"Simply put, the markets were looking for a reason to take a breather. :"

Portfolio Update - Febuary 2018

BRIEF INVESTMENT UPDATE ~ Feb 2018 When Good News Has Negative Consequences ..(and maybe tax reform isn't so great after all!)

So the equity markets, having been on an absolute tear since November 2016 have corrected. Finally we say! The 1100 plus drop on Monday, following a week of nearly 4% losses, essentially wiped out all the gains of January. But it had to happen sometime. More importantly, it needed to happen. Since the passage of the highly stimulative tax package, inflation pressures have come to the fore, and steam needs to be let off. Yes, we see this as a good thing.

As we pointed out in the Newsletter_2018_January, the economy has been running on all cylinders, and improving wages were finally making their way into the economy with unemployment touching 4% and wages growing nearly 2.7% in 2017. The S&P 500 was trading at very high prices. While economists were seeing whiffs of inflation, the markets were so dazzled by the soon-to-be-supercharged economy, and market fears so nonexistent, that a reckoning was inevitable: it was just a matter of when and what the trigger would be. The 2.9% January annualized wage gains just reported, along with associated increases in bond yields this past week, did the trick.

Simply put, the markets were looking for a reason to take a breather.

So in the space of one week, the markets went from a glass overflowing to one half-empty. The risks, in our minds were and remain as plain as day, quickly become the markets' obsessions: inflation, high equity and bond market valuations, geopolitical risks, and uncertainty about the new Federal Reserve Chairman and Board.

Inflation, however, is suddenly the most pressing concern on investors' minds at this moment. Even though inflation has been near historically low levels since the Great Recession, in an economy already running at nearly full capacity increases in wages stand to be the tipping factor to force prices to consumers and businesses up. But after years of stagnant wage growth here and abroad, with labor markets tightening, wages were and are destined to rise. Ironically, this is precisely what we've all been craving for, what a sustainable economy needs. Higher wages lead to greater consumer spending, which drives the economy.

But in a glass-is-half-empty world, this wage growth, and resulting price increases means a Federal Reserve and other central banks, ever-vigilant about inflation, to put the kibosh on growth by slamming the economic brakes. Throw in higher global energy and commodity prices and a weakening dollar (making imported goods more expensive for consumers), and you've stoked the fears of an inflation-fear-based economic downturn.

Will it happen? Probably not. Central banks are expected to have 3 or so modest funds rate hikes in 2018, and the new Fed Chair, Jerome Powell - greeted with a 4% market drop in his first day at the office - will have to be nimble and careful to manage expectations, create enough tightening of monetary supply to inhibit inflation but not negatively impact healthy growth. We think he can do it, at least for this year.

Why else the radical price swings? Computerized institutional selling of the billions of dollars of new world of ETF's - exchange traded funds and notes - which hold baskets of stocks, certainly have added to extreme market swings over the last 15 years. What begins as a modest sell-off by a few trading firms suddenly turns into a 1600 point plunge (as seen Monday, for example) as a cascade of pre-programmed computers pile on sell orders in nanoseconds. The only good news to this is that over a few days, often the same day, those same programs jump back in with purchases, and over the time prices normalize again, with the regular investor left with whiplash.

Complacency on the part of investors has also been a big problem. With markets on a mostly steady rise since 2009, investors are just not used to seeing volatility. The volatility index - the VIX - has been table flat for years. Yet when things perceived as negative happen (as in 2015, when China reported lower growth expectations), the markets reacted violently. Drops of 3% or more have happen 15 times since 2010, but each time investors quickly shook it off and quickly went back in. This is not particularly healthy - in our minds, it would be better if investors were a bit more cautious - the preferred "wall of worry" that goes with a slow and sustained market rally. This could help slow the steep run-ups in market prices such as we've seen of late that only exacerbate corrections.

Time to Worry? We think not, at least not for the near and mid-term for equities, although we expect to see continued choppiness for the foreseeable future. The market's fundamentals are extremely sound: corporate earnings are great and companies are awash in cash, key components of the economy are strong - construction, manufacturing, services, nearly full employment, strong global economy and relatively low inflation. We think this equity correction will be short lived.

The exception, and we're looking out for this, is if markets drop so precipitously that consumer and business confidence drops, and this cycles through the global economies as well.

Bonds, however, are and will continue to be under pressure with rising interest rates. (Increases in interest rates lower the value of existing bonds which are offering lower yields to investors than newer issuances.) We are keeping durations of bond portfolios short, looking to purchase bonds as yields rise, and focusing on bonds that can rise with inflation (e.g. TIPS, floating rate).

Longer term, however, things may not look quite as rosy for equities. Inflation, too-quickly rising bond prices, lack of productivity to match rising wages, a dollar that continues to weaken and an increasing trade deficit are real concerns. The massive addition to the budget deficit from the new tax law and possible infrastructure spending, are similarly disconcerting. All these factors could result in an economic slowdown, and/or introduce inflation pressures that results in central bank actions which would slow economic growth.

In the interim, however, we remain highly vigilant. Equity investors should see this as an opportunity to monitor their own responses to the negative stock headlines, however. For investors with long-term time horizons, this may also be an opportunity to invest. We see continued volatility ahead, however.

In Sum:

  • Equity markets have had extreme run-up since Dec 2016 (up nearly 40%), and were over-priced
  • Recent tax legislation threw gasoline on an already strong economy
  • Recent reports of increasing wages, sparked inflation fears, which provided key trigger for markets to correct
  • Near- and mid-term economic fundamentals remain strong here and globally
  • Major risks: inflation, over-priced stock and bond markets, geopolitical, new Federal Reserve
  • Markets tend to correct after rapid gains
  • Peace,

    Ron Stein, CFP

    Good Harvest Financial Group


    Disclaimer: each investor has different needs. The information herein should not be used to direct investment decisions without assistance. No guarantees can be made or implied in the above information.