cash flows pushes the present value of those cash flows lower. Of course, bonds that mature at par pay back the full amount of principal and interest over the life of the investment.
Staying the Course
Recent market movements have not caused our firm to make adjustments to client portfolios. The swing of 10% feels large but is not historically significant. As a matter of fact, stock prices were at the current level just six months ago. More important is asset allocation in determining the investor's exposure to overall risk. Given an appropriate risk level, the recent volatility is entirely tolerable.
Our tendency to allocate capital conservatively is intended for exactly these types of periods - so investors can withstand the volatility and remain invested, so that they can continue to earn the long term returns from their respective blends of asset classes.
We don't time the markets. In the event of a longer and more serious equity market decline, which we do not predict but is possible, we would look to rebalance into equities, thus buying low. This can only be done because our clients do tend to have substantial amounts in fixed income or cash, the volatility of which is much lower than that of stocks.
We continually evaluate the markets, the movements of security prices, and the economy. It is possible that we will change our views depending on the situation. But we will remain conservative, diversified and long term focused.