by Connor Darrell, Head of Investments
CLICK HERE TO GET TO KNOW CONNOR

After a rough start to spring, the market seemed to turn a corner during the middle of last week, when on Wednesday equities opened sharply lower but came roaring back to close the day in the black.  However, more disruptive trade talk on Friday erased all of the week’s gains. The Department of Labor also released its March jobs report on Friday, but anyone looking for an encore to February’s blockbuster report to provide some respite was left disappointed. The economy continued to add new jobs, but the rate of growth (103,000 new jobs) came in below expectations.

For equity investors, the transition from 2017 to 2018 has not been easy to stomach. Volatility has become the new norm, and news headlines that would have been shrugged off a year ago are now sending shockwaves throughout investors’ portfolios. We expect this trend of increased volatility to continue as markets come to terms with a much wider range of factors to consider. Monetary and fiscal policies are now pushing in opposite directions (the Federal Reserve’s policy of raising interest rates is considered to be contractionary, while tax cuts are considered to be expansionary), and rising trade tensions have added a new dynamic to the equation. All of this is occurring as we are yet another year further along in the economic cycle.

Volatility: Where Economics and Psychology Meet

Periods of heightened volatility are uncomfortable, but provide an excellent opportunity to reflect upon the psychological aspects of investing. When markets are firing on all cylinders, it can be awfully easy to forget that investing involves risk.  Ech and every one of us has a different level of tolerance for how much risk we are willing to accept, but often times we don’t know our true tolerance until we experience real volatility. If you find yourself losing sleep over the ebbs and flows of the equity market, then that probably means your portfolio is too aggressive. In many ways, the best portfolio allocation is not the one that maximizes your return, but the one that best aligns with your financial goals and risk tolerance.

Morningstar, a well-respected voice in the investment community, released a study back in 2017 that explored why the average portfolio has struggled to keep pace with the overall market. Their conclusion was that many investors try to time the markets, a notoriously difficult (if not, impossible) thing to successfully implement on a consistent basis. Not only is this approach typically unsuccessful, but it also adds transaction costs and can be very inefficient from a tax standpoint. Over the long term, the best portfolio strategy is the one that enables you to remain disciplined and “in the game.” Sometimes that means building a portfolio that may not keep pace with every bull market, but will provide you with peace of mind when the going gets tough. The ability to match your portfolio with your goals and risk tolerance, in addition to their role as a behavioral “coach” during periods of market stress, are two of the most significant benefits of working with an advisor that is familiar with your unique situation.

by Connor Darrell, Head of Investments CLICK HERE TO GET TO KNOW CONNOR
It was another bumpy week on Wall Street, though markets closed out the month of March and rolled into the holiday weekend on a positive note.  Bonds outperformed stocks as the 10 year treasury yield slipped down to 2.77% after reaching as high as 2.94% during the middle of the prior week.  A lot has been made of tariffs and trade policy over the past few weeks, and we touched upon that a bit in last week’s update, but moving forward our primary focus is elsewhere.  See below for more details.

What We Are Focusing On
As investment managers, we must always be challenging ourselves to identify possibilities that markets haven’t yet appreciated.  After all, a portfolio manager who follows the common “consensus” will never outperform.  Sound risk management is about recognizing risks in the market before they have major impacts on asset returns, and identifying strategies that can mitigate their effects on a portfolio.  As such, we are constantly asking ourselves “What could conceivably transpire that would cause us to fundamentally change our market outlook?”

Following years of historically low levels of volatility, we believe that the equity sell-offs in February and March were simply a return to what might be considered “normal”, and that economic fundamentals remain supportive of further gains.  However, as we evaluate the state of the economy and markets, we see two interrelated risks that could temper our optimism; interest rates and inflation.

Since the 2008 financial crisis, central banks around the world have taken extreme measures to try and breathe life back into the global economy.  Pushing interest rates lower and lower in an attempt to encourage lending and stimulate the economy.  Over longer periods of time however, interest rates are driven primarily by inflation and growth expectations, not central bank policy.  The chart below shows the US Inflation rate alongside the yield on the 10 Year Treasury.  As you can see, there is a strong relationship between the two.

There is a theory in economics that inflation should be negatively correlated to the unemployment rate in an economy.  The logic is that as the unemployment rate declines, there are fewer workers available for hire, and companies must increase wages to attract new employees from a smaller supply of available workers.  These increased wages put pressure on profits and force companies to increase prices, leading to inflation.  While far from an infallible rule of economics, this phenomenon has been observed through a variety of different periods in history.

With the US unemployment rate approaching its lowest level since the turn of the century (which itself was the lowest level since May of 1969), the potential for rising wages and input costs to begin putting upward pressure on inflation has increased.  When we combine this possibility with the fact that interest rates have been moving steadily lower for over 35 years (see chart from above), we believe it will be incredibly important to watch inflation expectations moving forward.  Since long term trends tend to break suddenly rather than gradually, a meaningful upward shift in inflation expectations could impact interest rates and cause disruption in the market.

Building upon the notion that portfolios tracking consensus expectations do not outperform, the below chart shows how inflation expectations have evolved since we emerged from the financial crisis.

The 10 Year breakeven Inflation Rate is calculated by subtracting the yield on 10 Year Inflation Protected Treasuries from the yield on 10 Year Treasury Bonds and is used as a proxy for the market’s expectation of inflation over that time period.  Thus, we can gather from the chart that inflation expectations have remained quite subdued over the past ten years or so.  We saw a slight increase recently, but far from meaningful given expectations are still very close to where they were back in 2016.  The key takeaway from this chart is that markets are still not convinced that inflation, and therefore long term interest rates, will push significantly higher over the next few years.  We at Valley National are not “convinced” either, but we do believe that there exists a distinct possibility that inflation expectations are adjusted upward as economic growth continues to improve and unemployment continues to decline.  Shielding a portfolio from this risk involves reducing interest rate sensitivity by shifting towards short term bonds.  We view this as relatively inexpensive “insurance”, since it does not require investors to sacrifice a significant amount of income given that bond yields are already at historic lows.  If you have any questions about specific strategies for your portfolio, please contact your financial advisor.

by Connor Darrell, Head of Investments
CLICK HERE TO GET TO KNOW CONNOR

2018 started out with a bang, with the S&P 500 index up 7.45% over the first 26 days of January.  Since then, a flurry of speculation surrounding tariffs, trade wars, and the Fed has pushed markets into a period of consolidation.  So where do we go from here?

That question is never easy to answer without the aid of a functional crystal ball, but based on the key data we track on a regular basis (see this week’s “Heat Map” for more details), we see little that would seem to portend a recession in the near future.  As markets have zigged and zagged over the past several weeks, we have been expressing to clients that from an economic standpoint, nothing much has changed.  Corporate earnings still look healthy, global growth is picking up, and new data from just over a week ago suggests that consumers are more confident now than at any point over the past 14 years.

All of this bodes well for the foundational support the markets need to continue their expansion, but it’s important to keep everything in context.  The reality is that the current bull market just celebrated its 9^th birthday, and we are likely closer to the summit than we are to the base of the mountain.  Investors are recognizing this and beginning to acknowledge that the next 5-10 years are likely to look very different than the last 5-10 years.  Given that reality, markets will likely be very sensitive to new news and speculation (like rumors about trade wars), which can lead to volatility.

A Note on Tariffs and ‘Trade Wars’
The biggest piece of economic news last week was far and away the Trump Administration’s announcement that it plans to impose approximately $50-$60 Billion worth of tariffs on Chinese imported goods in response to China’s history of strong-arming foreign companies who wish to do business there.  Global markets sold off in response to the announcement on Thursday, and that sell pressure carried over into Friday.  At this juncture, we do not see a need to change course in response to the news.  Ultimately, that trade wars have negative consequences is one of the few things that economists seem to unanimously agree upon, and both the United States and China benefit from a healthy economic relationship.  These realities provide an incentive for both sides to keep things from escalating too far.  As always, we will provide updates to our outlook if things change.

The market is so discombobulated right now that it can’t even decide what it’s afraid of.

What do we mean? When the Standard & Poor’s 500 index suffered its first correction since the beginning of 2016 last month, the cause was easily identified—a good old-fashioned inflation scare caused by a larger-than-expected increase in wages and a rapidly rising 10-year Treasury yield, which almost hit 3%.

Fast-forward more than a month, and those fears seem almost quaint. February’s payrolls print on March 9 alleviated those inflation concerns when wages rose far less than expected, but that hasn’t relieved the tension in the market, never mind the S&P 500’s 1.7% rise that day.

Consider this past week’s returns. The Dow Jones Industrial Average dropped 389.23 points, or 1.5%, to 24,946.51, while the Nasdaq Composite declined 1%, to 7481.99. The S&P 500 fell 1.2%, to 2752.01, after slipping for four consecutive days to start last week.

The funny part is that each day’s drop was caused by an apparently different reason—Special Counsel Robert Mueller’s subpoena of the Trump Organization, reports of new tariffs being planned for China, the exit of Secretary of State Rex Tillerson.

Our favorite, though, has to be the response to this past week’s retail-sales data. The number was bad—sales dropped 0.1% in February from January, its third consecutive monthly decline—and one that came despite the recent tax cuts that were supposed to get consumers spending again. The fact that the Atlanta Fed’s GDPNow forecast for first-quarter gross-domestic product growth dropped below 2% only added to the concern, and caused the 10-year Treasury yield to drop as low as 2.80%. With that, concerns about too much growth were replaced by fears there’s too little, a flip-flop worthy of a good politician.

It’s also a sign that the market has yet to recover from February’s correction. “The markets are jittery,” says Todd Lowenstein, chief equity strategist at HighMark Capital Management, who notes that investors are treating each incoming data point as the start of a new narrative.

Still, this isn’t unusual when markets are going through a corrective phase like they are now, writes Michael Shaoul, CEO of Marketfield Asset Management. That means there’s a good chance that if the market tumbles even more, it won’t be because of higher bond yields and concerns about inflation. “If a full retest of the March or February low is required, it may be accompanied by a very different set of headlines,” Shaoul explains.  Was last week just a sneak preview?

(Source: Barrons Online)

Nine years ago, the market decided it couldn’t go any lower. Now we’re still wondering just how high it can go.

On March 9, 2009, the Standard & Poor’s 500 index closed at 676.53, in what would prove to be the closing low of the financial crisis. And while the index has more than quadrupled since then, it proved that it still has some juice left in its tank.

The S&P 500 gained 3.5%, to 2786.57, last week, while the Dow Jones Industrial Average rose 3.3%, to 25,335.74, and the Nasdaq Composite climbed 4.2%, to 7560.81.

Even more impressive was the way the market earned those gains. We expected it to rise when the Trump administration’s tariffs were watered down to exempt Canada and Mexico. The rally on Friday, when the Dow gained 440.53 points, was another thing altogether. It came after Friday’s blockbuster payrolls report, with 313,000 jobs added to the U.S. economy, well above the 200,000 predicted by economists, and slightly weaker-than-expected wage growth—a combination that implies healthy growth and limited inflation pressures.

You’d expect the market to open higher with a number like that—which it did—but the trend following the 10 strongest reports since 1998 has been for the market to open up, rally a bit, and then give back most of the gains, according to Bespoke Investment Group data. That certainly wasn’t the case this time. And the fact that the data was almost the reverse of the previous month’s, which kick-started a correction with concerns of a more proactive Federal Reserve, didn’t go unnoticed.

“The market was gearing up for the worst, and when it doesn’t happen, you get 400 points in the Dow,” says Paul Hickey, Bespoke’s co-founder.

That doesn’t mean that the market is going straight up from here. Quincy Krosby, chief market strategist at Prudential Financial, notes that the concerns that have lingered over the market—inflation, rate hikes, and rising bond yields, among them—haven’t gone away, and there’s still a lot of data to come that could shake things up again.

The consumer-price index is set to be released next Tuesday, and it will be followed by the producer-price index on Wednesday. And even if wage growth was softer, job growth like February’s will eventually lead to higher wages. “This is a data-dependent market,” she says. “It will continue to feel vulnerable as inflation-related data is released.”

But vulnerable isn’t the same thing as weak. The Nasdaq Composite closed at an all-time high last week, while the S&P 500 and Dow are just 3% and 4.8%, respectively, below their own records. The Nasdaq has been given a lift by its heavy weighting to technology—the sector has gained more than 12% during the past month—and its lack of exposure to the likes of utilities and consumer staples, which have gained less than 1% during that period. But make no mistake, if the Nasdaq can do it, so can the S&P 500 and the Dow. “It’s not like other areas haven’t been moving up,” says Instinet’s Frank Cappelleri. “They just haven’t as quickly.”

Give them time.

(Source: Barrons Online)

Stocks ended the week on a strong note as the Dow Jones Industrial Average gained 348 points, or 1.4%, on Friday to finish at 25,310. The Standard & Poor’s 500 index rose 43 points, or 1.6%, in the session to end the week at 2,747, while the Nasdaq Composite was up 1.8% to 7,337.

Equity investors lately have focused on the bond market and the upward move in the 10-year Treasury note yield toward 3%. Higher bond yields—which often reflect expectations of rising inflation—have been viewed negatively, so the drop in the 10-year yield by about 0.05 percentage point on Friday, to 2.87%, provided support to stocks.

For the week, the Dow industrials added about 91 points, or 0.4%, and the S&P 500 rose 0.6%. Both indexes now have recouped more than half of what they lost during the market pullback that ended on Feb. 8. That move had left the S&P 500 about 10% below its peak of 2,873 set on Jan. 26.

(Source: Barrons Online)

Last week, the S&P 500 gained 4.3%, to 2732.22, its best showing in more than five years. Not to be left out of the fun, the Dow Jones Industrial Average climbed 1028.48 points, also 4.3%, to 25,219.38, while the Nasdaq Composite jumped 5.3% this week, to 7239.47.

Even better, the S&P 500 closed the week on a six-day winning streak, gaining 5.9%. The only problem: After a run like that, the market may not have the juice to push much higher. “This seems like it’s a bit too aggressive,” says MKM Partners strategist Michael Darda. “Anybody with a contrarian eye would say this is too much, too fast.

Market psychology could play a big part in where we go next. Investors who bought stocks on the first day of the year have gained 2.2%, and are probably not too worried. But if they chased stocks out of the gate this year, they could be sitting on losses. Some might hold on in the expectation of further gains, but others might decide to take profits. Either way, the wild ride will make everyone reconsider what they own and why they own it—and whether they still should. “Everyone has to reset,” says Instinet’s Frank Cappelleri.

More volatility would not be a surprise—or out of the ordinary. Consider: In 2017, the S&P 500 had just eight 1% moves in either direction; this year, there have already been 10, Cappelleri says. At this rate there’d be 78 1%-plus moves in 2018. While that seems unlikely, it’s not out of the question, as the rolling 12-month average of 1% moves spiked over 160 by the end of the financial crisis in 2009. “This suggests there’s a high probability that we’ll see more large moves in 2018,” Cappelleri says.

But a pickup in volatility doesn’t have to be a death knell for the bull market, he says. In 1996, a year that followed one that had been as calm and as strong as 2017, the number of 1% moves picked up, but the S&P 500 still gained 20.3%. So don’t be surprised if the market finishes higher this year.

Just don’t expect it to be easy.

(Source: Barrons Online)

So that’s what a correction feels like. Yes, it was painful, but there was a curious sensation about this one.

It’s been a long time since we’ve experienced a drop like we did last week. The Dow Jones Industrial Average tumbled 1330.06 points, or 5.2%, to 24,190.90 last week, its worst since Jan. 2016. The Standard & Poor’s 500 index slumped 5.2% to 2619.55. The Nasdaq Composite dropped 5.1% to 6874.49. On Thursday, both the S&P 500 and Dow had dropped more than 10% from their Jan. 26 high, the definition of a correction, though they made back some of those losses in a late-Friday rally.

And what a strange correction it has been. Unlike the past ones since the end of the financial crisis, this correction was caused by fears of too much growth, rather than concerns that there wouldn’t be enough. When the S&P 500 tumbled 13% from Nov. 3, 2015, through Feb. 11, 2016, it was caused by a collapse in oil prices that then spread into high-yield bonds, raising the specter that a recession was looming. Not this time. Economic data continue to come in strong—the Atlanta Fed’s GDPNow indicator estimates 4% growth this quarter—while companies continue to report strong earnings and give upbeat guidance even when the benefits of tax cuts are excluded. Even the high-yield bond market is refusing to act as if a crisis is at hand.

Sure, we can cite a litany of reasons for the correction. The market was overbought and overvalued. Investors had misjudged inflation and miscalculated how high bond yields could go. But really, we were just overdue. Too many traders had bet the market’s calm would last forever. It’s probably the most overused statistic about this market, but the S&P 500 had gone more than a year since its last drop of 5% or more.

So, a correction is what we got—and an uncomfortable one, just like it’s supposed to be. “They should be painful,” says Thomas Digenan, Head of US Intrinsic Value Equities at UBS Asset Management.

Still, the market needs a narrative—and so it’s latched on to whatever’s handy, in this case that the Fed is so far behind the curve that inflation will spike and bond yields will soar. As with many good stories, there’s a kernel of truth to this one. Inflation is picking up, bond yields are heading higher, and the Fed is behind the curve, says Richard Bernstein, chief investment officer at Richard Bernstein Advisors. Many had been reluctant to embrace that idea. Now they may have no choice. “The employment report destroyed the narrative that there would never be inflation again,” says Bernstein, who doesn’t foresee the correction becoming a bear market. “And that caused chaos at this point.”

History suggests that this correction isn’t the end of the bull market, despite the chaos. Part of that has to do with what came before the rally—a long period of what market technicians call consolidation.

From May 19, 2015, through July 11, 2016, a period that included a correction, the Dow went nowhere, explains Randy Watts, chief investment strategist at research shop William O’Neil. The next day, the benchmark hit a new high, and the Dow went on to gain 45% over the next 80 weeks.

Watts sees more similarities to a breakout that occurred in 1995. It occurred well into a bull market—just like the current one—and gains have been similar at the same period of time. And each of those initial rallies came with no hiccups—neither had even a 5% drop before their first correction. That bull market ended up running for 255 weeks, with the Dow nearly tripling during the same period. If the Dow follows that pattern, there could be more upside ahead.

Trading action suggests that the market could be close to finding a bottom. After hitting a new all-time high on Jan. 26, the S&P 500 had tumbled through its 20-day moving average a week later, and then through its 50-day on Monday. When the S&P 500 ticked below its 200-day moving average early Friday afternoon, it looked like that wouldn’t hold either. Instead, a furious rally ignited and the index finished up 1.5%. “At least it respected one technical level,” says Fundstrat technical analyst Robert Sluymer.

That doesn’t mean that the 200-day will hold again on Monday, but there’s no reason to call the end of the bull market just yet. Even Stifel Head of Institutional Equity Strategy Barry Bannister, who correctly called the correction last month, doesn’t foresee it becoming a bear for the simple reasons there’s no recession in sight.

Does that mean it’s time to rush in and buy everything in sight? No. Bannister expects a bottoming process, not a V-shaped bounce. And it might take a higher inflation print—the consumer price index is being reported on Wednesday—and a 3% yield before investors feel that the worst is over. “It could be a capitulatory moment for the stock market,” Bannister says.  Unless we’ve already had it.

(Source: Barrons Online)

Now that was a bad week—and don’t be surprised if it gets worse before it gets better.  The Dow Jones Industrial Average tumbled 1,095.75 points, or 4.1%, to 25,520.96 last week, its largest percentage decline in more than two years. The Standard & Poor’s 500 index dropped 3.9%, to 2762.13, while the Nasdaq Composite fell 3.5%, to 7240.95. Let’s just accept it—we’re in the midst of a correction, and one that was quite overdue. Don’t be surprised if the market’s major indexes decline by double digits from peaks hit just one week ago, as fear of missing out gives way to fear of staying in.

Ultimately, though, we’re betting that the pullback ends up being one to be bought, not sold—and it all goes back to economic data. For now, there’s no sign of a recession—the one thing almost guaranteed to cause a bear market—says Jason Pride, director of investment strategy at Glenmede. He notes that companies have been predicting solid earnings and sales for the rest of the year, something that should eventually support the market, too.

The selloff started last Monday, as bond yields began to rise, and kicked into high gear when Amazon.com (ticker: AMZN), JPMorgan Chase (JPM), and Berkshire Hathaway (BRK.A) announced plans to create a health-care company devoted to lowering costs. That news hit stocks across the health-care sector.

Then, on Friday, a better-than-expected payrolls report—one that contained signs of wage inflation—led to a 665.75-point decline in the Dow, as the 10-year Treasury yield rose to 2.852%, its highest since Jan. 22, 2014.

Based on recent trends, the market was desperately in need of a rest. The S&P 500 had gained 7.5% in just 18 trading days in 2018, putting it on pace to gain 158% this year. The index had gone 99 days without a drop of 0.6% or more before falling 0.7% on Tuesday. “This kind of thing was long overdue,” says Michael Darda, chief economist at MKM Partners.

Even great data aren’t enough to sustain stocks when the good news is already baked into prices. The Citigroup U.S. Economic Surprise Index—a metric designed to measure the extent to which economic data have been beating or missing expectations—had begun declining a few weeks ago from its recent peak. At the same time, momentum indicators such as the National Federation of Independent Business’ survey of small-business optimism have gotten so positive that they can’t get much better. Darda says. “It’s a bit foolhardy to jump on this very modest pullback as an immediate buying opportunity.”

Even after this past week’s decline, the S&P 500 has gone 404 days without a 5% pullback from its all-time high, says Chris Verrone, technical strategist at Strategas Research Partners. Such a drop would only put the index near its 50-day moving average at 2715.15. A 12% drop from the high would put the S&P 500 near its 200-day moving average, at 2532.41. “Put your thumb between those, and you get to where this shakes out,” says Veronne, who expects the pullback to be “unpleasant.”

After Friday’s drop, the S&P 500 still trades at 17.7 times forward earnings. A further drop “would reset the base for equities,” says Glenmede’s Pride. “A pullback like this is healthy.”

Even if it doesn’t feel like it right now.

(Source: Barrons Online)

The market is having a feel-good moment—maybe a little too good.

The Dow Jones Industrial Average gained 544.99 points, or 2.1%, to 26,616.71 last week, while the Standard & Poor’s 500 index rose 2.2%, to 2872.87. And the Nasdaq Composite climbed 2.3%, to 7505.77. All three indexes closed at all-time highs Friday. For the S&P 500, it was the 14th record high of the year, setting a record for the number of new highs in January.

And why shouldn’t the market feel good? Credit sparkling results from the likes of Intel (ticker: INTC) and Caterpillar (CAT). Fourth-quarter economic growth was lighter than expected, but strong enough, especially given that tax cuts could provide a boost in the quarters ahead. The Davos elite came away feeling relieved after President Donald J. Trump loudly proclaimed that “America is open for business,” and his administration is said to be readying a $1.7 trillion infrastructure plan that could be revealed next week. Party on, right?

That very well could be.

But there’s also a point where feeling good leads to bad behavior. U.S. gross domestic product rose at an annual rate of 2.6% during the fourth quarter, missing economists’ forecasts of 2.9%. But dig into the numbers and you see one area of major strength—consumer spending.  Not everyone is celebrating. Gluskin Sheff’s chief economist, David Rosenberg, notes that rising markets have made Americans feel wealthier, so they’ve been spending more and saving less. “This is a classic late-cycle development,” he says.

Consumers aren’t just spending money on clothes, cars, and whatever else catches their eye—they’re also buying stocks. Investors have put $24 billion into equities during each of the two most recent weeks, notes Bernstein strategist Inigo Fraser-Jenkins, a big change from 2017, when they withdrew $9 billion during the last six months of the year. That’s not worrisome—yet—but if investors buy stocks at just half that rate in the next four weeks, it would be. “We are not saying that will happen, but it quantifies how sentiment can change,” Fraser-Jenkins says.

(Source: Barrons Online)